A Single-Product Model, with Advertising

A second implication is that the sales maximize will spend more on advertising than the profit maximizing firm. In Boumol’s simplified explanation it is assumed that advertising does not affect a products price. It does, however. Lead to increased output sold (with diminishing returns) and it is assumed that advertising will always lead to a rise in TR, MR will never become negative. By assuming that advertising does not affect total non-advertising costs, and by measuring advertising expenditure also along the vertical axis, the TC line of figure 1.7 is derived.
Since advertising will always increase TR, the business will increase advertising until prevented by the profit constraint. In fig. 1.7, A1 is the profit maximizing level of advertising expenditure, at which the profit curve reaches it maximum point. It pC and firm chooses to maximize its TR with pC as the minimum profit constraint, it will spend OA2 on advertisement which is greater than OA1. We thus see that the objective of constraint revenue maximization leads to a greater level of advertising outlay than the objective of profit maximization.
Some comments
? The sales maximization hypothesis cannot be against competing behavioral hypothesis unless the demand function and cost function of individual firms are measured but such data are not disclosed by firms to researchers, and are commonly unknown to the firm.
? It has been argued that in the long run the profit maximization and sales maximization hypothesis converges into one, because profits attain their normal level in the long-run and the minimum profit constraint will coincide with the maximum attainable (‘normal) level of profit.
? The sales maximization theory does not show sales maximiser’s equilibrium position in an industry. The relationship between the firm and industry is not established by Baumol.
? Baumol’s hypothesis is based on the implicit assumption like firm has market power and can take decisions (price, expansion)without being affected by competitor’s reactions which is unrealistic.
? This theory cannot explain the core problem of uncertainty in non-collusive oligopoly market and market situations in which price is kept for considerable time periods in the range of in elastic demand.
? M.H. Peston ventured the idea that sales maximization is not incompatible with the goal of long-run profit maximization. He argues a firm can be willing to keep sales at a high level, even though they are unprofitable in the short run, hopping that eventually (in the long run) the product will become profitable once established in the market, especially for mew products. Such behavior, however, does not by itself provide a proof that the firm is a sales maximiser or a profit maximiser. Thus in Baumol’s model, sales and profits are mot competing goals up to the level of output at which profit is maximizing output. Thus, Peterson’s argument does not seem to invalidate Buamol’s theory.
? J.R. Wildsmith attacks Baumol model on the ground that the this model has the unacceptable implication that whenever profits aboue the minimum required level are earned Managers would derive extra satisfaction from huge outlays on advertising which brought negligible increase in sales and large reduction in profits. The argument by Wildsmith seems plausible enough. However, Wildsmith seems to overlook Baumol’s statement that although in his model only advertising is explicitly introduced for simplicity. Other activities (such as change is style of product, increase of staff, increase of prerequisites of managers, research and development expenses) mat be incorporated in it without altering it basic modality. Such activities are often undertaken (as well as additional advertising) when profits above the minimum required level is earned, and presumably they increase the utility of manager’s. Moreover generalized Baumol’s model’ allows increases of output as well as increases is advertising when surplus profits are earned. Thus Wildsmith’s argument does not seem valid.
? W.G. Shepherd has argued that if the demand curve has a steep kink, so that to the right of the kink MR is negative shown in fig. 1.8 (a), the maximization and R maximization objectives would not be competing as Baumol implies, because under these conditions and firm’s equilibrium would be at the point of the kink.
Mathematically, necessary condition of equilibrium for both (p, R maximiser) types of firms is aTR/aX>0 (provided that the profit constraint in operative).
Since at the output corresponding to the kink MR>0, while at any larger output MR>0, it is clear that irrespective of goal (p, R) the firm will choose to produce the output corresponding to the kink.
Kinky solution or argument has been attacked by C.J. Hawkins by saying that shepherd would be right were the only competitive weapon of firms, but there are various non-price weapons in the modern oligopolistic industry (for example advertising, product changes). Therefore, shepherd’s argument is not valid. With advertising taking place the kinked curve of a R maximiser, because sales revenue maximize allows in heavier advertising expenditures. Thus both types of firms will operate at the kink of their demand curves but the output of the p - maximiser will be smaller than the output of the sales maximize, because at the same price level the kink of the sales maximize’s demand will occur to the right of the kink of the profit maximiser. This situation is shown is shown in figure 1.8 (b), from which it is obvious that Xpm < Xsm at the same price p.