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Baumols Sales Maximisation Model
2 Prof. Baumol in his article on the theory of oligopoly presented a managerial theory of the firm based on sales maximization. Sales Maximization Theory is based on the following assumptions: 1. There is a single period time horizon of the firm. 2. Firm aims at maximizing its total sales and revenue in the long run subject to the profit constraint. 3. Firms minimum profit constraint is set competitively in terms of the current market value of its shares. 4. Firm is oligopolistic whose cost curves are U-shaped and the demand curve is downward sloping. Its total revenue and cost curves are also of conventional type.
3 Baumols findings of oligopoly firms suggest that the business firms are much concerned about their total increase in sales than profits. He gives number of arguments to support his point of view: 1. A firm attaches great importance to the magnitude of Sales and is much concerned about declining sales. 2. If sales are declining, banks,creditors and capital market are not prepared to provide finance to it. 3. Its own distributors and dealers might stop taking interest in it. 4. Consumers might not buy the products because of lack of popularity 5. Firm reduces its managerial and other staff with the fall in sales 6. If the firms sales are large, there are economies of scale, the firm expands and earns profits 7. Salaries of workers and management also depends on the large sale
4 By sales maximization Baumol means maximization of total revenue It does not imply the sales of large quantities of output, but refers to the increase in the money sales. Sales can be increase upto the point of profit maximization where the marginal cost is equal to the marginal revenue. If sales are increased beyond this point, money sales may increase at the expense of profits. But oligopolist firms wants its money sales to grow even though it earns minimum profits. Minimum profits are determined on the basis of firms need to maximize sales and also to sustain the growth of sales. It is required either in the form of retained earnings or new capital from the market. The firm also needs minimum profits to finance the future sales, to pay the dividends on the share capital and for meeting other financial requirements. Thus minimum profits serve as a constraint on the maximization of a firms revenue maximum revenue will be obtained only at the output at which the elasticity of demand is unity,i.e.at which MR is equal to zero. This is the condition which replaces the MC=MR profit maximisation rule
TC TR TP E L B 5 BaumolS Model C Q D K M S P OUTPUT TR/ TC/ P R O F I T S X Y
6 In the fig.TC is the total cost curve and MP the minimum profit or profit constraint line.. Firm maximises its profits at OQ level of output corresponding to the highest point B on the TP curve. But aim of firm is to maximise sales rather than profits. The sales maximisation output is OK where the total revenue KL is maximum at the highest of TR. The sales maximisation output OK is greater than the profit maximisation output OQ. But the sales maximisation is subject to the minimum profit constraint.
7 If minimum profit constraint is represented by line MP. The output OK will maximise the sales as minimum profits OM are not being covered by the total profits KS. For sales maximisation the firm should produce OD level of output where minimum profits DC (=OM) are consistent with DE amount of total revenue at the price DE/OD,( total revenue /total output) Baumols model of sales maximisation points out that the profit maximisation output OQ willl be smaller than the sales maximisation output OK, and price higher than under sales maximisation
Model With Advertising 8 Baumol has further shown that the profit constraint under sales maximisation is also effective in advertising and thereby increases the firms revenue.
o Q D M C P AdC TR TC T S A E TP X Y Advertising Outlay TR/ TC/ P 9
10 In the fig., expenditute on advertising is shown on the horizontal axis. TR is the total revenue curve. The 45 line AdC is the advertisement cost curve. By adding a fixed amount of other costs equal to OC to AdC curve we get the total cost curve TC. Here production costs OC are assumed independent of advertising costs. TP is the total profit curve which is the difference between TR and TP curve. MP is the minimum profit constraint line. The profit maximisation firm will spend OQ on advertising and its total revenue will be OS(=QA).
11 On the other hand given the profit constraint MP, the sales maximisation firm will spend OD on advertising and earn OT (=DE) as the total revenue. Thus the sales maximisation firm spends more on advertising OD than the profit maximising firm (OQ), OD>OQ and also earns higher revenue (DE) than the latter (QA), DE>QA, at the profit constraint MP. Thus it will always pay the sales maximiser to increase his advertising outlay until he is stopped by the profit constraint.