Baumol’s theory of sales revenue maximization was created by American economist William Jack Baumol. It’s based on the theory that, once a. W. J. Baumol suggested sales revenue maximisation as an alternative goal to profit maximisation.1He presented two basic models: the first is a static. W. J. Baumol suggested sales revenue maximisation as an alternative goal to profit maximisation.1 He presented two basic models: the first is a static.
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Baumol’s Sales Revenue Maximization Model
dales This, however, is a simplifying assumption which may be relaxed in a more general analysis. The firm in these models does not consider what will happen in subsequent periods as a result of the decisions taken in the current period.
Thus, Peston concludes, if firms are observed to sell too large an output, this does not show their preference for sales over profits, but may well be attributed to ignorance of demand conditions and the eagerness of firms to exploit technological changes which reduce costs at higher scales of output.
Peston ventured the idea that sales maximisation is not incompatible with the goal of long-run profit maximisation. If sales are salles beyond this point, money sales may increase at the expense of profits.
Baumol’s Managerial Theory of Sales Revenue Maximization
Given the shapes of costs and demand curves implied by the isorevenue and the isoprofit curves, output levels of both y and x are higher for a sales maximiser than for a profit maximiser. Further, so long as profits exceed the constraint, they will always be converted into advertising to increase sales. The growth function is actually derived from the profit function and is shown in figure So long as the fixed costs do not vary with the level of output and provided that the increase in TFC does not lead the firm to close down altogether the change in the TFC will not lead the profit maximiser to change his price and output in the short run.
This claim is not necessarily true. For the solution of the constrained maximisation problem we use the Lagrangian multiplier method. Demand and costs have the traditional shape: Hence Baumol implies that the increase in revenue will be attained from an increase in the volume X.
The product transformation curve is concave to the origin showing the increasing difficulty increasing cost of reducing product y and reallocating the resources to the increase of product x.
Their results suggest that the correlation between executive incomes and sales revenue is stronger than the correlation between executive incomes and profits. Mazimization firm attempts to maximise the present value of the stream of sales revenue over its lifetime, by choosing appropriate values for the current initial level of sales revenue R and its growth rate g.
Under our assumptions the iso-present-value curves will be downward-sloping and sapes be parallel to one another. Assumptions, Explanation and Criticisms! Why then sacrifice current profits in favour of increased current sales?
This is explained in Figure 7.
Baumol’s Sales Revenue Maximization Model
That is, the equilibrium of a sales maximiser is defined by a point of tangency of the isorevenue and the mdel curves; it will be a point on the curve Rabcde. However, in the Haveman-DeBartolo generalized model this prediction may not be true.
Several reasons seem to explain this attitude of the top management. If the firm is a sales maximiser, however, the lump-tax will shift the total-profit curve downwards and, given the profit constraint, the firm will be led to cut its level of output and increase its price, thus passing on to the consumer the lump-sum tax.
The sales maximiser will never choose a level of output at which price elasticity e is less than unity, because from the expression.
In particular Baumol does not examine explicitly the interrelationship between advertising, price, cost of production and level of output. Consequently it will always pay the sales maaximization to increase his advertising expenditure until he is stopped by the profit constraint.
The total-cost and total-revenue curves under the above assumptions are shown in figure If these costs are added to the advertising cost line we obtain the total-cost curve TC as baumoo function of advertising outlay.
If the LRAC salea falling and firms miscalculate their demand, they almost certainly surpass the profit-maximising output. The interrelationship between output and advertising and in particular the assumed positive marginal revenue of advertising permits us to see clearly that an unconstrained sales maximisation is ordinarily not possible.
Baumol claims that because in his model output will be larger than the output of a profit maximiser, the sales-maximisation hypothesis implies a lower degree of misallocation of resources and hence an increase in the welfare of the society. In any case advertising cannot be less in a sales-maximising model.
We may present the above solution graphically, assuming for simplicity that the firm produces two commodities, y and x. It is the dotted curve in figure There slaes be a conflict between pricing in the short sa,es and the long run.
Baumol’s Sales or Revenue Maximisation Theory: Assumptions, Explanation and Criticisms
Imposition of a specific tax will lead the sales maximiser to a larger reduction in output and a larger increase in price as compared with a profit maximiser.
Profit is the main means of financing growth of sales, and as such is an instrumental variable whose value is endogenously determined. From the above assumptions the following inferences can be drawn. It does not imply the sale of large quantities of output, but refers to the increase in bauol sales in rupee, dollar, etc.
Advertising expenditures will be higher for a sales maximiser, due to the assumption of a monotonic positive relation between sales revenue r and advertising expenditure. TR is the total revenue curve.