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Baumol’s Sales or Revenue Maximisation

Theory: Assumptions, Explanation and
Criticisms
By Smriti Chand Economics

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Baumol’s Sales or Revenue Maximisation Theory: Assumptions, Explanation and

Criticisms!

Prof Baumol in his article on the theory of Oligopoly presented a managerial theory of the firm
based on the sales maximisation.

Assumptions:

The theory is based on the following assumptions:

1. There is a single period time horizon of the firm.

2. The firm aims at maximising its total sales revenue in the long run subject to a profit
constraint.

3. The firm’s minimum profit constraint is set competitively in terms of the current market value
of its shares.
4. The firm is oligopolistic whose cost cures are U-shaped and the demand curve is downward
sloping. Its total cost and revenue curves are also of the conventional type.

Explanation:

Baumol’s findings of oligopoly firms in America reveal that they follow the sales maximisation
objective. According to Baumol, with the separation of ownership and control in modem
corporations, managers seek prestige and higher salaries by trying to expand company sales even
at the expense of profits.

Being a consultant to a number of firms, Baumol observes that when asked how their business
went last year, the business managers often responded, “our sales were up to three million
dollars.” Thus, according to Baumol, revenue or sales maximisation rather than profit
maximisation is consistent with the actual behaviour of firms.

Baumol cites evidence to suggest that short-run revenue maximisation may be consistent with
long-run profit maximisation. But sales maximisation is regarded as the short-run and long-run
goal of the management. Sales maximisation is not only a means but an end in itself He gives a
number of arguments in support of his theory.

1. A firm attaches great importance to the magnitude of sales and is much concerned about
declining sales.

2. If the sales of a firm are declining, banks, creditors and the capital market are not prepared to
provide finance to it.

3. Its own distributors and dealers might stop taking interest in it.

4. Consumers might not buy its product because of its unpopularity.

5. Firm reduces its managerial and other staff with fall in sales.

6. If firm’s sales are large, there are economies of scale, the firm expands and earns large profits.

7. Salaries of workers and management also depend to a large extent on more sales and the firm
gives them bonus and other facilities.

By sales maximisation, Baumol means maximisation of total revenue. It does not imply the sale
of large quantities of output, but refers to the increase in money sales (in rupee, dollar, etc.).
Sales can increase upto the point of profit maximisation where the marginal cost equals marginal
revenue. If sales are increased beyond this point, money sales may increase at the expense of
profits. But the oligopolistic firm wants its money sales to grow even though it earns minimum
profits.

Minimum profits refer to the amount which is less than maximum profits. The minimum profits
are determined on the basis of firm’s need to maximize sales and also to sustain growth of sales.
Minimum profits are required either in the form of retained earnings or new capital from the
market.

The firm also needs minimum profits to finance future sales. Further, they are essential for a firm
for paying dividends on share capital and for meeting other financial requirements. Thus
minimum profits serve as a constraint on the maximisation of a firm’s revenue. “Maximum
revenue will be obtained only”, according to Baumol, “at an output at which the elasticity of
demand is unity, i.e., at which marginal revenue is zero. This is the condition which replaces the
“marginal cost equals marginal revenue profit maximisation rule.”

Baumol’s model is illustrated in Figure 5 where TC is the total cost curve, TR the total revenue
curve, TP the total profit curve and MP the minimum profit or profit constraint line. The firm
maximises its profits at OQ level of output corresponding to the highest point B on the TP curve.
But the aim of the firm is to maximise its sales rather than profits.

Its sales maximisation output is OK where the total revenue KL is the maximum at the highest
point of TR. This sales maximisation output OK is higher than the profit maximisation output
OQ. But sales maximisation is subject to minimum profit constraint. Suppose the minimum
profit level of the firm is represented by the line MP.

The output OK will not maximise sales as the minimum profits OM are not being covered by
total profits KS. For sales maximisation, the firm should produce that level of output which not
only covers the minimum profits but also gives the highest total revenue consistent with it. This
level is represented by OD level of output where the minimum profits DC (=0M) are consistent
with DE amount of total revenue at the price DE/OD, (i.e., total revenue/total output).

Baumol’s model of sales maximisation points out that the profit maximisation output will be
smaller than the sales-maximisation output OD, and price higher than under sales maximisation.
The reason for a lower price under sales maximisation is that both total revenue and total output
are equally higher while. under profit maximisation, total output is much less as compared to
total revenue. Imagine if QB is joined to TR in Figure 5. “If at the point of maximum profit”
writes Baumol, “the firm earns more profit than the required minimum, it will pay the sales
maximiser to lower his price and increase his physical output.”

Model with Advertising:

Baumol has further shown that the profit constraint under sales maximisation is also effective in
advertising and thereby increases the firm’s revenue. In Figure 6, expenditure on advertising is
taken on the horizontal axis, and total revenue, costs and profit on the vertical axis. TR is the
total revenue curve.

