How firms (often irrationally) adjust to major disruptive events

Some (partly unexpected) firm responses to the 2011 Japanese earthquake

The trio of researchers decided to address this gap of knowledge. “Understanding inventory and flexibility patterns will allow us to explore their economic sustainability, drivers, and downsides and simply provide better guidance to industries,” they write. 

Using the specific, geographically well-defined event of the 2011 Japanese earthquake as a natural experiment, they carried out a study of more than 13,000 manufacturing firms between 2004 and 2007.

What they found is that affected firms appeared to have increased their inventory levels and, for a shorter period, their volume flexibility. This first finding was somewhat unexpected since, write the authors, “the development of long-term inventory buffers is economically impractical.” This general assumption is supported by their post hoc analysis, which shows that the inventory shifts identified between 2013 and 2015 reduced the affected firm's return on sales by 17.5% to 23.1%.

More detailed explorations into adjustments of different types of inventories showed an immediate increase in RAW (raw material) inventories, while WIP (work in progress) and FG (finished goods) inventories were reduced after the event with a one-year lag. The authors suggest that specifically increasing RAW inventories is a form of product flexibility – effective for addressing supply-demand imbalances for individual products, but less so than volume flexibility in addressing imbalances across a wide range of products - which is what occurred during the earthquake.

Tentative explanations for the behavioral patterns

The observed patterns were found to be altered by firms' risk preferences, and availability of inventories prior to the event: Risk-averse firms were found to have significantly larger increases in RAW inventories after the earthquake than risk-seeking firms. An increased buildup of inventories was also noted in firms that had relatively high RAW and FG inventories prior to the event. In contrast, firms that had greater volume flexibility before the event appear to have reduced it to a relatively greater extent afterwards.

Regarding decisions about inventories, the authors suppose managerial perceptions, and preferences for familiar approaches over new, uncertain ones, may be an explanation: “Managers who have already factored high uncertainty into their inventory and flexibility decisions prior to a disruptive event might see their forecast confirmed by the event and decide to maintain the already high levels.” 

In any case, if the patterns are driven by risk aversion and prior resource availability, it is likely, according to the researchers, “that managers do not conduct a fully informed cost-benefit analysis after an lp-hc event before deciding whether and how to adjust resilience.” In other terms, they follow their gut feeling, no matter how irrational it may be: Indeed, it has long been argued in the psychological literature that exposure to lp-hc events increases the perceived probability of the event recurring, even though the statistical likelihood remains extremely low or even unchanged.

Still, the researchers find the timing and duration of the changes (delayed decline in WIP and FG inventories, temporary increase in flexibility) interesting, as “they suggest that the affected firms made not only a one-time adjustment decision but also began some kind of search for a new operational equilibrium after the event.”