Critical evaluation of the management model of Baumol.

a) Introduction

In its static reasoning -which ignores time- the neo classical model has no advice on how to
make profit (or anything else) grow over time and can give incorrect guidance when applied
to a dynamic topic like a firm’s endeavours to earn a profit. The assumption that the firm only
aims to maximise profit by choosing the level of output which gives the biggest difference
between revenue and costs does not exist in the real business world. The neoclassical
method of maximising profit would only maximise the rate of growth of profit if there is some
quantity which is the appropriate quantity to produce for all time--and there is no such
quantity in real world.

In order for the firm to achieve profit maximisation, they need to know the cost and revenue
conditions in the market so that marginal revenue and marginal cost can be found. The firm
is unlikely to know its demand curve, and it is therefore impossible to obtain a marginal
revenue curve.

b) Benefits of the Baumol Model

The unconstrained nature of the neo-classical model in the Price, Output, and Profit is not
achievable since there are other market factors that can affect the three variables. By
assuming that some constraints exist for one or more of the three variables above, Baumol
constrained managerial model solved several issues not addressed by the profit
maximization model. The model is very useful for Short run dynamic such as the profit
maximizing firm and is dynamic enough to accommodate for the long run requirements for
profitable growth.

Baumol Model Key points underpinning the theory

Ownership Separate There is a separation of ownership
/management (Baumol largely addressed and control
The separation of ownership
firms are owned by
and control and the Principal shareholders but controlled
agent theory) by managers

owners’ and managers’
interests are different

managers have discretion to
use the firm’s resources in
1
their own interests
Environment Uncertainty Data related to marginal costs and
Interdependence/(game revenues are inherently inaccurate.
Theory). Finding and measuring the
equilibrium point attained when
Marginal cost (MC) =marginal
revenue (MR), (or the difference
between TR –TC is the greatest) is
too difficult to achieve, without a set
of constraints.

Imperfect Information: Perfect

internal knowledge rarely exists and
no organization can claim to possess
perfect external information with
reference to the market and business
environment in which they operate.
( Baumol addressed this weakness

1
Berle and Means (1932, 1967)
 by assuming “Bounded rationality)

Profit is total revenue (TR) minus total costs (TC). However, TR is accumulated as
increments of Average Revenue, while TC is accumulated as increments of Marginal Cost.
In a pure competition, equilibrium of MC
and MR is established. Monopolists
operate where MC=MR. For their part,
Baumol firms might operate elsewhere
since TR >TC for profit to be generated. In
a sales/market share maximization model,
the aim is to increase TR and TR is a
function of price and quantity (output) since
TR= (p).(q). Using a demand curve defines
the price, total revenue and marginal
revenue associated with each level of
output, where price changes act as the
mechanism whereby supply and demand
are balanced, a supplier will stop when the Figure 1
revenue made on the last item produced is no more than it cost to provide.

The demand curve is downward-sloping, or simply is an inverse relationship between price

and quantity. The Law of Diminishing Returns, as Jevons showed in 1871, underlies price
theory microeconomics. It gives curvature to the indifference curves, to which "supply" and
"demand" are related, respectively.Linear demand functions determine the fact that total
revenue increases and then reduces as output increases, as the law of diminishing returns
prescribes that the costs involved in producing an
extra unit of output go up, whilst the demand curve P, Cost MC
dictates that the revenue from each extra unit sold
goes down and profits deteriorate.

The demand curve introduces price as the common AC

denominator between different quantities. In turn, the
firm should respond to the supply and demand signals
(e.g. changes in costs) by adjusting its pricing policy,
output or both. In a Baumol firm, supply is nothing but
price and quantity: a P on the demand curve that D
MR
exceeds Average Cost should elicit further output,
even if returns are diminishing

In a Baumol firm Output is determined by the Q

intersection of marginal revenue and marginal cost,
and the market price is set by the demand curve at this Profit Sales
quantity. This arises once we interepret the quantity maximising maximising
variable as market share proxy variable. There will be decision decision
different prices but prices are to be treated as price
signals. In this context pricing is considered the
second best option after the quantity variable to
achieving market share. Figure 3

c) Critics of the Baumol Model

Baumol model has attracted its share of critics. Of the many criticisms directed at
sales/market share maximizing managerial model, four are particularly central (1) It is
primarily concerned with oligopolistic firms such as those found in retails and airline
industries, but not fully suitable for other types of market structure such as perfect
competition, monopoly and Monopolistic Competition; (2) Profit is considered exogenous to
the model ; (3) While accepting the presence of competition and presume interdependence,
it neglects rival behavior; and (4) manager have no utility trade-off between profits and sales,
up to the profit constraints the firm is concerned only with profit and after the constraints is
met, the only concern is with sales.
 Additionally, the Baumol model failed to address:

1. Rivalry of a Competitive markets and potential price competition

2. Research and development and product line extensions are ignored, so is the
need for diversification and differentiation.
3. The model gives only a snapshot of the organization position; it provides only
a one-off explanation of what organizations may look like and the manner in
which they may act.

d) Relevance of the Baumol model

Despite the above limitations, The Baumol model is fully relevant if the market structure is
2
characterized by (1) An industry which is dominated by a few firms ; (2) Homogenous or
unique products; (3) Blockaded entry and exit; (4) Imperfect dissemination of information and
(5) Opportunity for above-normal (economic) profits in long-run equilibrium. Oligopolistic
market structure can be found in National markets, retail markets and other controlled
market such as telecommunications, Airlines, etc…

Pricing structure is a key differentiator between LCAs and full-service carriers. Legacy
carriers commonly offer a great variety of services to differentiate their products. These
airlines usually operate on a comprehensive network consisting of a complex hub-and-spoke
system. Hub-and-spoke systems increase the number of connections between city pairs
served by the same number of flights compared to a point-to-point system. The size of the
network by means of the number of connections is a strategic success factor for legacy
airlines. The product concept of legacy airlines also relies on offering service variety. Legacy
carriers target all possible groups of passengers, from price-sensitive leisure travellers to
time-sensitive business passengers, while the low airfares of LCAs mostly attract price-
sensitive passengers.3

Organization operating in an oligopolistic environment can use Baumol model to determine

its market price or the output produced in order to maximize TR. Since the value of the point
price elasticity of demand changes along a linear demand function. Management can then
implement appropriate price strategies in order to increase total revenue as long as they
know the elasticity of the demand faced by the business.

2
UK definition of an oligopoly is a 5 Firm concentration ratio of more than 50%
3
The Financial Performance of Low-Cost and Full-Service Airlines in Times of Crisis
Triant Flouris, Thomas John Walker. Canadian Journal of Administrative Sciences. Halifax: Mar 2005. Vol.
22, Iss. 1; pg. 3, 18 pgs
References
Cook, M. and Farquharson, C., Business Economics, United Kingdom, Financial
Times Prentice Hall, 1998.

McNutt, P., Managerial Economics Unit 1. Management Objectives and Stakeholder value,
Bangor, U.K., Business & Management Education Limited, 2005.

Patrick McNutt, Managerial Economics: Economics of Strategy slides July 08 Semester

J. Doug Ohmans, Grid X: a 2d reconstruction of economics, 2005

Demand, Supply and Markets, by Xavier Duran, course workshop director

Howard Davies and Pun-Lee Lam, MANAGERIAL ECONOMICS, An Analysis of Business

Issues, Published online by FT Prentice Hall