The 45° line AdC is the advertisement cost curve. By adding a fixed amount of other costs equal
to OC to the AdC curve, we get the total cost curve TC. Here production costs OC are assumed
independent of advertising costs. TP is the total profit curve which is the difference between the
TR curve and the TC curve. MP is the minimum profit constraint line.

The profit-maximisation firm will spend OQ on advertising and its total revenue will be OS
(=QA). On the other hand, given the profit constraint AfP, the sales- maximisation firm will
spend OD on advertising and earn OT (=DE) as the total revenue. Thus the sales-maximisation
firm spends more on advertising (OD) than the profit-maximisation firm {OQ), OD >OQ and
also earns higher revenue (DE) than the latter (QA), DE> QA, at the profit constraint MP. Thus it
will always pay the sales maximiser to increase his advertising outlay until he is stopped by the
profit constraint.

Conclusion:

This theory leads to the conclusion that a sales-revenue maximisation firm:

(a) Will produce at a higher level,

(b) Will keep low prices, and

(c) Will invest in such a manner, as on advertisement, that the demand for its product will
increase.

Implications (or Superiority) of the Theory:

Baumol’s sales maximisation theory has some important implications which make it superior to
the profit maximisation model of the firm.

1. The sales maximising firm prefers larger sales to profits. Since it maximises its revenue when
MR is zero, it will charge lower prices than that charged by the profit maximising firm.

2. It follows from the above that the sales maximising output will be larger than the profit
maximising output.

3. The sales maximiser would spend more on advertising in order to earn larger revenue than the
profit maximiser subject to the minimum profit constraint.

4. There may be a conflict between pricing in the short run and the long run. In the short run
when output cannot be increased, revenue can be increased by raising the price. But in the long
run, it would be in the interest of the sales maximisation firm to keep the price low in order to
compete more effectively for a large share of the market and thus earn more revenue.

Criticisms: 

Baumol’s sales maximisation model is not free from certain weaknesses.

1. Rosenberg has criticised the use of the profit constant for sales maximisation by Baumol.
Rosenberg has shown that it is difficult to specify exactly the relevant profit constraint for a firm.
This is explained in Figure 7. Sales revenue of the firm is measured along the vertical axis and
profit on the horizontal axis. R refers to the profit constraint.

For any two combinations with profits below the constraint, the one with the larger profit will be
preferred. For instance, B on the profit level P1is preferred to A at the profit level P2 since the
line P1 represents a higher level of profit. Again, of the two combinations B and C lying on the
same profit line P1, the one with higher sales will be preferred, i.e., C will be preferred to B.
Similar is the case with points D and E on the constraint line R where E with higher sales will be
preferred to D. Thus it is very difficult to choose the sales maximisation and minimum profit
constraint in Baumol’s model. Further, so long as profits exceed the constraint, they will always
be converted into advertising to increase sales.

2. According to Shepherd, under oligopoly a firm faces a kinked demand curve and if the kink is
large enough, total revenue and profits would be the maximum at the same level of output. So
both the sales maximiser and the profit maximiser would not be producing different levels of
output.

But Hawkins has shown that if the firm is engaged in any form of non-price competition such as
good packaging, free service, advertising, etc.. Shepherd’s conclusions become invalid. When
the sales maximiser spends more on advertising, his output will be more than that of the profit
maximiser. This is because the kink of the former’s demand curve will occur to the right of the
kink of the profit maximiser.

3. Hawkins has also shown that Baumol’s conclusion that a sales-maximiser will in general pro-
duce and advertise more than a profit-maximiser, is invalid. According to Hawkins, a sales-
maximiser “may choose a higher, lower or identical output—and a higher, lower or identical
advertising budget. It depends on the responsiveness of demand to advertising rather than price
cuts. This conclusion holds for firms producing only one product, or one group of products.”

4. In the case of multiproducts, Baumol has argued that revenue and profit maximisation yield
the same results. But Williamson has shown that sales maximisation yields different results from
profit maximisation.

5. Another weakness of this model is that it ignores the interdependence of the prices of
oligopolistic firms.

6. The model fails to explain “observed market situations in which price are kept for
considerable time periods in the range of inelastic demand.”

7. The model ignores not only actual competition, but also the threat of potential competition
from rival oligopolistic firms.

8. The model does not show how equilibrium in an industry, in which all firms are sales
maximisers, will be attained. Baumol does not establish the relationship between the firm and
industry.

9. Prof. Hall in his analysis of 500 firms came to the conclusion that firms do not operate in
accordance with the objective of sales maximisation.

Despite these criticisms, there is no denying the fact that sales maximisation forms an important
goal of firms in the present day business world.

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