No Such Thing as a Free Lunch: Principles of Economics (Part 157)

Doing the same thing over and over again and expecting different results when, in fact, the results never change, is one definition of insanity. That goes for economics, too.

Lawrence Kudlow

Household and Firm Behavior in the Macroeconomy: A Further Look

(Part G)

by

Charles Lamson

Inventory Investment

We now turn to a brief discussion of the inventory investment decision. This decision is quite different from the plant and equipment investment decision.

The Role of Inventories Recall the distinction between a firm's sales and its output. If a firm can hold goods in inventory, which is usually the case unless the good is perishable or unless the firm produces services, then within a given period it can sell a quantity of goods that differs from the quantity of goods it produces during that period. When a firm sells more than it produces, its stock of inventories decreases; when it sells less than it produces, its stock of inventories increases.

Stock of inventories (end of period) = stock of inventories (beginning of period) + production - sales

If a firm starts a period with 100 umbrellas in inventory, produces 15 umbrellas during the period, and sells 10 umbrellas in the same interval, it will have 105 umbrellas (100 + 15 - 10) in inventory at the end of the period. A change in the stock of inventories is actually investment because inventories are counted as part of a firm's capital stock. In our example, inventory investment during the period is a positive number, 5 umbrellas (105 - 100). When the number of goods produced is less than the number of goods sold, such as 5 produced and 10 sold, inventory investment is negative. 

The Optimal Inventory Policy We can now consider firms' inventory decisions. Firms are concerned with what they are going to sell and produce in the future, as well as what they are selling and producing currently. At each point in time, a firm has some idea of how much it is going to sell in the current period and in future periods. Given these expectations and its knowledge of how much of its good it already has in stock, a firm must decide how much to produce in the current period.

Inventories are costly to a firm because they take up space and they tie up funds that could be earning interest. However, if a firm's stock of inventories gets too low, The firm may have difficulty meeting the demand for its product, especially if demand Increases unexpectedly. The firm may lose sales. The point between too low and too high of stock of inventory is called the desired, or optimal, level of inventories. This is the level at which the extra cost (and lost sales) from decreasing inventories by a small amount is just equal to the extra game (in interest revenue and decreased storage costs) .

A firm that had no costs other than inventory costs would always aim to produce in a period exactly the volume of goods necessary to make its stock of inventories at the end of the period equal to the desired stock. If the stock of inventory fell lower than desired, the firm would produce more than it expected to sell to bring the stock up. If the stock of inventory grew above the desired level, the firm would produce less than it expected to sell to reduce the stock.

There are other costs to running a firm besides inventory costs. In particular, large and abrupt changes in production can be very costly because it is often disruptive to change a production process geared to a certain rate of output. If production is to be increased, there may be an adjustment cost for hiring more labor and increasing the capital stock. If production is to be decreased, there may be an adjustment cost in laying off workers and decreasing the capital stock.

Because holding inventories and changing production levels are both costly, firms face a trade-off between them. Because of adjustment costs, a firm is likely to smooth its production path relative to its sales path. This means a firm is likely to have its production fluctuate less than its sales, with changes in inventories to absorb the difference each period. However, because there are incentives not to stray too far from the optimal level of inventories, fluctuations in production are not eliminated completely. Production is still likely to fluctuate, just not as much as sales fluctuate.

Two other points need to be made here. First, if a firm's stock of inventories is unusually or unexpectedly high, the firm is likely to produce less in the future than it would have, to decrease its high stock of inventories. In other words, although the stock of inventories fluctuates over time because production is smoothed relative to sales, at any point in time inventories may be unexpectedly high or low because sales have been unexpectedly low or high. An unexpectedly high stock will have a negative effect on production in the future, and an unexpectedly low stock will have a positive effect on production in the future.

An unexpected increase in inventories has a negative effect on future production, and an unexpected decrease in inventories has a positive effect on future production.

Second, firms do not know their future sales exactly. They have expectations of future sales, and these expectations may not turn out to be exactly right.

This has important consequences. If sales turn out to be less than expected, inventories will be higher than expected, and there will be less production in the future. Furthermore, future sales expectations are likely to have an important effect on current production. If a firm expects its sales to be high in the future, it will adjust its planned production path accordingly. Even though a firm smoothes production relative to sales, over a long time it must produce as much as it sells. If it did not, it would eventually run out of inventories. 

The level of a firm's planned production path depends on the level of its expected future sales path. If a firm's expectations of the level of its future sales path decrease, the firm is likely to decrease the level of its planned production path, including its actual production in the current period. Current production depends on expected future sales.

Because production is likely to depend on expectations of the future, Animal spirits may play a role. If firms become more optimistic about the future, they are likely to produce more now. John Maynard Keynes's view that animal spirits affect an investment is also likely to pertain to output.

A Summary of Firm Behavior

The following factors affect a firm's investment and employment decisions:

• Wage rate and cost of capital (the interest rate is an important component of the cost of capital)

• Firms' expectations of future output

• Amount of excess labor and excess capital on hand

The most important points to remember about the relationship between production, sales, and inventory investment are:

• Inventory investment---that is, the change in the stock of inventories---equals production minus sales

• An unexpected increase in the stock of inventories has a negative effect on future production

• Current production depends on expected future sales 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 620-622*

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