Unit 1: Basic Concepts of Economics

• An economy is a social system where individuals and organizations produce,

consume and exchange all types of goods and services.

• An economy is constituted of interrelated and interdependent economic activities

of the economic players. Economic players include individuals, households,
firms, farms, factories, financial institutions and government.

The economic problem, often referred to as the "basic economic problem," arises
because resources are scarce, while human wants and needs are virtually unlimited. This
creates a fundamental issue of how to allocate limited resources to satisfy as many
wants and needs as possible.

The key elements of the economic problem are:

1. Scarcity: Resources such as land, labor, and capital are finite and insufficient to
meet the unlimited desires of people. Scarcity forces individuals, businesses, and
governments to make choices about how to use resources efficiently.

2. Choice: Since not all wants can be satisfied, individuals and societies must
choose which wants to fulfill. This involves prioritizing the allocation of resources.

3. Opportunity Cost: Every choice has a trade-off. The opportunity cost is the value
of the next best alternative that is foregone when a decision is made. For example,
if a government spends money on healthcare, the opportunity cost might be the
reduction of spending on education or infrastructure.

4. Allocation of Resources: The economic problem requires the allocation of

resources across competing needs. Societies develop different systems (e.g.,
market economies, command economies, or mixed economies) to manage this
allocation.

This problem is universal and is the foundation of many economic theories and decision-
making processes across households, businesses, and governments.
Concept of Economies (capitalist, socialist and mixed economies),

Capitalist Economy (Market Economy):

• Definition: In a capitalist economy, the means of production and distribution are

owned and controlled by private individuals or corporations. Decisions regarding
investment, production, and distribution are guided by the free market,
determined by supply and demand.

• Key Features:

o Private Ownership: Individuals and businesses own property and

resources.

o Profit Motive: Businesses operate to make a profit, driving innovation and

efficiency.

o Minimal Government Intervention: The government's role is limited to

protecting property rights, enforcing contracts, and regulating some
aspects of business to prevent monopolies.

o Competition: Free competition exists, which helps to keep prices

competitive and encourages innovation.

• Examples: United States, Singapore, Hong Kong.

Socialist Economy (Planned Economy):

 • Definition: In a socialist economy, the government owns and controls the major
means of production and distribution. The allocation of resources and production
decisions are made centrally by the government to ensure equality and meet the
needs of society as a whole.

• Key Features:

o State Ownership: The government controls major industries, such as

healthcare, education, and transportation.

o Central Planning: The government decides what goods and services are
produced, how they are distributed, and at what prices.

o Equality: Emphasis is placed on equal distribution of wealth and income

to reduce class distinctions.

o Limited Role of Private Enterprise: In some socialist economies, small

businesses may exist, but large-scale industries are state-controlled.

• Examples: Cuba, North Korea, formerly the Soviet Union.

Mixed Economy:

• Definition: A mixed economy combines elements of both capitalism and

socialism. Both private businesses and the government play a role in the
economic decision-making process.

• Key Features:

o Coexistence of Private and Public Sector: Both private and public

enterprises operate in the economy. Essential services, such as healthcare
and education, may be government-owned, while consumer goods
industries may be privately owned.

o Government Intervention: The government intervenes to regulate

markets, provide social welfare, and correct market failures (e.g.,
environmental protection, income redistribution).

o Balancing Efficiency and Equality: The mixed economy seeks to balance

the efficiency of market-driven economies with the social welfare goals of
socialism.

• Examples: Most countries today, including India, France, the UK, and many
Scandinavian nations, follow a mixed economic system.

• According to Adam Smith (1976), the “father of economics”, economics is “an

inquiry into the nature and causes of the wealth of nations”.
 • According to Alfred Marshall, (1922), an eminent economist of the neo-classical
era, “Economics is the study of mankind in the ordinary business of life; it
examines that part of individual and social actions which is most closely
connected with the attainment and with the use of the material requisites of well-
being.”

• Economics can, thus be defined as a social science that studies economic

behaviour of the people, the individuals, households, firms, and the government.

• Economics as a social science studies how people allocate their limited

resources to their alternative uses with the objective of deriving maximum
possible gains from the use of their resources.

Economics as a social science has two major branches—

• microeconomics

• macroeconomics.

