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Has Production Management Improved Since 1984?: David G. Bivin
Has Production Management Improved Since 1984?: David G. Bivin
DAVID G. BIVIN
The growth rate of GDP stabilized around 1984. and improvements in production
management have been cited as a possible cause. This article examines this rationale
with two-digit SIC manufacturing data. The empirical questions are whether there is
evidence of structural change in industry output aroutid 1984 and, if so, did output
track demand more closely following the change? The results indicate that only
two industries exhibited structural change in the 1982-86 period. There is
evidence that output has tracked demand more closely in recent years, but this is
hecause demand shocks have become less persistent. {JEL C15, D21, E22)
mentation of JIT, but one of the major components is flexible production implying rapid
response and the ability to profitably produce
only what is immediately required. In this
ideal environment, no unfilled orders or finished goods are accumulated, and whatever
raw materials and work-in-process must be accumulated are quickly processed. More generally, the more flexible and well-coordinated
the production process, the more quickly output can respond to a demand shock."
The questions addressed here are as follows:
ABBREVIATIONS
GDP: Gross Domestic Product
JIT: Just-in-Time
MPQ: McConnell iind Perez-Quiros (2000)
SBIC: Schwarz Bayesian Infonnation Criterion
671
Economic Inquiry
(ISSN 0095-2583)
Vol. 44, No. 4, October 2006. 671-688
doi:10.I093/ei/cbj038
Advance Access publication March 22, 2006
2006 Western Economic Association Intemational
672
ECONOMIC INQUIRY
the long-term equality between output and demand. To implement the methodology, real
new orders are constructed for those industries
that produce to order. The Bureau of Economic Analysis provides data on real sales
but not on real new orders. Thus much of
the previous work has been confined to the relatively few industries that produce solely to
stock or have used real sales as the measure
of industry demand. The former approach
does not account for output volatility in the
durables sector even though output in this
sector is far less stable than in the nondurables sector.^ The latter approach is problematic because sales lag demand in industries
that produce to order.
This study differs from MPQ in its emphasis on the contemporaneous correlation between output and demand rather than the
stability of output. There is a tendency to associate the quality of production management
with the stability of output. But West (1989)
has noted that demand is more volatile than
output among industries that accumulate unfilled orders. Thus output may need to become
more volatile if it is to track demand more
closely.
Stock and Watson (2002) have emphasized
that changes in the dynamic properties of a
model may refiect changes in underlying dynamics or in the variances and covariances
ofthe shocks. Throughout this article, changes
in the dynamics of the model are emphasized
as an indication of improved production management. Although improvements to production may also appear in the form of smaller
independent shocks to output, any reduction
in the scale ofthe shocks could also reflect another source of enhanced stability, such as improved monetary policy or smaller aggregate
shocks to the economy.''
Section I motivates the empirical analysis
through a linear-quadratic model that includes both raw materials and finished goods.
The model is similar to that of Humphreys
3. The nondurdbles sector is primarily production to
stock, and the durables sector is primarily production lo order. Over the 1984-99 period, the standard deviation ofthe
annualized growth rate of output in the nondurables sector
was 15.8% compared to 26.97o for Ihe durables sector.
4. For a description and evidence of some of these
other sources of aggregate enhanced stability, see Kim
and Nelson (1999). Clarida. Gaii and Gertier (2(M)0).
Blanchard and Simon (2001), Ramey and Vine (2001).
Stock and Walson (2002), Ahmed et al. (2004). and
Kim et al. (2003).
et al. (2001). The transition from the theoretical model to the estimating model is described
in section II. Section III describes the data.
Section IV implements the tests for structural
change with an unknown break date. The
complete model is developed by progressively
adding explanatory variables to the righthand side of the equation as a means of determining the source of any structural change.
For instance, an important question is
whether the break in output volatility is due
to a change in the behavior of demand or
to changes in the way in which output responds to demand. The latter may reflect improvements in production management and
the former does not. Section V examines the
output response to demand shocks to determine whether output management has improved since the structural break.
I. THE MODEL
demand in period /,
output in period /,
= materials deliveries in period /,
= level of net fiinished goods inventories
on hand at the end of period r.
Ml level of raw materials inventories on
hand at the end of period /,
V, per unit raw materials purchase cost.
Demand and material costs are treated as
exogenous and random. Both variables are
defined as random walks:
where ef and e| are mean-zero random variables. (Constants are omitted for simplicity.
