PRODUCTION SMOOTHING IN THE LINEAR-QUADRATIC INVENTORY MODEL

Contrary to popular belief, the linear quadratic inventory model does not imply that, in response to demand shocks, output is always less variable than sales. When demand shocks are not anticipated, and without this assumption it is hard to see why firms should hold inventories in the first place, it is shown that output can be more variable than sales, even when the only shocks are demand shocks, and the inventory target is not a rising function of sales. The variance of output will typically exceed that of sales when the firm's marginal cost curve is fairly flat.