Baumol's Model of Sales Revenue Maximisation
Baumol presented sales revenue maximisation as an alternative goal to profit maximisation. From his experience as a consultant to large firms, Baumol found that managers are preoccupied with maximisation of sales rather than profits. Several reasons were given by Baumol to explain this attitude of the top management.
1. Salaries and other earnings (Slack) of top managers are correlated more closely with sales than with profits. Slack refers to the payments or other perquisites to the managers above the minimum necessary to retain them in the firm.
2. Banks and other financial institutions keep - a close eye on the sales of the firm and are more willing to finance firms with large and growing sales.
3. Personnel problems are handled more satisfactorily when sales are growing. The employees at all levels can be given higher earnings and better terms of work in general.
4. Large sales and growing overtime give prestige to the managers, while large profits go into the pockets of the shareholders.
5. Managers prefer a steady performance with satisfactory profits to spectacular profit maximisation projects. If they realise maximum high profits in one period, they might find themselves in trouble in other periods when profits are less than minimum.
6. Large, growing sales strengthen the power to adopt competitive tactics, while a low declining market share of the market weakens the competitive position of the firm and its bargaining power.
Baumol developed two basic models (i) Static model and (ii) Dynamic model, each with and without advertising. Detailed analysis of single product, static model, without advertising, will be undertaken. The static models of Baumol consider a single period when, firm tries to maximise sales revenue subject to profit constraint.
The minimum profit constraint is exogenously determined by the demands and expectations of the shareholders, the banks and .other financial institutions. The total cost (TC) and total revenue (TR) curves are shown in Fig. 2.3.Total sales revenue is maximum at the highest point of the TR curve, where price elasticity of demand is unity and slope of this TR curve (the marginal revenue) is equal to zero.
If the firm were a profit maxirniser, it would produce the level of output Xllm.
However, in Baumol's .model, the firm is a sales maximiser, but it must also earn a minimum level of profit acceptable to shareholders and to those who finance its operations. If the minimum level of profit is II1, the firm willproduce the level of output IIs which maximises its sale revenue. With this level of output (Xs)' the firm earns profit IIs, which is greater than the minimum required to keep the stockholders (and other interested parties) satisfied. Under these circumstances, we say that the minimum profit constraint is not operative.
If the minimum acceptable profit is II2 the firm will not be able to attain the maximum sales revenue, because the profit constraint is operative, and the firm will produce Xa units of output, which is less than at the level Xs. Thus, the firm has two options.
Profit constraint 'provides no effective barrier to sales maximisation (XS unit of output with a minimum acceptable profit of II1).
There is a profit constraint (Xa, units output with a minimum acceptable profit of II2).
The firm is assumed to be able to pursue an independent price policy; that is to set its price so as to achieve its goal of sales revenue maximisation (given the profit constraint) without being concerned about the reactions of competitors. With profit constraint operative, Baumol model can be used to make certain predictions,
1. The sales maximiser will produce a higher level of output compared to a profit maximiser, (Xs> XIIm)
2. The sales maximiser will sell at a price lower than the profit maximiser The price at any level of output is the slope of the line through the origin to the relevant point on the TR curve.
3. The salesmaximiser will earn Lower profits than the profit maximiser,
4. The sales maxirniser will never choose a level of output at which price elasticity is less than unity,
5. An increase in fixed costs (for instance the lump sum tax) will affect the equilibrium position of a sales maximiser. He will reduce his level of output and increase his price, since the increase in fixed costs shifts the total profit curve downwards, Subject to the profit constraint, the sales maximiser will pass the increase in costs to the customers by charging a higher price.
The sales revenue maximisation of Baumol has no conclusive empirical validity. Adequate data is not available to conduct meaningful tests of the hypothesis.
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