MANAGERIAL ECONOMICS

UNIT 2

CONTENTS

1. Law of variable proportions

2. Law of return
3. Optimal input combination
4. Output cost relations
5. Engineering cost curves
6. Technological change and product decisions
7. Revenue curves of a firm
8. Price output decisions under alternative market structure
9. Shut down points
10. Baumol sales maximization model
11. Advertising and price output decision

SR & LR production functions

The functional relationship between physical inputs (or factors of production) and output is called
production function. It assumed inputs as independent variable and output as the dependent variable.
Mathematically, we may write this as follows:

Q = f (L,K)

Here, ‘Q’ represents the output, whereas ‘L’ and ‘K’ are the inputs, representing labour and capital (such
as machinery) respectively.

Time period and production functions

The production function is differently defined in the short run and in the long run. This distinction
is extremely relevant in microeconomics. 

Those inputs that vary directly with the output are called variable factors. These are the factors that can
be changed. Variable factors exist in both, the short run and the long run. Examples of variable factors
include daily-wage labour, raw materials, etc.

On the other hand, those factors that cannot be varied or changed as the output changes are
called fixed factors. These factors are normally characteristic of the short run or short period of time
only. Fixed factors do not exist in the long run.

 The short-run production function defines the relationship between one variable factor

(keeping all other factors fixed) and the output. The law of returns to a factor explains such a
production function.
 Q= f(L)

The long-run production function is different in concept from the short run production
function. Here, all factors are varied in the same proportion. The law that is used to explain
this is called the law of returns to scale.

Q = f(L, K)

Assumptions

1. Perfect divisibility of input and output

2. There are only two factors of production
3. Limited substitution of factors
4. A given technology
5. Inelastic supply of fixed factors in short run

Short run laws of production- law of variable proportions

Also known as law of returns to a variable input or law of diminishing returns

It states that that as more units of a variable input are added to fixed amounts of land and
capital, the change in total output will initially increase at an increasing rate and then at
constant rate but eventually it will increase in diminishing returns.

Assumptions:

1. labour is homogeneous
2. The state of technology is given
3. Input prices are given.

We use three measures of production and productivity:

Total product (total output)- measure how much output is being produced.

Average product measures output per-worker-employed or output-per-unit of capital.

Marginal product is the change in output from increasing the number of workers used by one
person, or by adding one more machine to the production process in the short run.
Stage 1- Increasing returns – indivisibility of fixed factor resulting in under utilisation of capital if
labour is less than its optimal number.

Stage 2- diminishing returns- once the optimal capital-labour ratio is reached, employment of
additional workers amounts to substitution of capital with labour. But factors have limited
substitutability

Stage 3- negative returns- the marginal productivity of per worker falls.

Long run production function or laws of returns to scale

When a firm expands its scale, i.e.,it increases both the inputs proportionately, there are 3
possibilities:

1. TP may increase more than proportionately – Increasing returns to scale

2. TP may increase proportionately – Constant returns to scale
3. TP may increase less than proportionately – diminishing returns to scale

 Increasing Returns to Scale:

Increasing returns to scale or diminishing cost refers to a situation when all factors of production are
increased, output increases at a higher rate. It means if all inputs are doubled, output will also
increase at the faster rate than double. Hence, it is said to be increasing returns to scale. This
increase is due to many reasons like division external economies of scale, technical and managerial
indivisibilities, higher degree of specialization, dimensional relations. Increasing returns to scale can
be illustrated with the help of a diagram.
 
OX axis represents increase in labour and capital while OY axis shows increase in output. When
labour and capital increases from Q to Q 1, output also increases from P to P1 which is higher than the
factors of production i.e. labour and capital.

Constant Returns to Scale:

Constant returns to scale or constant cost refers to the production situation in which output
increases exactly in the same proportion in which factors of production are increased. In simple
terms, if factors of production are doubled output will also be doubled.

In this case internal and external economies are exactly equal to internal and external diseconomies.
This situation arises when after reaching a certain level of production, economies of scale are
balanced by diseconomies of scale and the production function becomes homogeneous.

Diminishing Returns to Scale:

Diminishing returns or increasing costs refer to that production situation, where if all the factors of
production are increased in a given proportion, output increases in a smaller proportion. It means, if
inputs are doubled, output will be less than doubled.

The main cause of the operation of diminishing returns to scale is that internal and external
economies are less than internal and external diseconomies.