Microeconomics is the study of the economizing behaviour of the individual economic

entities—individuals, households, firms, industries and factory owners.

For example, microeconomics studies how individual consumers make choice of goods
and services they want to consume and how they allocate their limited income between
the goods and services of their choice to maximize their total economic welfare.

Macroeconomics, studies the economic phenomena at the national aggregate level.

macroeconomics is the study of working and performance of the economy as a whole.

It studies what factors and forces determine the level of national output or national
income, rate of economic growth, employment, price level, and economic welfare.

macroeconomics studies how government of a country formulates its macroeconomic

policies—taxation and public expenditure policies (the fiscal policy), monetary policy,
price policy, employment policy, foreign trade policy, etc., to resolve the problems of the
country.

Nature and Scope of Managerial Economics

• Managerial economics can be defined as the study of economic theories, logic,

concepts and tools of economic analysis applied in the process of business
decision-making.

• Managerial economics is an integration of economic science with decision

making process of business management.
 • According to Spencer and Siegelman: “The integration of economic theory with
business practice for the purpose of facilitating decision-making and forward
planning by management”.

• In the words of TJ. Webster, ”Managerial economics is the synthesis of

microeconomic theory and quantitative methods to find optimal solutions to
managerial decision-making problems.”

The scope of managerial economics is comprised of economic concepts, theories

and tools of analysis that can be applied in the process of business decision making
to analyse business problems, to evaluate business options, to assess the business
prospects, with the purpose of finding appropriate solution to business problems and
formulating business policies for future.

internal management issues can be listed as follows.

• What to produce—choice of the business

• How much to produce—determining the size of the firm

• How to produce choice of efficient and affordable technology

• How to price the product—determining the price of the product

• How to promote sale of the product

• How to face price competition from the competing firms

• How to enlarge the scale of production—planning new investment

• How to manage profit and capital.

The microeconomic theories and tools of analysis that provide a logical basis and ways
and means to find a reasonable solution to business problems constitute the
microeconomic scope of managerial economics. The main microeconomic theories that
fall within the scope of managerial economics are following: Theory of Consumer
Demand, Theory of Production, Theory of Cost, Theory of Price Determination and Theory
of Capital and Investment Decisions.

Macroeconomics is the study of economic conditions of the economy as a whole

whereas a firm is a small unit of the economy. As such, macroeconomic theories are not
directly applicable to managerial decisions. However, business managers, while making
business decisions, cannot assume the economic conditions of the country to remain
the same for ever. As a matter of fact, economic conditions of the country keep changing.
Changing economic conditions change the economic environment of the country, and
thereby business environment and business prospect.
while making business decisions, managers have to take into account the economic
environment of the country. The factors which, in general, determine the economic
environment of a country are (i) the general trend in national income (GDP), saving and
investment, prices, employment, etc., (ii) the structure and role of the financial
institutions, (iii) the level and trend in foreign trade, (iv) economic policies of the
government, (v) socio-economic organizations like trade unions, consumer associations,
and (vi) political environment.

Managerial Economics and decision-making

The primary function of managers is to take appropriate decisions and implement them
effectively to achieve the objective of the organization to maximum possible extent, given
the resources. Application of economics contributes a great deal to managerial decision-
making as it provides guidance in finding an appropriate solution to the business
problem.

economic theories, concepts and tools of analysis are applied as roadmap to find
solution to business problems.

The objective of managerial economics is to enhance the efficiency of decision-making

in enterprises to enhance profit.

• Pricing: Managerial economics helps business organizations in determining the pricing

strategies and suitable pricing levels for their products and services.

• Elastic Vs. Inelastic Goods: Economists can decide price sensitivity of products using
a price elasticity analysis. This will ensure that it becomes easy to take decisions related
to marketing and pricing of goods.

• Operations and Production: Quantitative methods are used by managerial to analyze

production and operational efficiency by means of schedule optimization, economies of
scale and resource analyses.

• Investments: Many managerial economic tools and analysis models are used to assist
in making investing decisions both for corporations as well as individual investors. These
tools are used to make stock market investing decisions and decisions on capital
investments for a business.

