How Importers May Hedge Demand Uncertainty

This paper examines how firms deal with demand uncertainty when importing intermediate goods takes time, and orders have to be placed before the realization of demand is known. We consider two strategies to hedge this uncertainty: building up inventory of imported goods, and relying on more expensive domestic supplies to cover peak demand. Which strategy is optimal depends on the price of imported relative to domestic goods, and on the degree of demand uncertainty. We also show that there are relative import prices and degrees of demand uncertainty for which the firm chooses not to hedge uncertainty and may thus stock out. The optimal hedging strategy implies a non-monotonic relationship between firm-level output volatility and the relative import price.