Baumol’s model of sales revenue maximization
As with all managerial theories, Baumol’s (1959) starting point was the assumption of a divorce of ownership from control within oligopolistic markets. 6 From experience as a consultant to large corporations, he proposed that rather than maximise profit, managers instead seek to maximise sales revenue, subject to an acceptable profit constraint. As we will see, in maximising sales revenue the firm will generally have higher sales and sales growth than a profit-maximising enterprise.
The preoccupation of management with sales revenue was largely rationalised on the grounds that managerial salaries, perks and status were more closely linked to sales revenue than profit. Baumol also noted the favourable attitude of banks and other financial institutions to sales growth and that growth enhanced opportunities for promotion and higher salaries. Alternatively, with declining sales revenue, employees might need to be laid off or have their salaries reduced. Banks and other financial institutions would now look less favourably upon financial provision, and retail outlets would become less willing to provide prime points of sale. Indeed, if sales fell below a certain threshold, retailers might choose to cease trading a good altogether.
In his basic model, Baumol assumed the firm to produce a single product and aim to maximise sales revenue (SR) over a single time period. There is no consideration of the interdependence between the firm and others within and outside the industry.
This model can be illustrated by Figure 6.1. The total revenue (TR) and total cost (TC) curves are derived from conventional downward-sloping demand curves and U-shaped cost curves. The profit function is also shown. (This basic diagram was previously shown in Chapter 5 as Figure 5.15a.)
To maximise profit, the firm produces Qm.To maximise SR, the firm increases sales to Q by charging a lower price, resulting in a lower level of profit.
As indicated, the model assumes a profit constraint. This represents the minimum profit required to maintain the satisfaction of shareholders and financial markets. This constraint might be either operative or inoperative. For example, in maximising SR, the firm would not achieve a constraint such as π2 and would be obliged to increase price and reduce output to Qb'. This profit constraint would therefore be ‘operative’. Alternatively, a constraint of π3 would be ‘inoperative’ as the firm can still maximise SR and achieve a profit in excess of the constraint and more than satisfy the demands and aspirations of shareholders and financial markets.
Where the firm is faced with an inoperative profit constraint, the firm could be assumed to spend surplus profit (i.e. profit above the profit constraint) on any activity that would further enhance SR. For example, surplus profit could be spent on additional advertising, shifting the demand curve to the right and the TR curve upwards. The firm would continue spending more money on advertising (also shifting the TC upwards) until all surplus profit was exhausted and the profit constraint became operative. (The level of profit now equals the profit constraint.) Such a position must be reached if we assume there are diminishing returns to advertising: that is, increased expenditure upon advertising eventually having a diminishing impact upon SR.
Therefore, so long as the profit constraint is less than maximum profit, Baumol’s firm will always produce more and charge a lower price than a profit maximiser. It is also likely that the firm will advertise more and generally invest more in any activity likely to increase demand.
An additional feature of Baumol’s model is its prediction of how the firm reacts to a change in fixed or variable costs. First, imagine an increase in fixed costs. This would cause the total cost curve in Figure 6.1 to shift upwards in a parallel fashion and the profit curve to shift downwards. This is illustrated in Figure 6.2 with the profit curve shifting downwards from π' to π''.With an ‘operative profit’ constraint of π2, the sales maximiser would react to the increased cost by raising price and reducing output from Qb' to Qb*.This is in contrast to the prediction of the profit-maximising model where because a change in fixed cost does not affect marginal cost, the profit-maximising output (where MC equals MR) is not affected. Therefore, price and output remain unchanged despite the increase in fixed cost. This can also be seen in Figure 6.2 by the profit-maximising output remaining at Q .The reaction of Baumol’s firm appears more realistic.