Baumol’s Sales Maximisation Model – Revenue & Profit Maximisation

Objective

Baumol’s sales maximization model has two important subheads

1. revenue maximization
2. profit maximization theory

which together explains the idea behind maximizing sales.

Therefore, we will take a quick overview of the two concepts first, which are as follows:

Revenue maximization

Revenue maximization refers to maximizing sales in a business using various techniques, such as sales promotion, advertisement, campaign, demos and test samples, references, etc., to increase revenue and capture greater market share in the company.

However, revenue maximization is possible at the point where MR( marginal revenue) is equal to zero. Revenue is generally the company’s income before any expenses are calculated; however, sales include the proceeds from selling goods.

Brief

• To maximize the wealth of shareholders, each business achieves this goal by handling the revenue sector. Revenue is targeted since it maximizes profits.
•  In the modern world, it becomes difficult to increase revenue due to the customer-driven approach.
•  It dictates that if the customer is satisfied, the products will sell, leading to a boost in revenue.
• However, the company should also keep the worst scenario in mind, i.e., shutdown/losses.
• A company must not stop at a point where the total revenue decreases but rather where marginal revenue is equal to zero.
• Moreover, a company may incur losses even if revenue increases. Therefore, the aim must be to maximize revenue, not just to improve it (referring to its sustainability).

Note: Before discussing the concept of revenue, one must know the marginal product, which is discussed in detail in MRTS in economics.

Graphical representation

• It should be noted that total revenue first increases, reaches its maximum, and then decreases.
• However, marginal revenue and average revenue are downward sloping, i.e., decreasing in nature.
• As a result,

The revenue maximizes at the point where MR = 0.

Example

A company sells new chocolates with the intention of maximizing revenue(relating to Baumol’s sales maximization model). The table below depicts the total income and marginal revenue. Moreover, the selling price reduces with an increase in the quantity sold.

Formula

TOTAL REVENUE = SELLING PRICE X QUANTITY SOLD

For example:

A POINT = 100 x 1 = 100
B POINT = 90 x 2 = 180
C POINT = 80 x 3 = 240

MARGINAL REVENUE = CHANGE IN TOTAL REVENUE/ CHANGE IN QTY SOLD =TR/ Q

For example:

POINT B = 180-100/2-1 = 80
POINT C = 240-180/3-2 = 60

Here, revenue maximizes when the 6th quantity is sold, after which the increase in the qty sold will not maximize the income and make the marginal revenue negative. At this point, the total income is maximum while the marginal revenue is zero.

Benefits

To maximize wealth, we studied the fact that revenue maximization is necessary. Also, that point must be stated prior to setting the sales targets and growth.

Moreover, the benefits of revenue maximization (under Baumol’s sales maximization model) are as follows:

Rise of Market Share

To build up, a start-up focuses on maintaining a large and strong customer base in the market, i.e., expanding its market share.

As the quantity sold increases, only the marginal cost rises, while the fixed cost remains the same, causing the overall price to fall.

Therefore, on the one hand, the price of the product decreases while customers’ attention gradually increases the market share.

Developing a Brand Name

It must be remembered that a company can also create a good name by selling quality products at a lower price. Moreover, this builds brand loyalty among customers and keeps them entitled to the product for a longer duration.

Economies of Scale

When the company reaches a point of revenue maximization, it sells a large quantity at a lower price. At bulk selling, the fixed cost per unit decreases as the quantity increases, which indicates that the fixed assets are being fully utilized. As a result, the company gains an advantage in manufacturing high-quality products, which in turn increases profitability.

Profit Maximization Theory

Firstly, relating to the neoclassical theory, profit maximization (relating to Baumol’s sales maximization model) counts as the main objective for a firm. However, a firm can maximize its profits when it satisfies two conditions:

Conditions

1.  MC = MR
2. MC must rise after cutting the MR curve, or MC cuts the MR from below

Profit maximisation condition

Maximise π (q), Where π (q) = TR(p,q) – TC(q)

π (q) = profit , TR(p,q) = total revenue , TC(q) = total cost

Maximum profits are determined as pure profits that are gained above average costs. This includes the amount left behind by the owner after paying all the expenses. As a result, it depicts the extra income of the entrepreneur beyond his normal profits.

The conditions mentioned above for marginal revenues and profit maximization (relating to Baumol’s sales maximization model) apply to both perfect competition and imperfect competition(For example, in the oligopoly market, monopoly market, etc.)

Assumptions for profit maximization theory

• The main objective of the business is to maximize profit, which is determined by the difference between total revenue and total costs.
• Tastes, preferences, and habits of the customers are given and constant.
•  Techniques and technology of production are stated/ given.
• The business is aware of the quantity of output that can be sold at each price.
• New firms cannot enter the industry in the short run; this is only possible in the long run.
• Profits need to be maximized(according to Baumol’s sales maximization model) in the long and short run.
• The firm only manufactures a single, standardized, and perfectly divisible commodity.
• Certainty is required to know a firm’s costs and demand.

Considering the conditions mentioned above and assumptions, let’s study how profit maximization (relating to Baumol’s sales maximization model)can be done under both perfect and imperfect competition(like monopolistic competition, a monopoly in economics, etc.)

Under Perfect Competition

In perfect competition, there are a large number of producers, and an individual firm cannot influence the price of the market. As a result, a firm is a quantity adjuster and price taker, whereas an industry is a price giver. Since a firm can only decide the quantity sold, therefore, under perfect competition, MR = AR.