The random walk simplifies the presentation
because it allows us to replace current and future expected values of Q, and V, with Q,_^
and K,_.|, respectively. Moreover, it is consistent with the data although demand exhibits
drift, which is excluded here for convenience.
The evolution of stocks and flows within the
673
F,-
(lb)
M, -
^ D, - X,
0.5
f 4- V,D,
where ay, QD-, ^> Pi and ^ are non-negative. Increasing marginal costs are attached to output
to reflect the fact that some of the resources
used in production are fixed. The inventory
cost functions reflect the combined influence
of carrying costs (which rise as inventories
rise) and stockout avoidance costs (which fall
as inventories rise). The slope of the marginal
cost function for both stocks is set to /) because
there is no benefit to distinguishing between
the two. The stockout avoidance parameters
are p for finished goods and tj) for raw materials. JIT is associated with inventory minimization, so it is standard to assume that the
implementation of JIT is reflected in smaller
values of p and <[).
In period 0, the firm maximizes the expected value of its discounted profit over an
674
ECONOMIC INQUIRY
(3)
(6b)
max
EidXl/dF,)
(5b)
E{dn/dM,)
(6a)
where L is the lag operator and 7XL) ^ (1 XL-^)i\ - L) = - -H (1 + A,) - XL-\ The
presence of 7^{L) implies that L""^ and L^ both
appear in the model, and thus there are four
roots that satisfy (7). The solution is such that
two of the roots are convergent and two are
divergent. Denote the convergent roots as 6|
and 01. Planned finished goods and raw materials in period 0 is^
(8a)
(8b)
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ECONOMIC INQUIRY
676
and may be interpreted as a stationary random error. Convergence implies that (9) is a
relationship between stationary variables.
Put differently, output and new orders are
cointegrated when new orders obey a random
walk. Equation (9) is the basis for the estimations undertaken next.
To appreciate the influence of the cost factors in determining the rate at which output
converges with demand, suppose that ao 0.
It is shown in the appendix that (9) becomes
(10)
where Zj = (1 ~ Tz){Ft - Fl^
V[a2 - 4X1)/2X, and a = (1 +
average lag is
, 7i = ( o t -
)- The
j=0
{\-n)-1
- So)
II.
period should cause output to rise in the current period as a means of distributing the excess stocks across stages of fabrication. The
absence of raw materials in the decision rule
for finished goods is explained in note 7.
Let .Vf and q, denote the log of output and
the log of demand, respectively. Assuming
that both variables are unit root processes,
it follows that
(II)
y,=x,-
q,
67?
the same mean, they are expressed as deviations from their common mean, calculated
as the simple average ofthe mean growth rates
over the period.
The error-correction model in (13) can be
converted to a standard trivariate vector autoregression in A^,, ^Xt, and y, by appending
an additional estimating equation that estimates y, as a function of the 7 - 1 lags of
A^;. A.V,. and i,. This extension introduces
additional lags of;', into (13) but the added
lags do not enhance the explanatory power
of that model for the growth rates of demand
or output because of the following linear
dependence:
(14)
y, =
ECONOMIC INQUIRY
678
FIGURE 1
The Values ot yi for Durables and Nondurables
0.1-
. 11
0-
-0.05-
NTfi'i yy
-0.1-
679
TABLE 1
Standard Deviation of _v,
Industry
Manufacturing
Durables
Stone, clay, and glass
Primary metals
Fabricated metals
Industrial machinery
Electronics
Transportation
Instruments
Nondurables
Food
Tobacco
Apparel
Chemicals
Petroleum
Rubber
1,
0.021
0.040
0.028
0.091
0.050
0,066
0.048
0,092
0,071
0,006
0.010
0.021
0.019
0.012
0.014
0.018
0.014
0.027
0.025
0.041
0.027
0.037
0.039
O.ltO
0,071
0.005
0.006
0,043
0.018
0.013
0.017
0.009
0.651
0.664
0.865
0.445
0.536
0.564
0.821
1,193
1.008
0.878
0.638
2,058
0.955
1.080
1.276
0.493
7=1
u,
Note the lag lengths for the four right-handside variables are all J. This is consistent with
the VAR framework and also simplifies the
search for the optimal model. The value of
J is chosen through the Schwarz Bayesian
Information Criterion (SBIC). The constant
is retained for the time being for reasons to
be explained.