Optimal input combination

The least cost combination or the optimum factor combination refers to the combination of factors
with which a firm can produce a specific quantity of output at the lowest possible cost.
here are two methods of explaining the optimum combination of factor:
 
1. The marginal product approach.

2. The isoquant / isocost approach.
 
The marginal product approach

In the long run, a firm can vary the amounts of factors which it uses for the production of goods. It
can choose what technique of production to use, what design of factory to build, what type of
machinery to buy. The profit maximization will obviously want to use that mix of factors of
combination which is least costly to it. In search of higher profits, a firm substitutes the factor whose
gain is higher than the other. When the last rupee spent on each factor brings equal revenue, the
profit of the firm is maximized.

The isoquant approach

Also known as “equal product curve” or “product indifference curve”. It represents the locus of
points representing various combinations of two inputs- capital and labour – yielding the same
output.

Assumptions:
1. There are only two inputs
2. The two inputs can substitute each other but at a diminishing rate
3. The technology of production is given
Properties of isoquants:
1. Negative slope
2. Convex to the origin – diminishing MRTS
3. Cannot intersect or be tangent to each other
4. Upper isoquant represents higher output

The optimal input combination depends upon three factors:

1. The firm’s budget line also known as isocline, budget line or budget constraint line.
2. The least cost criteria- the first-order condition and the second order condition
3. Effect of change in input price

Cost concepts

Total Fixed Costs (TFC):

Refer to the costs that remain fixed in the short period. These costs do not change with the change
in the level of output. Fixed costs have implication even when the production of an organization is
zero. These costs are also called supplementary costs, indirect costs, overhead costs, historical costs,
and unavoidable costs.

TFC remains constant with respect to change in the level of output. Therefore, the slope of TFC curve
is a horizontal straight line.

Figure-3 depicts the TFC curve:

Total Variable Costs (TVC):
Refer to costs that change with the change in the level of production. For example, costs incurred on
purchasing raw material, hiring labor, and using electricity. If the output is zero, then the variable
cost is also zero. These costs are also called prime costs, direct costs, and avoidable costs.

Figure-4 shows the TVC curve:

Total Cost (TC):

Involves the sum of TFC and TVC.

It can be calculated as follows:

Total Cost = TFC + TVC

TC also changes with the changes in the level of output as there is a change in TVC.

It should be noted that both TVC and TC increase initially at decreasing rate and then they increase
at increasing rate Here, decreasing rate implies that the rate at which cost increases with respect to
output is less, whereas increasing rate implies the rate at which cost increases with respect to
output is more.

Average Fixed Costs (AFC):

Refers to the per unit fixed costs of production. In other words, AFC implies fixed cost of production
divided by the quantity of output produced.

It is calculated as:
AFC = TFC/Output

TFC is constant as production increases, thus AFC falls.

AFC curve is shown as a declining curve, which never touches the horizontal axis. This is because
fixed cost can never be zero. The curve is also called rectangular hyperbola, which represents that
total fixed costs remain same at all the levels.

Average Variable Costs (AVC):

Refer to the per unit variable cost of production. It implies organization’s variable costs divided by
the quantity of output produced.

It is calculated as:
AVC = TVC/ Output

Initially, AVC decreases as output increases. After a certain point of time, AVC increases with respect
to increase in output.
Average Cost (AC):
Refer to the total costs of production per unit of output.

AC is calculated as:
AC = TC/ Output

AC is also equal to the sum total of AFC and AVC. AC curve is also U-shaped curve as average cost
initially decreases when output increases and then increases when output increases.

Marginal Costs:
Marginal cost is calculated as:
MC = TCn = TCn-1
n= Number of units produced

It is also calculated as:

MC = ∆TC/∆Output

MC curve is also a U-shaped curve as marginal cost initially decreases as output increases and
afterwards, rises as output increases. This is because TC increases at decreasing rate and then
increases at increasing rate.

Engineering cost curves

Engineering costs are derived from engineering production functions.

Each productive method is divided into sub-activities corresponding to the various physical-technical
phases of production for the particular commodity.

For each phase the quantities of factors of production are estimated and finally the cost of each
phase is calculated on the basis of the prevailing factor prices.

The total cost of the particular method of production is the sum of the costs of its different phases.

Such calculations are done for all available plant sizes. Production isoquants are subsequently
estimated, and from them, given the factor prices, the short-run and the long-run cost functions may
be derived. 

Engineering production functions are characterized by a limited number of methods of production.

The production isoquants are kinked, reflecting the fact that factor substitutability is not continuous,
but limited. On the straight segments of the production isoquant a combination of the adjacent
methods of production is employed. Factors cannot be substituted for each other except by
changing the levels at which entire technical processes are used, because each process uses factors
in fixed characteristic ratios.

Short run engineering cost curves

 

Long run engineering cost curves

In the long run, all the factors of production used by an organization vary. There are no fixed inputs
or costs in the long run. There is no distinction between the Long run Total Costs (LTC) and long run
variable cost as there are no fixed costs. It should be noted that the ability of an organization of
changing inputs enables it to produce at lower cost in the long run.

