5 - 1

Copyright 2009 by R. S. Pradhan. All rights reserved.

Welcome to the session
on
Estimates of Inventory Demand
by Nepalese Corporations

Research in Nepalese Finance
5 - 2
Copyright 2009 by R. S. Pradhan. All rights reserved.
Estimates of Inventory Demand by Nepalese
Corporations
Regressions one year lagged sales on
inventories produced the following results:
Empirical results:
ln Y
t
= 0.33 + 0.68 ln S
t-1
(9)
(12.62*)
R-bar square = 0.64, F = 159.32

ln Y
t
= 1.85 + 0.65 ln S
t-1
0.68 ln i
t
(10)
(11.97*) (2.37*)
R-bar square = 0.658, F = 86.67
5 - 3
Copyright 2009 by R. S. Pradhan. All rights reserved.
Regressions of current year sales on inventories
produced the following results:
ln Y
t
= 0.33 + 0.69 ln S
t
(11)
(12.57*)
R-bar square = 0.638, F = 157.98
ln Y
t
= 1.99 + 0.65 ln S
t
0.76 ln i
t
(12)
(12.07*) (2.67*)
R-bar square = 0.662, F = 88.07
The partial adjustment model results:
ln Y
t
=0.78+0.08 ln S
t-1
0.43 ln i
t
+0.85 ln Y
t-1
(13)
(2.62*) (2.27*) (15.23*)
R-bar square = 0.889, F = 238.55
xxx
5 - 4
Copyright 2009 by R. S. Pradhan. All rights reserved.
Estimates of Inventory Demand by Nepalese
Corporations
Statement of the problem
There is no controversy as to the fact that
target inventory level is a function of expected
sales as indicated by almost all the earlier
studies on the demand for inventories by firms.
The controversy arises as to the presence of
economies of scale in inventory holdings, the
cost of capital and other effects on inventory
demand, and the adjustment speed of actual
inventory level with target inventory level.
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Copyright 2009 by R. S. Pradhan. All rights reserved.
Among others, Irvine (1981 May, 1981
September) and Akhtar (1983) clearly indicated
economies of scale in inventory holding.
However, some of the inventory demand
functions of Lieberman (1980) showed
diseconomies of scale.
Much of the controversies, however, exist with
the cost of capital effect on inventory demand.
Theoretically, the level of inventories of a firm
would depend on the costs associated with
holding inventories.
However, the earlier studies on the demand for
inventories did not present unanimous findings.
5 - 6
Copyright 2009 by R. S. Pradhan. All rights reserved.
Liu (1963, 1969), Kuznets (1964), Lieberman,
Irvin and Akhtar reported statistically significant
effect of capital costs on the demand for
inventories.
However, Robinson (1959), Lovell (1961, 1964),
Burrows (1971), Joyce (1973), and Maccini and
Rossana (1981) did not report the same.
Controversy also exists with respect to
coefficients of adjustment.
Among others, Burrows, Maccini and Rossana
and Irvine observed faster adjustment between
actual inventories and target inventories.
While Lovell and Grossman (1973) observed
slow speed of adjustment.
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Copyright 2009 by R. S. Pradhan. All rights reserved.
Thus, there is no unanimous finding with
respect to:
- economies of scale in inventory holdings,
- capital costs effect on inventory demand, &
- adjustment coefficient of actual inventories to
desired inventories.
It has therefore become difficult to support
one view or another as there exists no such
studies in the context of Nepal.
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Copyright 2009 by R. S. Pradhan. All rights reserved.
I. The Model
The decision about the aggregate level of
inventories to be held may be regarded as
subject to the constraint of wealth and the cost of
holding inventories.
As a first approximation to the theory, the
function may be written as,
Y* = f (S, i) ... (1)
Where, Y* is real desired level of inventories,
S is the real desired wealth defined in terms of
sales, and i is the holding cost.
In an empirical investigation, expression (1)
takes the form.
Y* = k S b
1
i b
2
e
u
(2)
Where, the error terms e
u
is assumed to be
independently and normally distributed.
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Copyright 2009 by R. S. Pradhan. All rights reserved.
Taking the natural logarithm of the expression
(2) gives,
ln Y* = ln k + b
1
ln S + b
2
ln i + U
i
(3)
It is assumed that the desired level of
inventories (Y*) is equal to its actual level (Y).
Thus, the equation to be estimated is,
ln Y = b
0
+ b
1
ln S + b
2
ln i + U
i
(4)
Where, b
0
is constant, b
1
and b
2
are elasticities
of Y with respect to sales and holding costs
respectively.
The above model assumes the following
reasonable a priori hypothesis:
y/s > 0, & y/i < 0 (5)
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Copyright 2009 by R. S. Pradhan. All rights reserved.
While estimating the above equations,
inventories and sales have been deflated by using
a deflator.
The empirical analysis also takes into account a
partial adjustment or flexible accelerator model of
inventory behaviour.
This model hypothesizes that each corporation
has a desired target level of inventories, and that
each corporation, finding its actual level of
inventories not equal to its desired level, attempts
only a partial adjustment towards the desired
level within any one period.
The partial adjustment model is used to
indicate the speed with which corporations adjust
their actual level to desired level of inventories.
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Copyright 2009 by R. S. Pradhan. All rights reserved.
The partial adjustment model is stated as,
ln Y
t
=c
0
+c
1
ln S
t
+c
2
ln i
t
+(1 ) ln Y
t-1
+U
t
(7)
Where, =rate of adjustment coefficient, c
1
& c
2