The existence of a break date is assessed
through the exponential lest developed in
Andrews (1993) and Andrews and Ploberger
(1994). The date of the structural break is
identified as the date that maximizes the
Wald statistic for structural change. The significance of the break date is assessed using
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ECONOMIC INQUIRY
TABLE 2
Test for Structural Change in Ax, with Unknown Break Dates: Univariate Model
Industry
Manufacturing
Durables
Stone, clay, and glass
Primary metals
Fabricated metals
Industrial machinery
Electronics
Transportation
Instruments
Nondurables
Food
Tobacco
Apparel
Chemicals
Petroleum
Rubber
First Estimated
Break Date
Second Estimated
Break Date
August 1979
March 19S0
December 1983
August 1984
August 1971
December 1979
October 1985
March 1986
May 1984
May 1984
February 1990
May 1979
February 1966
February 1992
August 1993
March 1984
October 1967
Third I'^itimated
Break Date
May 1986
August 1995
December 1982
1
December 1997
September 1980
Note.t: The dates listed are those for which there was evidence of a break date using the Andrews and Ploberger
exponential test and a signifiaince level of 5%. Break dates occurring in the 1982-86 period are highlighted in bold.
TABLE 3
Test for Structural Change in Ax, with Unknown Break Dates: Cointegration Model
with A.Y, and Aq,
Industr)'
Manufacturing
Durables
Stone, clay, and glass
Primary metals
Fabricated metals
Industrial machinery
Electronics
Transportation
Instruments
Nondurables
Food
Tobacco
Apparel
Chemicals
Petroleum
Rubber
First Estimated
Break Date
Second Estimated
Break Date
Third F^stimated
Break Date
July 1968
February 1991
January 1997
December 1971
August 1981
March 1982
March 1991
March 1998
June 1989
August 1978
April 1982
March 1991
March 1991
January 1993
May 1982
January 1972
June 1979
October 1997
February 1984
Notcr The dates listed are those for which there was evident^ of a break date using the Andrews and Ploberger
exponential test and a significance level of 5%, Break dates occurring in the 1982-86 period are highlighted in bold.
682
ECONOMIC INQUIRY
TABLE 4
Test for Structural Change in Ax, with Unknown Break Dates: Cointegration Model with
Ax,, Aq,, AVf, and Am,
IndtLstry
Manufacturing
Durables
Stone, clay, and glass
Primary metals
Fabricated metals
Industrial machinery
Electronics
Transportation
Instruments
Nondurables
Food
Tobacco
Apparel
Chemicals
Petroleum
Rubber
First Estimated
Break Date
March 1991
Augtist 1991
July 1968
Second Estimated
Break Date
Third Estimated
Break Date
Febniary 1994
July 1980
March 1991
December 1989
December 1983
April 1998
December 1997
September 1974
July 1979
October 1996
June 1972
February 1980
February 1998
May 1984
April 1995
Notes: The dates listed are those for which there was evidence of a break date using the Andrews and Ploberger
exponential test and a significance level of 5%. Break dates occurring in the 1982-86 period are highlighted in bold.
machinery exhibited a break date in the 198286 period. There is still a significant break for
nondurables in 1982. and apparel and petroleum in the nondurables sector exhibit break
dates in the 1982-86 period as well.
The final question is whether the break
dates are sensitive to the inclusion of material
costs and the growth rate of raw materials.
Even if firms have adopted improved production management techniques, shocks to
these variables are likely to account for
short-run deviations of output from demand.
Thus their presence is important to ensure a
properly specified model, even in the absence
of structural change. Moreover, improvements in production management should alter
the responses of output to shocks to raw materials and material costs. For instance, one of
the goals of JIT is inventory minimization,
and this suggests that positive shocks to raw
materials will elicit a more rapid output response following the adoption of the JIT production strategy. For this model, all of the
parameters in (15) are estimated, and the null
hypothesis is that they are all constant.
The significant break dates are shown in
Table 4. Only instruments and petroleum
contain a break date in the 1982-86 period.