Since market forces set the price and only set the output, MR is horizontal to the x-axis. Therefore, for a perfectly competitive firm, the equilibrium point is when MR=MC=AR(PRICE).

Graphical representation

The equilibrium of a perfectly competitive firm is shown in the figure below, where point F satisfies the condition that MR=MC.

However, it is not a profit-maximizing point since the MC curve still falls and is below the MR curve. As a result, the firm can still gain higher profits by producing beyond point F.

However, after point C, a firm stops production since it satisfies both the conditions required for equilibrium. Moreover, if the firm decides to produce more than point C, it will incur losses. As a result, it has a maximized profit(relating to Baumol’s sales maximization model) of area BAEC with Q1 as the output sold at point B as the price.

Conditions for short-run

Moreover, in the short run, the firm produces to the point of PAVC. This explains that the firm operates until the profits are equal to fixed costs or losses are not more than fixed losses; otherwise, it shuts down.

Under Imperfect Competition

Imperfect competition includes different markets, such as an oligopoly, monopoly, monopolistic competition, etc. The market forces no longer set the price, and the firm can set it according to its advantage. Also, a firm can only fluctuate one, either price or output. Therefore, given the tastes and preferences of the consumers, the demand curve is downward sloping to the right.

However, if a firm sets the price of the product, then the customers determine the outputs of what they purchase at that price and vice versa(which can be briefly understood in pricing under monopoly). Ultimately, the major objective of any firm is to maximize its profits (relating to Baumol’s sales maximization model).

Conditions

i)  MC=MR < AR (PRICE)

ii) MC must rise after cutting the MR curve

Graphical Explanation

The above graph shows the price OP, and the OQ output level depicts the profit-maximizing point. If more output is produced, then the MC curve will be higher than MR, making the profits fall. As a result, point E is said to be an equilibrium point where the firm earns a profit of area BRAP.

However, in the short run, the firm produces PAVC. This explains that the firm operates until the profits are equal to fixed costs or losses are not more than fixed losses; otherwise, it shuts down.

Differentiate between Revenue maximization and Profit maximization

(relating to Baumol’s sales maximization model)

Baumol’s Sales Maximisation Model

Professor Baumol aims to maximize sales, which depicts the total revenue gained by selling goods. As a result, it is termed Baumol’s sales maximization model. According to Baumol’s sales maximization model, the main target remains sales revenue instead of maximizing profits (after the profits touch an acceptable level).

Baumol’s sales maximization model clearly states that after the firm achieves profits that are satisfactory to the shareholders (which are referred to as profit constraint), the manager’s efforts are directed more towards revenue through sales rather than maximizing profits.

Characteristics of Baumol’s Sales Maximisation Model

• Firstly, it should be remembered that Baumol’s sales maximization model does not ignore profits but attains them to a certain level, after which their goal shifts.

• Secondly, Baumol’s sales maximization model explains that in large organizations and in the long run, management is a different concept from the owners. Salaries and other benefits are linked largely with sales rather than profits.

• Thirdly, firms that wish to seize new opportunities and maximize their market advantage use Baumol’s sales maximization model strategy.

• Fourthly, managers often take the company’s sales personally and, therefore, try to maximize total revenue rather than profits. Moreover, sales are considered a better indicator of the firm’s position, which strengthens the firm’s competitive spirit.

• Lastly, since Baumol’s sales maximization model is sales-oriented, the managers are more interested as their performance is measured in terms of achieving the sales targets.

Graphical representation of Baumol’s sales maximization model

• The graph for Baumol’s sales maximization model below depicts TC, TR, and total profit curves. (Where, TC=Total cost, TR=Total revenue)
• It should be noted that the maximum profits are not at the point where TR is maximum or where TC is minimum.
• Therefore, point A explains the profit maximization theory.
• Moreover, sales maximize at point Rs with output Qs. At this level, profits may not be maximum, and TC might not be minimum, but they give better results in the long run.

Arguments in favor of Baumol’s sales maximization model

Realistic

Since a firm’s success and growth are measured by its sales revenue, it becomes more realistic for a firm to pursue models with theoretical analysis instead of plausibility and reality. Managers focus on achieving the sales targets, which directly contributes to sales maximization, i.e., the main objective of the firm.

Practical

There prevails a chronological order since the sales increase the production, which further lowers the price. As a result, customers are attracted to such a goal along with a promotion for their welfare.

Easy availability of loans

Baumol’s sales maximization model is beneficial in sanctioning loans for firms since financial institutions mainly consider their sales only. As a result, the ones with greater sales take advantage.

Position in the market

Usually, the major reason for a firm’s large sales build-up is its customer base, power, and expansion strategy. These factors indicate a strong position and the firm’s progressive nature.

Frequently Asked Questions 

What is Baumol’s sales maximization model?

Baumol’s sales maximization model clearly states that after the firm achieves profits that are satisfactory to the shareholders (which are referred to as profit constraint), the manager’s efforts are directed more towards revenue through sales rather than maximizing profits.

How is Baumol’s sales maximization model different from Marris model?

In Baumol’s model managers are interested only in their own utility. In Marris’s model under conditions of steady growth managers can attain contemporaneously the maximisation of their own utility and of the utility of owners.