are the short run elasticities of inventories with
respect to sales & interest costs respectively.
Long run elasticities with respect to sales &
interest costs are b
1
and b
2
.
Since c
1
= b
1
and c
2
= b
2
,
b
1
= c
1
/ & b
2
= c
2
/ (8)
Short-term interest rate of commercial banks
has been used as a proxy for holding cost of
funds invested in inventories.
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Copyright 2009 by R. S. Pradhan. All rights reserved.
Empirical Results
The regression of inventories on sales
produced the following result:
ln Y
t
= 0.33 + 0.68 ln S
t-1
(9)
(12.62*)
R-bar square = 0.64, F = 159.32
The elasticity of sales with respect to
inventories is less than unity showing evidence of
economies of scale
It thus supports the findings of Akhtar and
Irvine and contradicts unitary or more than
unitary sales elasticities noticed in some of the
equations of Lieberman.
Equation (9) ignores the opportunity cost of
funds invested in inventories.
5 - 13
Copyright 2009 by R. S. Pradhan. All rights reserved.
The regression of inventories on sales and
capital cost produced the following:
ln Y
t
= 1.85 + 0.65 ln S
t-1
0.68 ln i
t
(10)
(11.97*) (2.37*)
R-bar square = 0.658, F = 86.67
Interest rate coefficient is statistically
significant with a theoretically correct sign.
Previously, this coefficient used to be either
positive or not significant in many of the studies
on the demand for inventories by firms.
The highly significant coefficient of sales is
consistently less than unity in equation (10).
It shows evidence suggesting economies of
scale in inventory holding.
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Copyright 2009 by R. S. Pradhan. All rights reserved.
This finding supports the conclusions of Liu,
Kuznets, Lieberman, Irvine and Akhtar.
And contradicts with the results of Robinson,
Lovell, Jon Joyce, Burrows, and Maccini and
Rossana.
Holding the sales constant, it indicates that a
one percentage point increase in capital cost
leads on an average to about a 0.68 percent
decline in inventory investment.
Similarly, holding the capital cost constant, a
one percentage point increase in sales leads on
an average to about 0.65 percent increase in
inventory investment.
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Copyright 2009 by R. S. Pradhan. All rights reserved.
So far the estimated results are based on
previous year sales (S
t-1
).
These results may not be directly comparable
to results of some of the earlier studies which
used current year sales (S
t
) as an explanatory
variable so long as the results are similar.
Hence, it is felt necessary to use S
t
instead of
S
t-1
.
The regressions of Y
t
on S
t,
and on S
t
and i
t

produced the following results:
ln Y
t
= 0.33 + 0.69 ln S
t
(11)
(12.57*)
R-bar square = 0.638, F = 157.98
ln Y
t
= 1.99 + 0.65 ln S
t
0.76 ln i
t
(12)
(12.07*) (2.67*)
R-bar square = 0.662, F = 88.07
5 - 16
Copyright 2009 by R. S. Pradhan. All rights reserved.
The use of S
t-1
or S
t
produced similar results.
After assessing the scale effect and cost of
capital effect on inventory demand, we now
estimate the partial adjustment model of
inventory demand.
The pooled estimate of the partial adjustment
model is as follows:
ln Y
t
= 0.78 + 0.08 ln S
t-1
0.43 ln i
t
+ 0.85 ln Y
t-1
(13)
(2.62*) (2.27*) (15.23*)
R-bar square = 0.889, F = 238.55
In equation (13), the coefficient of the lagged
dependent variable has been observed to be 0.85.
Since the coefficient of lag ln Y
t
is equal to 1
minus the adjustment coefficient (1-), the
adjustment coefficient is equal to 0.15.
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Copyright 2009 by R. S. Pradhan. All rights reserved.
The speed of adjustment between desired and
actual inventories as implied by this value is
much slower, about 15 percent.
The result therefore contradicts the high speed
of adjustment observed by Burrows, Maccini and
Rossana, and Irvine.
In the partial adjustment model, the estimated
coefficients of the independent variables are
equal to the elasticities of these variable times the
adjustment coefficient, e.g., c
1
= b
1
& c
2
= b
2
,
b
1
=c
1
/ & b
2
=c
2
/. These coefficients are thus
.08/.15=0.53 for sales & .43/.15=2.87 for interest
rate which again support the conclusions drawn
earlier.
The capacity utilization as a significant variable
affecting the demand for inventories is doubtful.
THANKING YOU