• Risk: Uncertainty exits in every business and managerial economics can help reduce
risk through uncertainty model analysis and decision-theory analysis. Statistical
probability theory is largely used to provide potential scenarios for business enterprises
while making decisions.
The concept of a firm refers to a business organization or entity that engages in the
production, purchase, and sale of goods or services to generate profit. Firms operate
within the broader context of the economy, playing a key role in producing goods,
providing employment, and creating value for consumers and shareholders. Firms are
central to economic activity and decision-making, and they vary in size, structure, and
purpose, depending on their industry, goals, and ownership.

Key Characteristics of a Firm:

1. Production:

o A firm produces goods or services by combining various factors of

production (such as land, labor, capital, and entrepreneurship). The goal is
to transform these inputs into outputs that can be sold in the market.

2. Profit Maximization:

o A firm typically operates with the objective of maximizing profit. This means
that firms seek to produce goods or services at the lowest cost possible
while selling them at the highest price that the market will allow,
considering competition and demand.

3. Decision-Making Unit:

o The firm acts as an independent decision-making entity. It makes choices

about what to produce, how much to produce, pricing strategies,
investment decisions, and how to allocate its resources efficiently to
achieve its objectives.

4. Ownership and Legal Status:

o Firms can be owned by individuals, groups, or the government, and they

exist in various legal forms such as sole proprietorships, partnerships,
corporations, or cooperatives. Each type of firm has its own legal structure,
liability, and financial requirements.

5. Market Interaction:

o Firms interact with both consumers (to whom they sell goods and services)
and suppliers (from whom they buy inputs). In addition, firms compete with
other firms in their industry, influencing prices and innovation.

6. Risk and Uncertainty:

o Firms operate under conditions of uncertainty, such as changes in market

demand, fluctuations in input costs, and shifts in government regulations.
Managing risk and adapting to market changes are essential for long-term
survival.
Types of Firms:

1. Sole Proprietorship:

o A business owned and managed by a single individual. It is the simplest

form of a firm, where the owner is fully responsible for the business’s
operations, profits, and liabilities.

o Examples: Small retail shops, freelance businesses.

2. Partnership:

o A business entity owned by two or more individuals who share the

responsibilities, profits, and liabilities of the firm. Partnerships can be
general or limited, depending on the level of involvement of each partner.

o Examples: Law firms, medical practices.

3. Corporation:

o A firm that is a separate legal entity from its owners (shareholders).

Corporations can raise capital by selling shares of stock, and they offer
limited liability to their owners, meaning shareholders are not personally
liable for the firm's debts.

o Examples: Large multinational companies like Apple, Toyota, or Amazon.

4. Limited Liability Company (LLC):

o A hybrid business structure that offers the limited liability protection of a

corporation with the flexibility and tax efficiencies of a partnership.

o Examples: Many small to medium-sized businesses operate as LLCs.

5. Cooperatives:

o A firm owned and operated by a group of individuals for their mutual

benefit. Cooperatives are typically created to serve a common economic
need, and profits are shared among the members.

o Examples: Farmer cooperatives, credit unions.

6. Government-Owned Firms:

o These firms are owned and operated by the government. They often provide
essential public services like transportation, healthcare, or utilities.

o Examples: National railways, state-owned power companies.

Functions of a Firm:
 1. Production of Goods and Services:

o Firms are responsible for producing goods and services by combining

resources efficiently. This involves managing the factors of production and
converting inputs into outputs through various production processes.

2. Employment Generation:

o Firms provide jobs and income to individuals, contributing to economic

growth. They are key players in the labor market, determining wage levels,
work conditions, and career development opportunities.

3. Profit Generation and Distribution:

o Firms aim to generate profit, which can be reinvested in the business for
growth or distributed to shareholders as dividends. Profitability is crucial
for the sustainability and expansion of the firm.

4. Innovation and Growth:

o Firms invest in research and development (R&D) to innovate and improve

their products, services, and processes. This contributes to technological
advancements and overall economic progress.

5. Resource Allocation:

o Firms allocate resources like labor, capital, and raw materials to produce
goods and services. Efficient resource allocation leads to greater
productivity and better economic outcomes.

6. Risk Management:

o Firms must manage various risks related to production, finance, market

conditions, and regulatory changes. Effective risk management ensures
the firm’s stability and continuity.

