Equilibrium Adjustment with Endogenous Information and Inventories

Abstract

The paper analyzes the interaction of information acquisition and inventory flexibility with industry adjustment to imperfectly perceived cost and demand disturbances. Improved information about disturbances reduces the extent to which disturbances are unperceived and dampens the use of inventories. Reduced inventory flexibility induces firms to devote more resources to acquiring information about disturbances. The analysis demonstrates how equilibrium price and output adjustment depend endogenously on the degree of inventory flexibility and other structural parameters influencing the acquisition of information. In this paper we analyze how endogenous information acquisition and inventory flexibility influence price and output adjustment in a competitive industry. We focus on the potential substitutability of information acquisition for inventory flexibility when disturbances are imperfectly perceived by individual firms. The analysis highlights the general issue of how market adjustment depends on structural parameters that influence agents' incentives to acquire information. There are several reasons why information acquisition may play a role in market adjustment. First, the rapid development of information technology has enabled firms to gather and process data relevant to production and sales decisions from a greater number of external and internal sources. This trend has reduced the costs of forecasting and monitoring factors influencing production and demand conditions for the individual firm relative to those of its competitors, as well as for the industry as a whole. In particular, it has permitted quicker awareness of changing customer demand as well as greater control of the flow of inputs and intermediate goods during the production process. This implies that the resources devoted to information acquisition and processing have come to play an important role in firm decisions.2 Second, improved information about demand and cost conditions may affect the function of inventories. Inventory adjustment allows a firm's production costs to be smoothed in response to anticipated movements in demand and costs and to be buffered against unanticipated disturbances (see Ashley and Orr 1985). Thus,