Introduction
The inventory-based theory of price stickiness which was pioneered by Alan Blinder in 1982 proposes that firms use stock levels as a primary buffer against demand fluctuations, choosing to let inventory accumulate or deplete rather than continuously adjusting prices. That is, instead of treating price as the sole market-clearing mechanism, firms treat inventory as a shock absorber.
Price responsiveness changes depending on where a firm sits within its inventory cycle:
- High-Inventory Phase (Demand Shortfall): When demand drops unexpectedly, inventory builds up above target levels. Rather than immediately cutting prices risking brand erosion or price wars, firms absorb the excess stock and slow down production. Prices remain sticky downward as long as carrying costs are manageable.
- Low-Inventory Phase (Stockout Danger): As inventory drops below target levels, the probability of stockout rises. Once stock falls to a critical threshold where carrying costs are outweighed by stockout costs, price stickiness weakens, and firms raise prices upward to ration remaining inventory.
- Target Inventory-to-Sales Ratios: Firms maintain a target ratio of inventory to sales. Small-to-moderate demand shocks that keep inventories within an acceptable band around this target result in zero price changes. Prices only adjust when inventory deviations breach these bands.
Key Academic Literature
Alan Blinder (1982, 1991) showed that when production costs are convex (it is expensive to rapidly scale output up and down) and holding costs are modest, firms rationally prefer to keep prices smooth over business cycles and let inventory do the balancing work.
Reagan (1982) formalized asymmetric pricing in inventory models. She showed that inventory availability buffers downward price movements during recessions, but capacity/stockout constraints force upward price flexibility during expansions.
Bils and Kahn (2000) and Kryvtsov and Midrigan (2013) introduce integrated inventory dynamics into modern business cycle models, showing that targeted inventory behavior propagation explains why prices remain sticky across micro-level goods and macro aggregate economic shocks.
Impact on Transfer Pricing
Consider the identity for sales and inventory accumulation given by:
\quad
(1)\qquad
s_{t}=q_{t}+I_{t-1}-I_{t}where:
- q_{t} = total quantity produced at time t
- s_{t} = total quantity sold at time t
- I_{t} = inventory at end of period t
- I_{t-1} = inventory at the beginning of the period t
Consider also the target ratio for inventories given by z, where:
\quad
(2)\qquad
\frac{I_{t}}{p_{t}s_{t}}=z+e_{t}where p_{t} is price at period t. We assume that p_{t} is sticky or unchanged for t from 0 to T at p.
Let’s consider the operating profit function P for a firm given by:
\quad
(3)\qquad
P_{t}=p\left(q_{t}+I_{t-1}-I_{t}\right)-F-cq_{t}-d\left(\frac{I_{t}+I_{t-1}}{2}\right)\quad
(4)\qquad
P_{t}=ps_{t}-F-c\left(s_{t}+I_{t}-I_{t-1}\right)-d\left(\frac{I_{t}+I_{t-1}}{2}\right)where F is the fixed cost of production, c is the marginal cost of production and d is the carrying cost of inventory. Rearranging:
\quad
(5)\qquad
P_{t}=-F+ps_{t}\left(1-\frac{c}{p}-c\left(\frac{I_{t}}{ps_{t}}-\frac{I_{t-1}}{ps_{t}}\right)-d\left(\frac{I_{t}+I_{t-1}}{2ps_{t}}\right)\right)Approximating, since:
\quad
(6)\qquad
s_{t-1}\approx s_{t}\quad
(7)\qquad
OP_{t}=-F+R_{t}\left(1-\frac{c}{p}-c\left(e_{t}-e_{t-1}\right)-dz-d\left(\frac{e_{t-1}}{2}+\frac{e_{t}}{2}\right)\right)and rearranging:
\quad
(8)\qquad
OP_{t}=-F+R_{t}\left(1-dz-\frac{c}{p}\right)+R_{t}\left(e_{t-1}\left(c-0.5d\right)-e_{t}\left(c+0.5d\right)\right)where R is revenue.
Conclusion
Several important conclusions follow:
- If inventories are always at target level, operating profitability P and R are on a straight line since e_{t-1}=e_{t}=0.
- Any departures from the straight line are due to inventory cycle which feeds into the regression analysis.
- To obtain a complete picture, the analyst needs to regress on the time period representing a complete cycle of inventory for each firm.
- The error term is heteroscedastic and therefore OLS with HC3 errors is advised.
References
Alan Blinder, “Inventories and Sticky Prices: More on the Microfoundations of Macroeconomics,” The American Economic Review, Vol. 72, No. 3, pp. 334–348
Alan Blinder and Louis Maccini, “Taking Stock: A Critical Assessment of Recent Research on Inventories”, Journal of Economic Perspectives, Vol. 5, No. 1, pp. 73–96
Patricia Reagan, “Inventory and Price Behavior”, The Review of Economic Studies, Volume 49, Issue 1, pp. 137–142
Mark Bils and James Kahn, “What Inventory Behavior Tells Us about Business Cycles”, American Economic Review, Vol. 90, No. 3, pp. 458–481
Oleksiy Kryvtsov and Virgiliu Midrigan, “Inventories, Markups, and Real Rigidities in Menu Cost Models”, The Review of Economic Studies, Vol. 80, Issue 1, pp. 249–276