Now there is no evident structural change in
683
TABLE 5
Sample Break Dates
First Period
Second Period
Industry
Start Date
End Date
Start Date
End Date
Durables
Stone, clay, and glass
Industrial machinery
Electronics
Transportation
Instruments
April 1959
April 1959
April 1959
May 1959
April 1959
April 1959
March 1990
Sept. 1990
July 1979
March 1990
Dec, 1988
Dec. 1982
April 1992
Oct. 1992
Sept. 1981
April 1992
Jan. 1991
Jan. 1985
July 1999
July 1999
July 1999
April 1997
Dec. 1996
July 1999
samples and therefore to represent these variables as deviations from their means. Thus
constants are omitted from the regressions.
Some of the industries are omitted because
there were no significant break dates. Others
are omitted because their break dates fall
too near to the beginning or the end of the
sample to be of practical interest. Finally,
a few industries are omitted because the break
dates are too close together to yield reliable
estimates. To allow for gradual adjustments
prior to or following the break dates. 12 observations on both sides of the break dates are
dropped. The sample dates are contained in
Table 5. The ending dates for the first sample
range from 1979 to 1990, and the start dates
for the second sample range from 1981 to
1992. This broad range of dates casts doubt
on a common source of structural change.
The first question is whether _v, stabilized after the structural change and, if so, whether
the stabilization is due to improved dynamics
or smaller shocks. The tests conducted in the
previous section are predicated on the assumption that improved production management
appears in the fonn of more stable dynamics.
Stock and Watson (2002) illustrate how crosssample changes in volatility can be partitioned
into a contribution due to smaller shocks and
a contribution due to changes in dynamics.
Let Z, [A(/,,, Av,, Am,, A.x,, y,]' and let U,
denote a 5 x 1 vector of serially independent
random error terms. Then the system of equations may be written as
U,
k=l
where Cy is a 5 x 5 matrix containing the moving average coefficients for lag /. From this
expression, it folJows that the variance of Z, is
(17)
j=0
ECONOMIC INQUIRY
TABLE 6
Decomposing the Second-Period SD of y,
Vl' ^ARo-,
Industry
Durables
Stone, clay.
and glass
Industrial
machinery
Electronics
Transportation
[nstrumenls
Nole:
The
0.784
0.802
1.085
0.728
0.787
0.939
1.199
0.994
0.901
1.058
0.940
0.609
as ratios to
TTiere is a very slight reduction for instruments, but the volatility of y, fell by almost
40% for durables manufacturing. The second
column maintains a constant variance of the
shocks across samples. Now all of the ratios
are less than one except for transportation
and stone, clay, and glass, which experienced
a 5-lOyo increase in volatility due to changes
in dynamics. Improved dynamics account for
reductions in the standard deviation of y, of
20yo and 21% in the durables and industrial
machinery sectors. Electronics and instruments both stabilized as well, but the reductions are less than 10%) in both cases.
The question remains as to whether these
reductions in volatility refiect greater output
fiexibility. Although output has tracked demand more closely in recent years for some
industries, the reason may simply be that
demand has become easier to track, perhaps
because demand shocks are smaller or decay
more rapidly.
One measure of output flexibility is the contemporaneous response of the growth rate of
output to a one-unit independent shock to demand. Ideally, this number will be 1, indicating that the demand shock is fully absorbed by
the output shock in the period in which it
occurs. This statistic is essentially the correlation coefficient between the residuals from
the demand equation and the residuals from
the output equation and is denoted as p,'^
Another measure is the estimate of p,.' ^he
error-correction coefficient for output. This
15. Specifically, p = cov(uA,.Ui,)/var(MA^) and the
correlation coefficient iscov(ua,,H^)/7(var(M4,)var(u4,).
The measures are precisely equal when the variance of
ihe demand shocks and the variance of the output shocks
are equal.
describes the output response to a one-unit imbalance between log output and log demand in
the preceding period. Two versions of this statistic are considered here. The first is simply
the estimate of p.^ and the second is the estimate of pj(/{l - p^). The latter is the proportion of the imbalance eliminated by output
after accounting for the portion eliminated
by demand. If both demand and output adjust
to eliminate a portion of the response and y,
adjusts monotonically, then p^ > 0 > p^ >
(p,, - 1) and - 1 < p.^( I - Prf) < P.V < 0. Values
closer to 1 indicate improved production
flexibility.
The results are contained in Table 7.
Improvements in production flexibility are
reflected in larger values of p. However, p
declined in five of the six industries. Apparently demand shocks elicited a smaller contemporaneous output response in the second
sample than in the first. This may reflect less
production flexibility, but it could also occur
if demand shocks were viewed as more transitory in the second sample than in the first.
