The model of Baumol

Last Updated: 08 May 2020
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The model of Baumol is a management technique used by many by companies especially in determination of optimal use and availability of the limited resources through competitive pricing and desirable output levels so as to maximize revenue. According to Gaffney, the Baumol model allows business entities to predict and determinate the optimal levels of output and sales that needs to be maintained under normal conditions (Gaffney, 2008)

This situation is necessitated by the fact that most enterprises are increasingly implementing business strategies in effort to cut down the cost of operations by the management by going a head to incur opportunity costs with intent of realizing more profits at later date as opposed to the present (Baker, 1998). According to William, it is the ultimate objective of nearly every firm to aim at maximIzation of sales revenue rather than the profit, a manageral function known as the sales maximization and revenue maximization theory (William, 2008).

Sales ,computed as the value of price per output multipled by the quantity of output sold of, and the emphasy to maximize it has therefore formed the objective of many firms. The Baumol’s Model The model is based on the assupttiom that firms aim to maximaize the value of their sales revenue , but subject to a constraint that the profits are maintained at a given acceptable level.

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As a result, if the profits are within the desired level , the implication is that the managent will forcus on and develop to implement more strategies aimed at incresing the sales volumes which also help in the entrenchment of a competitive position in the market. In employing the model, according to Baker, given the total cost and the total revenue curves , the prifit curves can be obtained by plotting the difference between Total Revenue and Total Cost curves.

Profit is taken to be zero at the point at which the total revenue is equal to the total costs. At equlibrium where revenue is maximum, the slope of the total revenue is equals to zero. Similarly, the peak of the total revenue curve is the total maximum sales revenue at which output is optimal. Discussion William (2008) explains that , using the Baumol's model, a short-run revenue maximization, if properly implemeted will be in line with the long run profit maximazation obejective, a common occurrance among many oligopolistic firms.

The model also stipulates that management strive to maximaze sales since high sales would assist in attracting new customers due to the product’s popularity and discoutns , a situation which also ensure financial credibilty , credit worthiness , and retention of good employess. Since the model seeks to establish an optimal point, the management may apply it in pricing and output decisions to ensure that the consumers and suppliers receive the most competitive rates as a way of trading-off profit today for more profit tomorrow through repeat sales and purchases.

The Baumol model is therefore employed by the management to establish the equilibrium for a revenue maximization which is indicated when price, cost, output, and advertising outlay are all free to vary (Haveman, Robert ; Bartolo, Gilbert, 1970). In a ologopilitc firm , the total revenue is taken as a function of output, while the marginal production cost which illustrates the output is taken to be an increaisng positive function of output (Haveman, Robert ; Bartolo, Gilbert, 1970).

Haveman and his colegues further argue that the marginal revenue, an outcome of total revenue differetiation is a decreasing positive function of fixed costs. Based on this argument, when one is provided with a prift function to analyse using the Baumol model, it will not directly relate costs like advertisng expenses to the output to give profit above the function and maximmun sales revenue (Haveman, Robert ; Bartolo, Gilbert, 1970). In this case therefore, the model will not give a direct insight on the output-sales relationship.

Though sharteholdre are normally more keen on the profits to be declared, the Baumol’s model tend to deviate from this notion and attempts to expalin why the managemnt prefer to link the prices and total revenue in the process of sales maxization strategy. The management‘s focus on sales revenue , according to the model, is based on the need to factor in the costs of production and the profit margin,all which are covered by the sales revenue (William, 2008).

The model further links the prices and total revenue by arguing that a firm should charge a competitive price that will not only cover the production coss but also meet the minimum level of the desired profit. In the line with this analysis, the model suggests that for a digopolists whose ultimate aim and major feature is sales maximization yet the output does not yield adequate profit, the indifferent managemnmt may opt to choose the output level which guarantees adequate profit even if the required sales maximization lecvel is not attained.

As a result the management may be indifferent as to what strategy to adopt in quest of revenue maximization. This scenario represents the opportunity cost to be incurred in such a state of the management indifference as they trade-off profit today for more profit tommorrow. In conclusion, it is eveident that profit maximation should not be the ultimalte goal of a firm as supported by the Baumol’s model. The managemnt should also aim at investing the funds advanced to the firm into strategies aimed at maximising sales like advertisemnets in a bid to expand the margin.

By taking all these factors into consideration,the firm will be able to maximize returns on capital and equity hence achievement of the overall goal for a firm to meet the needs of its stakeholdres (Baker, 1998). However the model has some weaknesess like it is postulated as a partial model where all production and marketing costs are fixed hence it assumes that the non advertising costs of increasing sales is zero (William, 2008).

References: Longman. Wesley. 1999. Short Term Financial Management. [Online] Available at:htttp://ftp. aw. com/busecon/authors/eakins/chap_16. ppt [Accessed February 9, 2009]. Baker.

Profitmaximization. 1998. [Online]Availableat:http://www. westburnpublishers. com/marketing-dictionary/p/profit-maximization. aspx. [Accessed February 9, 2009]. Gaffney. Baumol Model for Managing Inventories. 2008. [Online] Available at: www. masongaffney. org/class/Baumols_Model_for_Managing_Inventories_3_92. pdf. . [Accessed February 9, 2009]. Haveman, Robert ; Bartolo, Gilbert. The Revenue Maximization Oligopoly Model:Comment. 1970. [Online]Availableat:http://mpra. ub. unimuenchen. de/9877/1/MPRA_paper_9877. pdf. [Accessed February 9, 2009]. William. Towards Competition in Local Telephony. 2008. .[Online]Available

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