Goals of a Firm:

1. Profit Maximization:

o Most firms prioritize maximizing profits, balancing revenue and costs to

achieve the highest possible financial returns.

2. Growth:

o Firms often seek to expand by increasing their market share, diversifying

products, or entering new markets. Growth can enhance their competitive
position and long-term sustainability.

3. Survival:
 o Especially for new or smaller firms, survival is a key goal, which involves
ensuring sufficient revenue to cover costs and weather market
fluctuations.

4. Social Responsibility:

o Many firms incorporate social and environmental goals alongside profit.

Corporate Social Responsibility (CSR) initiatives reflect a firm's
commitment to ethical practices, sustainability, and contributing to the
community.

5. Customer Satisfaction:

o Firms aim to meet customer needs and expectations to build loyalty,

enhance brand reputation, and ensure repeat business.

Types of Markets in Which Firms Operate:

1. Perfect Competition: Firms operate in a market where many competitors offer

identical products, and no single firm can influence market prices.

o Example: Agricultural markets (wheat, corn).

2. Monopolistic Competition: Firms sell differentiated products and have some

control over pricing due to brand or product features.

o Example: Clothing, restaurants.

3. Oligopoly: A few large firms dominate the market, and each firm’s decisions affect
the others.

o Example: Automobile industry, airlines.

4. Monopoly: A single firm dominates the market, controlling prices and supply.

o Example: Utility companies in certain regions.

The concept of a market refers to any structure or system where buyers and sellers
interact to exchange goods, services, or resources. Markets can take different forms,
from physical locations like shops or farmer’s markets to digital platforms such as e-
commerce websites. They play a critical role in determining the price and quantity of
goods or services based on the forces of supply and demand.

Key Elements of a Market:

1. Buyers and Sellers:

 o Buyers (consumers) seek to purchase goods or services, and sellers
(producers or firms) offer goods or services to meet this demand.

2. Goods and Services:

o These are the commodities or offerings that are being exchanged. Markets
exist for both tangible products (e.g., food, clothing, electronics) and
intangible services (e.g., banking, consulting, healthcare).

3. Price Determination:

o Prices in a market are determined by the interaction of supply (from sellers)

and demand (from buyers). When demand exceeds supply, prices tend to
rise, and when supply exceeds demand, prices tend to fall.

4. Exchange Mechanism:

o A market facilitates the exchange of goods and services, often through the
use of money. However, bartering or credit-based exchanges also occur in
some markets.

5. Competition:

o Sellers compete with each other to attract buyers by offering better prices,
quality, or services. Buyers also compete when there is a limited supply of
goods or services.

Types of Markets:

1. Based on Geographical Location:

o Local Markets: Buyers and sellers are from the same area, and
transactions take place within a limited geographical region (e.g., local
grocery stores, farmers' markets).

o National Markets: Markets that operate within a country’s borders (e.g.,

national stock exchanges or industries like the automobile market in a
country).

o International/Global Markets: Markets where goods and services are

traded across international borders (e.g., the oil market, foreign exchange
market).

2. Based on Goods and Services:

o Product Market: A market where final goods or services are traded (e.g.,
consumer goods, electronics, food).
 o Factor Market: A market where factors of production such as labor, land,
and capital are bought and sold (e.g., labor market, real estate market).

3. Based on Structure:

o Perfect Competition: A market where many buyers and sellers trade

identical products, and no single entity has the power to influence prices
(e.g., agricultural markets for wheat or corn).

o Monopoly: A market where there is only one seller or producer with

significant control over the price and supply of a product (e.g., public
utilities in some regions).

o Oligopoly: A market dominated by a few large sellers or firms, often with

significant barriers to entry for new competitors (e.g., the airline industry,
smartphone market).

o Monopolistic Competition: A market where many sellers offer

differentiated products, meaning each seller has some control over price
due to product variation (e.g., clothing brands, restaurants).

4. Based on Time:

o Spot Market: Where goods or assets are traded for immediate delivery.

o Futures Market: Where goods or assets are traded for future delivery at a
predetermined price.