The remaining columns contain the errorcorrection coefficients. The values of p should
still be negative in the second period, but
larger in absolute value. Again, there are
very few case in which output became more
flexible by these measures. Industrial machinery and transportation are the only examples
in which the second-sample error-correction
coefficients increased in absolute value.'"^
Apparently, the enhanced flexibility is not
evident in the contemporaneous or one month
lagged response of output to a shock to the
growth rate of demand. An explanation for
this behavior can be found in Figure 2, which
illustrates the impulse responses to demand
shocks for the durables sector. For both samples, the initial shock to the growth rate of demand is set to the standard deviation of the
residuals from the first sample. The behavior
of _V, is represented in the first panel. The second and third panels illustrate the demand and
output responses in the first and second samples, respectively. Output and demand are
level data derived from the simulated growth
16. The positive estimate of p, in the second period for
instruments indicates ihat the output response to the imbalance actually made the imbalance worse. For electronics in the second period, p, < 0 but pj > 1 and thus the
adjusted error-correction coefficient is positive (0.224). ln
this case, the growth rate of demand is very "flexible" and,
as a result, y, oscillates around 0.
685
TABLE 7
Short-Run Output Flexibihty
Contemporaneous Output
Respoase to an Independent
Demand Shock (p)
Industry
Durables
Stone, elay, and glass
Industrial machinery
Electronics
Transportation
Instruments
Error-Correction
CoefBcient on
Output p .
Adjusted Error-Correction
Coefficient on
Output (P Al - M
First Period
Second Period
First Period
Second Period
First Period
Second Period
0.403
0.580
0.221
0.265
0.281
0.128
0.302
0.505
0.264
0.194
0.226
0.123
-0.165*
-0.205
-0.124*
-0.252*
-0.060
-0.081*
-0.095
-0.124*
-0.299*
-0.065
-0.071
0.213
-0.180*
-0.703*
-0.133*
-0.219*
-0.124*
-0.124*
-0.154
-0.133*
-0.326*
0.224
-0.179
0.170
rates using the inverse transformation; for instance, Q, = Qr_iCXp{Aq,) for demand.
From the first panel, it is apparent that y,
converges more rapidly in the second sample
than in thefirst.'^Thusoutput has tracked demand more closely in recent years. The second
and third panels suggest that the reason for
this is that demand shocks have become less
persistent. In both samples, there is a large
gap between demand and output in the period
of the shock. In the first sample, the gap is
eliminated by gradual declines in demand
and gradual increases in output. About 50%
of the long-run error correction is due to demand adjustments and 50% to output adjustments. In the second sample, however, about
100% of the long-run error correction is due to
declines in demand. It is interesting that even
though the initial output response to a demand
shock is smaller in the second sample than
in the first, very little output adjustment is
required in the periods following the shock
because demand eliminates so much of the
gap. Thus output arrives at its new long-run
equilibrium in the period of the shock and demand reaches the new long-run equilibrium
in the period following the shock although
it deviates in the following period.
These results are somewhat muddled because of the intermingling of output and demand dynamics. To avoid this difficulty, an
additional simulation is carried out in which
demand suddenly rises by 10% and then
17. The differences, however, are not significant when
parameter uncertainty and random shocks are taken into
accoutit.
ECONOMIC INQUIRY
686
FIGURE 2
Responses of Demand, Output, and y, to a Demand Shock for the Durables Industry
0.005
First Sample
Second Sample
-0.03
1.04
Demand
OLItpUt
1.03-
1.02-
1.0J -
1.04
Second Sample
Demand
Output
L03-
1.02-
1.01-
687
TABLE 8
Average Lags of y^
Output Shock
Industry
First Period
Second Period
First Period
Second Period
4.601
1.277
8.103
5.350
5.078
9.450
5.006
L500
3.261
3.549
5.245
17.943
14.873
1.382
14.873
17.649
1.514
3.013
2.947
0.511
18.896
1.467
1.479
3.392
Durables
Stone, clay, and glass
Industrial machinery
Electronics
Transportation
Instruments
VI.
Demand Siiock
REFERENCES
Ahmed, S.. A. Levin, and Beth A. WiLson. "Recent U.S.
Maeroeconomic Stability: Good Policies, Good
Practices, or Good Luck?" Review of Economies
and Statistics, 86, 2004, 824-32.
688
ECONOMIC INQUIRY