BAUMOL’S THEORY OF SALES

MAXIMISATION

Prof. Prabha Panth,Osmania University

Hyderabad

Prabha Panth 2

• Profit Maximisation not the only goal of a firm. • According to Baumol – Firm’s objective is “Sales

Maximisation” not “Profit Max.”Why do firms prefer Sales Maximisation?• Ownership and Management are separate.• Managers and Owners have different goals.• Managers’ goals based on Sales Maximisation

because of the following reasons:

Managerial models of the firm

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1. Salaries and perks to managers depend on sales, not profits.

2. Banks give loans to firms with more sales,3. Better payment to staff, when sales, but falls when

sales decrease,4. Sales increases prestige of managers, but large

profits go to shareholders/ owners.5. Managers prefer steady level of profits, not

maximum profits which are difficult to maintain.6. Increasing sales increases firm’s market power,7. Managers wish to avoid risky ventures that may

temporarily increase profits.

Prabha Panth 4

Baumol’s Static Model• Assumptions:1. Single time period,2. Oligopoly firm,3. Sales Maximisation objective, 4. Minimum profit to satisfy shareholders’ expectations,

keep up share prices, and meet bank requirements,5. U – Shaped cost curves (AC and MC), P.C. in factor

markets,6. Downward sloping D-curve,

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R, C

0

a

Qx

TR

TC

Rm

R, CRs

QsQm

R/q >0

R/q = 0

a

Figure 1. BAUMOL’S SALES MAXIMISATION

b

g

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• In Figure 1, taking TC and TR, the usual profit maximisation Q is Qm, where TR – TC is maximum.

• But here TR is still rising, it has not reached its maximum, R/q > 0.

• According to Baumol, managers prefer to have maximum sales, up to Qs.

• Here R/q = 0, and TR is maximum.• Some minimum profits = Rs Qs = 0a, can still be

earned. • Line aa is the minimum acceptable profits, to satisfy

shareholders, owners, etc. (Profit constraint).• But if minimum acceptable profit > Rs, then not

possible to maximise sales revenue.

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Difference between Sales and Profit Maximisation

Pm

Ps

Qm Qs

m

s

e>1

e=1

AR

MR

Sales Profits1.Qs > Qm2.Ps < Pm3.Profits s < Profits m4.Ed =1, Ed > 15.MR = 0, MR >0

Prabha Panth 8

Criticism• Cost and demand functions of individual firms

are not known.• Oligopoly interdependence has not been taken

into account. Other firms may also lower P, leading to P wars.

• Uncertainties in oligopoly, not discussed.• Relationship between firm and industry

equilibrium not shown.• Owners may demand higher profits not sales.