Demand Uncertainty, Inventory, and the Cost Structure

Building on Banker, Byzalov, and Plehn-Dujowich’s (2014) congestion cost theory, we model firms’ tradeoff between rigid cost structures and high inventory levels in reducing congestion costs caused by uncertain demand. We show that more inventory results in lower cost rigidity, while the effect of cost rigidity on inventory is theoretically ambiguous. Using a large sample of U.S. manufacturing firms, we empirically investigate the dynamic interdependence between the cost structure and inventory choices. Our results reveal that cost rigidity and inventory negatively affect each other, suggesting that they work as substitutes in tackling demand uncertainty. Further analysis shows that the costs of fixed inputs and carrying inventory influence the inventory-cost structure tradeoff in a way consistent with our model predictions