Evaluation of Baumol's Model

Topics: Profit maximization, Economics, Generally Accepted Accounting Principles Pages: 7 (1720 words) Published: April 22, 2011

Generally in business, there is a trade-off between selling many units at a low price and selling only a few units at a high price. There are different managerial models in a firm embodying different assumptions like the Profit Maximization Model which is a traditional model, the Marris Model, the Williamson Model and the Baumol Model.

This write-up will focus on understanding management preferences in terms of price, revenue and profit maximization, critically evaluate the management model of Baumol and review the extent to which the Baumol model provides a more useful insight into pricing and output decisions of modern management.

In conclusion, how low cost airlines apply the Baumol model in terms of pricing will be discussed.

Prices, Total Revenue and Profit Maximization

To understand management preferences, we have to realize that profit maximization is the objective of all companies. Without profit, a company can die off in no time. Management has an indifference relationship which is a trade-off of profits today for more profit tomorrow while some others focus on revenue maximization today.

For most organizations with a concentration of ownership and control within the hands of the small entrepreneur, there was considered to be more of a need for profits to be maximised.

The profit maximizing firm embraces a model that is holistic because the firm is seen as an entity that can have objectives of its own take decisions. This is in marked contrast to the ‘behavioral’ model of the firm where it is argued that ‘only people can have objectives, organizations cannot’.

Profit maximization may also be justified if it leads to correct predictions about firm behaviour. That is managers should have perfect information about future profit and cost streams.

The profit maximization is an optimizing model, where the firm is seen as attempting to achieve the best possible performance, rather than simply seeking ‘feasible’ performance which meets some minimum criteria. See figure below.


The above graph shows that the profit maximization point does not necessarily have to meet the marginal cost equals to marginal revenue criteria (MC=MR) but also the slope of total cost must exceed that of total revenue.

Supporters of the profit maximizing model may put forward a methodological argument in its defense. The descriptive realism of an assumption is not necessarily a valid criterion on which to judge a model. If the purpose of the model is to predict rather than to describe, then the criteria for evaluation are quite clear. First, the model must yield predictions, which is true for a profit maximizing model. Second, those predictions should be testable against the data, which is a test the model also passes. Third, the predictions should be supported by the data, which its supporters would claim is also the case. If this proposition is accepted, then the basic arguments of the managerial and behavioral schools are ill founded, because the realism of the profit maximizing firm is irrelevant.

Critical Evaluation of the Baumol Model

Baumol’s model stems from his observation that the salaries of managers, their status and other rewards often appear to be more closely linked to the size of the companies in which they work, measured by sales revenue, than to their profitability. In that case, managers may be more concerned to increase size than to increase profits, and the firm’s objective will be to maximize sales revenue...

References: 1. Patrick A. McNutt, Signalling, Strategy & Management Type
2. Cook M. and Farquharson C., (1998) Business Economics; First edition
3. Michael R. Baye, Managerial Economics and Business Strategy
4. www.easyjet.com. Easyjet Plc Annual Report & Financial Statements for the year ended 30 September, 2008 Easyjet Analyst and Investor Day.
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