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According to the production-smoothing buffer stock model, inventories of a

firm’s products allow it to supply unexpected demand without having to adjust

Output immediately. When costs per additional unit produced are increasing,

using inventory to smooth production is efficient as long as the savings from not

adjusting production exceed the cost of holding inventory. Inventory acts as a

buffer stock, absorbing increases or decreases in demand while production

remains relatively steady.

If firms are smoothing production, then sales should vary more than

production. If inventories are used as a buffer stock, then high-frequency

changes in inventory should be in the opposite direction to sales. Empirical

research using aggregate data daes not confirm this expectation, however;

production varies more than sales, and changes in inventory and sales tend to

vary in the same direction. Thus either the production-smoothing buffer stock

model is incorrect, or other factors are preventing empirical confirmation of the

smoothing effect.

Most of the research that finds contradictions of production smoothing uses

seasonally adjusted aggregate data concerning inventory and sales. It is possible

that firms actually do use inventory to smooth production, but the research has

failed to detect signs of this activity because the data are too highly aggregated

over many firms. But even research at the level of individual companies has

failed to confirm the model.

Manufacturers and retailers tend to look askance at gray markets, where products are sold at cut-rate prices outside their authorized distribution channels. Manufacturers fear that gray markets will undercut margins and tarnish brand names. Retailers fear that they will siphon away customers and erode prices.

A new study indicates, however, that gray marketing actually benefits manufacturers and retailers in markets that meet two criteria: first, sharp differences exist in consumers' price sensitivity; second, large numbers of consumers are price-insensitive. In such markets, the low prices of the gray market will attract the most price-sensitive customers. The authorized channels will then compete only for the remaining customers—those who are insensitive to price but sensitive to service.

When that happens, the structure of competition and the economics of the market shift. The authorized retailers, freed from having to cater to the bargain hunters, can raise their prices and focus on service. If the concentration of price-insensitive shoppers is high enough, the resulting increase in prices will more than offset the loss of sales to the bargain hunters. The margins and profits of the authorized retailers will increase, and manufacturers will, as a result, be able to boost their wholesale prices.