Production and Inventory Dynamics Under Ambiguity Aversion

We propose a production-cost smoothing model with Knightian uncertainty and ambiguityaversion to study the joint behavior of production, inventories, and sales. Our model canexplain four facts that previous studies find difficult to account for simultaneously: (i) the highvolatility of production relative to sales, (ii) the low ratio of inventory-investment volatility tosales volatility, (iii) the positive correlation between sales and inventories, and (iv) the negativecorrelation between the inventory-to- sales ratio and sales. We find that the stock-out avoidance