Production and Inventory Dynamics Under Ambiguity Aversion

Abstract

We propose a production-cost smoothing model with Knightian uncertainty and ambiguity aversion to study the joint behavior of production, inventories, and sales. Our model can explain four facts that previous studies find difficult to account for simultaneously: (i) the high volatility of production relative to sales, (ii) the low ratio of inventory-investment volatility to sales volatility, (iii) the positive correlation between sales and inventories, and (iv) the negative correlation between the inventory-to- sales ratio and sales. We find that the stock-out avoidance