Baumol’s Sales or Revenue Maximization
The below mentioned article provides an overview on Baumol’s Sales or Revenue Maximisation.
Prof. Baumol in his book Business Behaviour, Value and Growth (1967) has presented a managerial theory of the firm based on sales maximisation. He discusses two models of sales maximisation: a static model and a dynamic model. We shall analyse only his static model of sales maximisation with its variants of single product model without advertisement.
The model is based on the following assumptions:
1. There is a single period time horizon of the firm.
2. The firm aims at maximising its total sales revenue in the long run subject to a profit constraint.
3. The firm’s minimum profit constraint is set competitively in terms of the current market value of its shares.
4. The firm is oligopolistic whose cost curves are U-shaped and the demand curve is downward sloping. Its total cost and revenue curves are also of the conventional type.
Baumol’s findings of oligopoly firms in America reveal that they follow the sales maximisation objective. According to Baumol, with the separation of ownership and control in modern corporations, managers seek prestige and higher salaries by trying to expand company sales even at the expense of profits.
Being a consultant to a number of firms, Baumol observes that when asked how their business went last year, the business managers often respond, “Our sales were up to three million dollars”. Thus, according to Baumol, revenue or sales maximisation rather than profit maximisation is consistent with the actual behaviour of firms.
Baumol cites evidence to suggest that short-run revenue maximisation may be consistent with long-run profit maximisation. But sales maximisation is regarded as the short-run and long-run goal of the management. Sales maximisation is not only a means but an end in itself.
He gives a number of arguments in support of his theory.
1. A firm attaches great importance to the magnitude of sales and is much concerned about declining.
2. If the sales of a firm are declining, banks, creditors and the 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 its product because of its unpopularity.
5. Firm reduces its managerial and other staff with fall in sales.
6. But if firm’s sales are large, there are economies of scale and the firm expands and earns large profits.
7. Salaries of workers and management also depend to a large extent on more sales and the firm gives them bonus and other facilities.
By sales maximisation, Baumol means maximisation of total revenue. It does not imply the sale of large quantities of output, but refers to the increase in money sales (in rupee, dollar, etc.). Sales can increase up to the point of profit maximization where the marginal cost equals marginal revenue.
If sales are increased beyond this point money sales may increase at the expense of profits. But the oligopolistic firm wants its money sales to grow even though it earns minimum profits. Minimum profits refer to the amount which is less Quantity than maximum profits. The minimum profits are determined on the basis of firm’s need to maximize sales and also to sustain growth of sales.
Minimum profits are required either in the form of retained earnings or new capital from the market. The firm also needs minimum profits to finance future sales. Further, they are essential for a firm for paying dividends on share capital and for meeting other financial requirements.
Thus minimum profits serve as a constraint on the maximisation of a firm’s revenue. “Maximum revenue will be obtained only” according to Baumol, “at an output at which the elasticity of demand is unity, i.e. at which marginal revenue is zero.”
This is the condition which replaces the “marginal cost equals marginal revenue profit maximisation rule.” This is shown in Figure 5 where the profit maximisation firm produces OQ output where MC = MR at point E. But the sales maximisation firm will produce OQ1 output where MR is zero.
Baumol’s model is illustrated in Figure 6 where TC is the total cost curve, TR the total revenue curve, TP the total profit curve and MP the minimum profit or profit constraint line. The firm maximises its profits at OQ level of output corresponding to the highest point В on the TP curve.
But the aim of the firm is to maximise its sales rather than profits. Its sales maximisation output is OK where the total revenue KL is the maximum at the highest point of TR.
This sales maximisation output OK is higher than the profit maximisation output OQ. But sales maximisation is subject to minimum profit constraint. Suppose the minimum profit level of the firm is represented by the line MP.
The output OK will not maximise sales as the minimum profits OM are not being covered by total profits KS. For sales maximisation the firm should produce that level of output which not only covers the minimum profits but also gives the highest total revenue consistent with it.
This level is represented by OD level of output where the minimum profits DC (=OM) are consistent with DE amount of total revenue at the price DE/OD, (i.e., total revenue/total output). Baumol’s model of sales maximization points out that the profit maximization output OQ will be smaller than the sales maximization output OD, and price higher than under sales maximization.