How importers hedge demand uncertainty through dual sourcing and safety inventory

Abstract

We develop a dynamic model of inventory and trade to study how an importer may hedge demand uncertainty when importing involves an order lead time. We show that when the import cost is low, the importer optimally holds safety inventory (i.e., inventory of imported goods in excess of expected sales) to deal with demand surges. As the import cost rises, the firm switches from safety inventory to dual sourcing (i.e., to covering demand surges through quickly available but expensive domestic supplies while using imports for base-level demand). The endogenous adjustment of the hedging strategy implies that the volume of inventory and imports falls by more than expected sales as the import cost rises. This effect is magnified by an increase in demand uncertainty.