Inventory Investment: Subject-Matter, Reasons and Model

Let us make an in-depth study of the Inventory Investment. After reading this article you will learn about: 1. Subject-Matter of Inventory Investment 2. Reasons for Holding Inventories 3. The Acceleration Model of Inventories.

Subject-Matter of Inventory Investment:

Although inventory investment is a very small part of total business investment, it is of considerable importance to the economy of a country because fluctuations of such investment causes business cycles.

That investment is the most volatile component of GDP is true. But it is not the whole truth. In a brief recession, more than 50% of the fall in investment spending of the firms is due to a sharp decline in inventory investment.

Inventory investment tends to be closely related to changes in production. When higher levels of output are being produced, there are more goods in the pipeline. Filling up the pipeline to the higher level requires more inventory investment.

Consequently, years of rapid GDP growth tend to be years of high inventory investment. This is an important place where the acceleration model is in operation, to which we turn in the next section of this chapter.

Reasons for Holding Inventories:

Business firms hold different types of inventories such as finished goods, raw materials, semi-finished (intermediate) goods (called goods-in-process or work-in-progress).

Four main reasons for holding inventories are:

1. Intertemporal production smoothing:

Most firms find it convenient to maintain a .steady level of production even in the face of fluctuating demand. Production fluctuations in the face of fluctuating demand are not always warranted. When sales are low, a firm is left with unsold stocks which are put into inventory.

When sales are high, the firm first reduces its inventories. So its produces less than its sales level. This motive for holding inventories is known as smoothing out of the level of production over time.

2. Inventories as productive capital:

Inventory holding of raw materials is necessary to avoid temporary suspension of production. Manufacturing firms keep inventories of spare parts to prevent the stoppage of work when a machine suddenly breaks down.

Thus the volume of output which a firm can produce depends on the stock of inventories its holds. In this sense inventories can be treated as a factor of production. This is known as the precautionary motive for holding inventories, since inventories act as a hedge against uncertainty.

3. Stock-out avoidance:

Inventory holding conduces to efficient operation of a firm. Inventory of finished goods is held to avoid loss of potential profit. So inventories are held to avoid running out of stocks in a period of unexpectedly high demand. If demand exceeds production and there are no inventories, some business is lost to rivals.

This also leads to loss of goodwill, which is likely to affect future sales and profitability, apart from loss of current sales and profits. This stock-out avoidance is an important motive for holding inventories by publishers of textbooks.

4. Linked processes:

In case of production systems involving several linked process inventories act as the balancing factor and not just as a buffer stock. In such industries unless certain components and spare parts are produced, the next stages of the production process cannot start.

In such situations where a product such as a motor car is only partly produced, its components are counted as part of the automobile assembly plant’s inventory. For example if sufficient numbers of car chasis are not manufactured, some steel, glass, paint, and tyres and tubes will become useless. Thus inventory of chasis can be taken as a factor of production without which finished cars cannot be produced.

The Acceleration Model of Inventories:

Inventories are proportional to a firm’s output. This relation is captured by a model called the acceleration model. The model reasons (proposes) that when output is high, producing units need more raw materials and finished goods on hand and they have more goods-in- process (or semi-finished goods also).

In the upswing of the business cycles, when consumer demand is high retailers place in more orders with the manufacturers. Thus if N is the economy’s stock of inventories and Y is the output, we have

N = βY

where β is the proportionality factor. It shows how much inventory firms are planning to hold as a proportion of output.

Inventory investment I_i is the change in the stock of inventories ΔN. Thus we have

I_i. = ΔN = βΔY

The main prediction of the acceleration model is that inventory investment is proportional to the change in GDP. In the expansionary phase of the business cycle when output is rising, firms plan to hold a large amount of inventory.

So inventory investment is high. In the contractionary phase of the business cycle when output falls, firms want to hold a small amount of inventory. As they run down their inventories, inventory investment becomes negative.

The name ‘acceleration’ model is derived from the fact that ΔY is the ‘acceleration’ of production. If Y (the rate of output) is high but is not increasing there will be no acceleration of investment. This means that inventory investment depends on the phase of the business cycle, i.e., whether the economy is speeding up or slowing down.

The acceleration effect is very strong for inventory investment, because lags are less important for inventories than for fixed investment. The acceleration model explains a large proportion of the movements in investment. It partly accounts for the close association between investment and GDP.