Baumol’s Sales Maximisation Model – Revenue & Profit Maximisation

Objective

Baumol’s sales maximisation model has two important subheads

1. revenue maximisation
2. profit maximisation theory

which together explains the idea behind maximising the sales.

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

Revenue maximisation

Revenue maximisation refers to the maximising of sales in a business using various techniques like sales promotion, advertisement, campaign, demos & test samples, references, etc so that an increased revenue along with capturing greater market share in the company.

However, revenue maximisation is possible at the point where MR( marginal revenue) is equal to zero. Revenue is generally the income of the company before the calculation of any expenses however sales includes the proceeds from selling goods.

Brief

• To maximise the wealth of shareholders, each business achieves this goal by handling the revenue sector. Revenue is targeted since it maximises 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 only then the products 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 the revenue increases. Therefore, the aim must be at maximising the revenue but not just to increase it (referring to its sustainability).

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

Graphical representation

• This 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 maximises at the point where MR = 0.

Example

A company sells chocolates that are new and have the will to maximize revenue(relating to Baumol’s sales maximisation model). The table below depicts the total revenue 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 maximises when the 6th quantity gets sold after which the increase in qty sold will not maximize the revenue and make marginal revenue negative. At this point, the total revenue is maximum while the marginal revenue is zero.

Benefits

To maximize wealth, we studied that revenue must maximisation is necessary. Also, that point must be priorly stated, to set the sale targets and growth.

Moreover, the benefits of revenue maximisation(under Baumol’s sales maximisation 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 expansion of the market share.

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

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

Developing a Brand Name

This must be kept in mind that a company can also create a good name by selling quality products and at a lower price. Moreover, this brings the brand loyalty of the customers and keep them entitled to the product for a longer duration.

Economies of Scale

When the company reaches a point of revenue maximisation, it sells a large quantity that is operating at a lower price. At bulk selling, the fixed cost per unit decreases as the quantity increases which tells that the fixed assets are being fully utilized. As a result, the company gets an advantage to manufacture high quality which in turn increases profitability.

Profit Maximization Theory

Firstly, relating to the neoclassical theory, profit maximisation (relating to Baumol’s sales maximisation 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 the pure profits which are gained above the average costs. This includes the amount left behind with the owner after paying all the expenses. As a result, it depicts the extra income with the entrepreneur beyond his normal profits.

The above-mentioned conditions for marginal revenues and profit maximisation (relating to Baumol’s sales maximisation model) apply to both perfect competition and imperfect competition( For example, Oligopoly market, Monopoly market etc)

Assumptions for profit maximisation 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.
• The new firms cannot enter into the industry in the short run. This is only possible in long run.
• Profits need to be maximized( relating to Baumol’s sales maximisation model) both 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 above-mentioned conditions and assumptions, let’s study how profit maximisation (relating to Baumol’s sales maximisation 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 where 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 the 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 sets the output, therefore, MR is horizontal to the x-axis. Therefore for a perfectly competitive firm 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.

But it is not a profit maximising 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 the production since it satisfies both the conditions required for the equilibrium. Moreover, if the firm decides to produce more than point C, then it will incur losses. As a result, it has a maximised profit(relating to Baumol’s sales maximisation 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 PAVC. This explains that the firm operates till the profits are equal to fixed cost or losses are not more than fixed lost otherwise they shut down.

Under Imperfect Competition

The imperfect competition includes different markets like an oligopoly, monopoly, monopolistic competition etc. The market forces no more set the price and the firm can set them according to its advantage. Also, a firm can only fluctuate only 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 output is determined by the customers on 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 maximisation model).

Conditions

i)  MC=MR < AR (PRICE)

ii) MC must rise after cutting the MR curve

Graphical Explanation

In the above-mentioned graph, the price OP and the output level OQ depicts the profit maximising 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 till the point PAVC. This explains that the firm operates till the profits are equal to fixed cost or losses are not more than fixed lost otherwise they shut down.

Differentiate between Revenue maximisation and Profit maximisation

(relating to Baumol’s sales maximisation model)

Baumol’s Sales Maximisation Model

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

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

Characteristics of Baumol’s sales Maximisation Model

• Firstly, this should be kept in mind that Baumol’s sales maximisation model does not ignore the profits but attain it to a certain level after which their goal shifts.

• Secondly, Baumol’s sales maximisation model explains that in large organisations 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, the strategy of Baumol’s sales maximisation model is used by the firms who wish to take up the new opportunity and maximum advantage in the market.

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

• At last, since Baumol’s sales maximisation model is sales-oriented therefore the managers are more interested as their performance is measured concerning achieving the sales targets.

Graphical representation of Baumol’s sales maximisation model

• The graph for Baumol’s sales maximisation model below depicts TC, TR and total profit curves. (Where, TC=Total cost, TR=Total revenue)
• This should be noted that the point of maximum profits neither lies at the point where TR is maximum nor where TC is minimum.
• Therefore point A explains the profit maximisation theory.
• Moreover, the sales maximize at point Rs with output Qs. At this level, the profits may not be maximum and TC might not be minimum but gives better result in long run.

Arguments in favour of Baumol’s sales maximisation model

Realistic

Since a firm’s success and growth is measured from its sales revenue therefore it becomes more realistic for a firm rather than pursuing the models with theoretical analysis instead of plausibility and reality. Managers focus on achieving the sales targets which directly adds up to the sales maximisation i.e the main objective of the firm.

Practical

There prevails a chronological order since the sales increase the production which further makes the price fall. As a result, customers attract to such a goal along with a promotion in their welfare.

Easy availability of loans

Baumol’ sales maximisation model is beneficial in sanctioning loan to the 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. As a result, the factors indicate a strong position and the progressive nature of the firm.