5. Digital or Physical:

o Physical Market: Transactions take place face-to-face, such as in a store

or at a market stall.

o Virtual Market: Transactions happen online or via electronic platforms

(e.g., Amazon, eBay, stock trading platforms).

Functions of a Market:

1. Price Discovery: Markets help determine the price of goods and services based
on the interactions of buyers and sellers.

2. Efficient Allocation of Resources: Resources are allocated where they are most
valued, as buyers and sellers respond to price signals.

3. Facilitating Trade: Markets enable the exchange of goods and services, creating
opportunities for buyers and sellers to meet and transact.

4. Promoting Competition: Markets encourage competition among sellers, which

can lead to innovation, improved product quality, and lower prices.
 5. Providing Information: Markets supply essential information to both consumers
and producers about trends, preferences, and pricing, helping them make
informed decisions.

Invisible hand theory

invisible hand, metaphor, introduced by the 18th-century Scottish philosopher and

economist Adam Smith, that characterizes the mechanisms through which beneficial
social and economic outcomes may arise from the accumulated self-interested actions
of individuals, none of whom intends to bring about such outcomes.

This concept aligns with the theory of laissez-faire economics, where the market finds
equilibrium through the people engaging in it instead of through the intervention of
government or other governing bodies. Invisible hand economics provides context for
how a market can stabilise itself by people acting with their own interests in mind, which
benefits everyone within the economy. As a foundational element in rational choice
theory, the invisible hand concept suggests that consumers are rational in making
economic decisions, leading to balance within the economy.

The concept of the “invisible hand” was invented by the Scottish Enlightenment
thinker, Adam Smith. It refers to the invisible market force that brings a free market to
equilibrium with levels of supply and demand by actions of self-interested individuals.

The concept was first introduced by Smith in “The Theory of Moral Sentiments” in 1759
and he used it again in his book, “An Inquiry into the Nature and Causes of the Wealth of
Nations,” which was published in 1776. The theory states that individuals that trade in a
free market pursuing their own interests will end up maximizing social benefits.
Furthermore, the benefits derived from the free market are maximum and more than
those in a regulated and planned economy.

According to the theory, the motivation to maximize profits drives a free economy. Every
individual, acting in their self-interest, generates a demand or supply which compels
others to buy or sell goods or services. In return, he either receives or pays compensation
and one party makes a profit. In this process of exchange in a free economy, resources
are allocated in the most efficient manner.

The invisible hand theory basically tries to convey that without any intervention, if all
individuals in the economy act in their best self-interest, the result is automatically in the
best interests of the economy. The results will always be better than those of a centrally
planned and regulated economy.

If each consumer is allowed to choose what and how much to buy and each producer is
free to choose its production quantity, technique, and prices, it will be beneficial, as a
whole, to the economy. Producers would use an efficient method of production to cut
costs and charge low prices to maximize revenue. Consumers would buy from sellers
who offer the lowest price. Also, investors would invest in industries that maximize their
return. All this would take place automatically if the economy is set free.

Morris’ Growth Maximization Model:

Working on the principle of segregation of managers from owners, Marris proposed that
owners (shareholders) aim at profits and market share, whereas managers aim at better
salary, job security and growth. These two sets of goals can be achieved by maximising
balanced growth of the firm (G), which is dependent on the growth rate of demand for the
firm's products (gD) and growth rate of capital supply to the firm (gC). Hence growth rate
of the firm is balanced when the demand for its product and the capital supply to the firm
grow at the same rate.

Maximise g = gD = gC

where g = balanced growth rate

gD = growth of demand for the products of the firm

gC = growth ofthe supply of capital

Marris further said that firms face two constraints in the objective of maximisation of
balanced growth, which are explained below:

Managerial Constraint Among managerial constraints, Marris stressed on the importance

of the role of human resource in achieving organisational objectives. According to him,
skills, expertise, efficiency and sincerity of team managers are vital to the growth of the
firm. Non- availability of managerial skill sets in required size creates constraints for
growth: organisations on their high levels of growth may face constraint of skill ceiling
among the existing employees. New recruitments may be used to increase the size of the
managerial pool with desired skills; however new recruits lack experience to make quick
decisions, which may pose as another constraint.

