Inventory Signals

How does operational competence translate into market value, when firms cannot credibly communicate their competence to the market? The author considers the example of inventory and fills rates. When the market sees a high-inventory firm, it cannot tell whether the inventory is due to incompetence or to a strategy to enhance fill rate. Firms might decide to signal their competence to the market by carrying fewer inventories. The author shows conditions for separating and pooling perfect Bayesian equilibria. The author also provides empirical evidence consistent with three sharp predictions of this theory that inventory has a signaling role.