Profit Maximization and Baumol Model

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Managerial Economics
August 15, 2007

The key points underpinning the economics of a profit maximizing firm Neoclassical model of the firm states that organization will have the main objective of maximizing its profit within a given period of time. Maximum profit was achieved at the output at which marginal cost is equal marginal revenue. There are several factors which need to be considered when talking about the profit maximizing firm: 1. The assumption of the profit maximizing firm is that there is no segregation between managers and owners of the firm. Owners economically depended on their firms and therefore tried to make the biggest profit from their businesses. The effectiveness of their firm was measured by the profit declared. In the real world the ownership of the firm (especially for the larger firms) is different from the management. Managers become responsible for all day-to-day operations as well as finance objectives. Those can be different for management and for the owners. Managers tend to satisfy their own well being rather then acting on the best interests of the owners. Shareholders would like to see the increasing value of the stock from year to year. The separation of ownership from control lead to less power of shareholders over the manager’s behavior as well as less awareness of how efficient the decisions are made. 2. Profit maximizing firm assumes the horizontal marginal revenue curve and U shape marginal cost curve. This means that the market conditions are always ideal, not very competitive and the revenue cost declines as a result of discounts made to encourage the customers to purchase the products. In reality it is difficult to accurately measure the cost and revenue within organization and therefore difficult to determine the optimal, profit maximizing level. There are a lot of constraints and conditions which need to be evaluated at any given period of time to determine the cost and revenue curves. Rapidly changing conditions will make it difficult and sometimes impossible to make the accurate measurements. 3. Another assumption is that the organization short-term objectives are the same as its long term objectives leading to profit maximization. In reality, as in long term objective may be to maximize the firm stock value and increase the shareholders profit, the short term objective may be to keep investing in a firm to establish a better position for the future. Other constraints like social responsibility of the firm, imperfect or changing market conditions, demand versus supply curves etc. will affect the objectives of the firm. 4. One of the assumptions of the neoclassical model is that the organizations have a perfect knowledge of the operating conditions. It is recognized in the modern firm that they operate under the uncertainty level, which, however can be reduced by increasing the knowledge for market, competition and environment. With these factors the conclusion is that the profit maximization cannot be the sole objective of a firm. The factors need to be taken into consideration to determine the optimum firm strategy and firm objectives.

Critical evaluation of Baumol management model.

Baumol model is a sales revenue maximization model. Baumol model is the alternative to the profit maximization model. The main idea of Baumol model is that the objective of a firm is the sales revenue-maximization rather then profit maximization. The most important points supporting Baumol model are:

- The is recognition of separation between firm ownership and management. Managers have discretion to pursue personal goals to maximize their own utility. Therefore a minimum profit constraint on management is set up by shareholders to address shareholders concerns and interests. - Manager’s more focuses on their own tangible benefits rather then on profit maximization for the company. Salary increases are likely related to the level of sales rather then organization...
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