Financial Constraint This relates to the prudence needed in managing financial

resources. Marris suggested that a prudent financial policy will be based on at least three
financial ratios, which in turn set the limit for the growth of the firm. In order to prove their
discretion managers will normally create a trade-off and prefer a moderate debt ratio,
moderate liquidity ratio and moderate retained profit ratio.

The utility of managers is a function of salary, power, status and job security which they
aim to maximize.
On the other hand the utility of owners which they aim to maximize, is a function of profits
, capital , output , market share, public esteem.

Marris feels that the conflict between the maximizing behavior of owner’s and
shareholders is not so great as the variables in the two utility functions are strongly
correlated to the size of the firm. They have a common interest in the size of the firm, and
therefore, are primarily concerned with maximization of the rate of growth of size.

Policy variables: The model identifies several policy variables that a firm can use to
achieve balanced growth, including:

o Financial policy: The firm can choose its financial policy, which determines
the liquidity ratio, debt ratio, and retention ratio

o Diversification rate: The firm can decide to expand its product range,
change the style of its existing products, or both

o Advertising and R&D: The firm can decide how much to spend on
advertising and R&D

Baumol’s Static and Dynamic Models:

Prof. Baumol in his book Business Behaviour, Value and Growth (1967) has presented a
managerial theory of the firm based on sales maximisation. He discusses two models of
sales maximisation: a static model and a dynamic model.

Assumptions:The model 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 curves are U-shaped and the demand curve is
downward sloping. Its total cost and revenue curves are also of the conventional type.

The Model:
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 modern
corporations, managers seek prestige and higher salaries by trying to expand company sales
even at the expense of profits. 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.

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. But if firm’s sales are large, there are economies of scale and 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 up to the point of profit maximization 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 Quantity 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.”
Baumol’s model is illustrated in Figure 6 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 В 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 (=OM) 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
OQ will be smaller than the sales maximisation output OD, and price higher than under sales
maximisation.

Implications or Superiority of the Model:

Baumol’s sales maximisation model 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. In Figure 43.4, the profit maximisation firm produces OQ output while the
sales maximisation firm produces OQ1 output, OQ1 > OQ.
3. The sales maximiser would spend more on advertisement 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 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 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 to earn more revenue.
5. The profit maximization firm is assumed to act rationally which goes against the actual
behaviour of firms. On the other hand, the Baumol firm behaves satisfactorily for the purpose
of earning minimum profits at a fair sales maximization output.

Criticism:

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

1. Rosenberg has criticised the use of the profit constraint for sales maximisation by Baumol.
Rosenberg has shown that it is difficult to specify exactly the relevant profit constraint for a
firm.

Baumol’s Static Model

Assumptions 1) Time-horizon of a firm is a single period. 2) The firm maximises total sales
revenue subject to a profit constraint. 3) The minimum profit constraint is exogenously
determined by the demands and expectations of the shareholders, banks and other financial
institutions. 4) Cost curves are U-shaped and the demand curve is downward sloping.

Model 1: A single–product model without advertising The total cost (TC) and total revenue
(TR) curves under the above assumptions are shown below in Figure 12.1. The curve (inverted
U) below the TR and TC curves is the total profit curve, obtained by deducting TC from TR
for every level of output (X). The maximisation of sales revenue for a firm occurs at a point
where the marginal revenue equals zero.

Model 2: A Single-product model with advertising In this model, the firm maximises sales
revenue subject to a minimum profit constraint, which is exogenously determined. An
important addition into this model is that of advertising expenditure and a crucial assumption
is that sales revenue rises with advertising expenditure (that is, ∂R a∂ > 0, where R = sales
revenue, a = advertising expenditure). Baumol also assumes that price remains constant, and
production costs are independent of advertising.

Baumol’s Dynamic Model

The dynamic model is an improvement over the static single-period model. The most serious
weakness of the static model is the short time-horizon of the firm and the treatment of the profit
constraint as an exogenously determined variable. These problems have been solved in the
dynamic model by incorporating an extended time-horizon and endogenizing the profit
constraint.
Assumptions 1) The firm maximises the rate of growth of sales over its lifetime. 2) Profit is the
main source of finance for growth of sales. It is an instrumental variable whose value is
endogenously determined. 3) Demand is downward sloping and costs curves are U-shaped.