OPTIMAL INVENTORIES: THE SQUARE ROOT RULE AND PROFIT MAXIMIZATION

Inventory models are usually based on the existence of transaction costs and explain inventories from efficiency considerations alone. The simplest model involves a "square root rule" where inventory varies with the square root of its determinants. Accounting for profit maximizing behavior relaxes those rigid results and alters their interpretation. The analysis integrates inventory demand theory with the neoclassical theory of the firm and industry.