BAUMOLS SALES REVENUE MAXIMIZATION MODEL

W.J.Baumol suggested sales revenue maximization as an alternative goal to profit maximization. He presented two basic models: a) The first is a static period model. b) The second is a multi period dynamic model of growth of sales revenue maximization. RATIONALISATION OF THE SALES MAXIMIZATION HYPOTHESIS a) There is evidence that salaries and other earnings of top managers are correlated more closely with sales than with profits. b) The banks and other financial institutions keep a close eye on the sales of firms and are more willing to finance firms with large and growing sales. c) 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.

d) Large sales, growing over time, give prestige to the managers, while large profits go into the pockets of shareholders. e) Managers, prefer a steady performance with satisfactory profits to spectacular profit maximization projects. If they realize maximum high profits in one period, they might find themselves in trouble in other periods when profits are less than maximum. f) Large growing sales strengthen the power to adopt competitive tactics, while a low or declining share of the market weakens the competitive position of the firm and its bargaining power vis--vis rivals. BAUMOLS STATIC MODELS The basic assumptions of the static models 1. The time horizon of a firm is a single period. 2. During this period the firm attempts to maximize its total sales revenue subject to a profit constraint. 3. The firm must realize a minimum level of profits to keep shareholders happy and avoid a fall of the prices of shares on the stock exchange.

4. Baumol accepts that cost revenues are U-shaped and the demand curve of the firm is downward sloping.
5. Production costs are independent of advertising. 6. Advertisement will always result in creating favourable conditions for the product. In other words, it will always shift the demand curve to the right, which implies that the firm will sell larger quantity and earn larger revenue.

Model 1. A single product model, without advertising

Model 2. A single product model, with advertising

Model 3. A multiproduct model, without advertising

Model 1. A single product model, without advertising

TR TC (Rs)

TC

TR

K1 K2 K3

p0

p
Q

Q1

Q2

Q3

According to Baumol, it is only after the profit constraint has been satisfied that profits become subordinate to sales in the firms hierarchy of goals. In the above figure, this profit constrain is shown by a line p. Obviously, sales maximiser will keep on selling till MR remains positive. So, the sales maximisers level of output would be OQ1 where MR equals to zero. If the minimum profit constraint p0 is above the level of profits where MR = 0, (at point K1), the sales revenue maximiser is constrained to stop at OQ3 output where minimum profit constrained p0 is met. On the other hand, if minimum profit constraint is p (which is less than the profits where MR=O) then the sales revenue maximiser will face no profit constraint and would, therefore, produce OQ1 output. Thus, if minimum profit constraint is less than the maximum profit, the sales maximiser will produce a greater output than the profit maximiser.

Implications of Baumols Model

1. If both the profit maximiser and a constrained sales maximiser face the same demand curve, the latter will charge a lower price to sell the extra output (Q3Q2). 2. A sales maximiser will spend more on advertising than does a profit maximising firm. Baumol assumes that advertising does not affect the products price but it does lead to increased output sold. It is also assumed that advertising will always lead to a rise in TR; MR will never become negative. This is shown in the adjacent graph. Since advertising will always increase TC, the management will increase advertising until prevented by the profit constrained (p0 ). TC With advertisement advertisement cost

TC p0 A1 p A2 Advertisement Expenditure

Without advertisement Profit Constraint

BAUMOLS DYNAMIC MODELS The most serious weakness of the static model is the short time horizon of the firm and the treatment of the profit constraint as an exogenously determined magnitude. In the dynamic model the time horizon is extended. The basic assumptions of the dynamic models are 1. The firm attempts to maximize the rate of growth of sales over its lifetime. 2. Profit is the main means of financing growth sales. 3. Demand is downward falling and costs are U-shaped. Profit is not a constraint but an instrumental variable, a means whereby the top management will achieve its goal of a maximum rate of growth of sales.

MARRISS MODEL OF THE MANAGERIAL ENTERPRISE

I. GOALS OF THE FIRM The goal of the firm in Morris model is the maximization of the balanced rate of growth of the firm, that is, the maximization of the rate of growth of demand for the products of the firm, and of the growth of its capital supply: Maximize g = gD = gC Where, g= balanced growth rate. gD=growth of demand for the products of the firm. gC=growth of the supply of capital. Managers set their goals which do not necessarily coincide with those of owners. The utility function of the managers includes variables such as salaries, status, power and job security, while the utility function of owners includes variables such as profits, size of capital, share of the market and public image. Thus managers want to maximize their own utility.

UM = f (salaries, power, status, job security) While the owners seek the maximization of their utility. UO= f* ( profits, capital, output, market share, public esteem). Morris argues that the difference between the goals of managers and the goals of the owners is not so wide, because most of the variables appearing in both functions are strongly correlated with a single variable: the size of the firm. U owners= f * (gc) Where gc= rate of growth of capital The managerial utility function is UM = f (gD, s) Where, gD= rate of growth of demand for the products of the firm. s= a measure of job security