Inventories and Backlogs: An Analysis of The Business Cycle

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This project concerns an important and interesting topic, namely the determinants of production inventories and backlogs. For many years there has been in economic research the realization that inventories play a central role in changes in the business cycle. Even though the level of quarterly inventory investment is, typically, less than one percent of GNP, changes in inventory investment often are important at cyclical turning points. In fact, empirical evidence shows that changes in inventory investment account for nearly one half the total change in business activity for most of the eight post- World War II recessions in the U.S. Data is limited for the pre-World War II era, but indications are that the same relationship holds. Thus analyzing changes in inventories might be a good method to predict wide shifts in business activity. In spite of the obvious importance of knowing why firms accumulate inventories, there is little unambiguous evidence as to whether firms are avoiding unforeseen fluctuations in production costs or in sales of final products when they increase inventories. In addition, firms can accomplish the same goals by accumulating backlogs of orders. Thus the models most often used to study inventory accumulation, namely the production smoothing models, are inherently flawed. This project studies production inventories from the standpoint of firms' avoiding the costs of backlog orders. These costs can in general be greater than those of simply holding inventories, since having unfilled backlog orders incurs bad customer relations. Technically, Professor West estimates structural models to test whether backlog costs are numerically and statistically significant. A production lag is assumed, and a within period backlog occurs if orders exceed production at the beginning of each production period. He also does stochastic numerical simulations of the nonlinear model, to explain the observed facts about inventories, in particular whether the model predicts that negative demand shocks, that is recessions, induce inventory liquidations of the sort observed in the post-World War II period.