Long Run Total Cost:

Long run Total Cost (LTC) refers to the minimum cost at which given level of output can be produced.
LTC represents the least cost of different quantities of output. LTC is always less than or equal to
short run total cost, but it is never more than short run cost.

The LTC curve is made by joining the minimum points of short run total cost curves. Therefore, LTC
envelopes the STC curves.

Long Run Average Cost:

Long run Average Cost (LAC) is equal to long run total costs divided by the level of output. The
derivation of long run average costs is done from the short run average cost curves.

The long run average costs curve is also called planning curve or envelope curve as it helps in making
organizational plans for expanding production and achieving minimum cost.

LAC depicts the lowest possible average cost for producing different levels of output. The LAC curve
is derived from joining the lowest minimum costs of the short run average cost curves.
It first falls and then rises, thus it is U- shaped curve. The returns to scale also affect the LTC and
LAC. 

Long Run Marginal Cost:

Long run Marginal Cost (LMC) is defined as added cost of producing an additional unit of a
commodity when all inputs are variable. This cost is derived from short run marginal cost.  On the
graph, the LMC is derived from the points of tangency between LAC and SAC.

If perpendiculars are drawn from point A, B, and C, respectively; then they would intersect SMC
curves at P, Q, and R respectively. By joining P, Q, and R, the LMC curve would be drawn. It should be
noted that LMC equals to SMC, when LMC is tangent to the LAC.

Technological change and production decisions

Technological change alters the firm’s production function by either changing the relationship
between inputs and output or introducing a new product and therefore a new production function.
An improvement in technology enables your firm to produce a given quantity of output with fewer
inputs shifting the production isoquant inward. Technological change that introduces new products
have their own, new production functions.

Determining the impact technological change has on your firm is important. Two such measures,
labor productivity and total factor productivity, are based upon a comparison between the quantity
of output produced and the amount of input employed.

Labour productivity measures output per unit of input or, typically, output per labor-hour. An
increase in labor productivity is frequently associated with an improvement in technology.
Total factor productivity measures changes in output relative to changes in the quantity employed of
all inputs

The following formula is used to calculate total factor productivity, represented by the symbol α:
 q
a=
P 1 I 1+ P 2 I 2+ P 3 I 3+… .=PnIn

where q represents the firm’s quantity of output, I1 through In represent the quantity employed of

inputs 1 through n, and p1 through pn represent the prices of inputs 1 through n.
If prices are held constant over time, changes in total factor productivity represent changes in the
firm’s efficiency. Increases in total factor productivity represent improvements in a firm’s efficiency
that result from technological change.

Revenue curves of a firm

Revenue provides the income which a firm needs to enable it to cover its costs of production, and
from which it can derive a profit. Revenue is measured in three ways:

Total revenue

Total revenue (TR), is the total flow of income to a firm from selling a given quantity of output at a
given price, less tax going to the government. The value of TR is found by multiplying price of the
product by the quantity sold.

Average revenue

Average revenue (AR), is revenue per unit, and is found by dividing TR by the quantity sold, Q. AR is
equivalent to the price of the product, where P x Q/Q = P, hence AR is also price.

Marginal revenue

Marginal revenue (MR) is the revenue generated from selling one extra unit of a good or service. It
can be found by finding the change in TR following an increase in output of one unit. MR can be both
positive and negative.

Revenue curves
Total revenue

Initially, as output increases total revenue (TR) also increases, but at a decreasing rate. It eventually
reaches a maximum and then decreases with further output.

Less competition in a given market is likely to lead to higher prices and the possibility of higher
super-normal profits.

Average revenue

However, as output increases the average revenue (AR) curve slopes downwards. The AR curve is
also the firm’s demand curve.
Marginal revenue

The marginal revenue (MR) curve also slopes downwards, but at twice the rate of AR. This means
that when MR is 0, TR will be at its maximum. Increases in output beyond the point where MR = 0
will lead to a negative MR.

Price-output decision under different market structure

Price-output decision under perfect competition

Perfect competition refers to a market situation where there are a large number of buyers and
sellers dealing in homogenous products.
Moreover, under perfect competition, there are no legal, social, or technological barriers on the
entry or exit of organizations.

Under perfect competition, the buyers and sellers cannot influence the market price by increasing or
decreasing their purchases or output, respectively. The market price of products in perfect
competition is determined by the industry. This implies that in perfect competition, the market price
of products is determined by taking into account two market forces, namely market demand and
market supply.

In Figure-1, when price is OP, the

quantity demanded is OQ. On the other
hand, when price increases to OP1, the
quantity demanded reduces to OQ1.
Therefore, under perfect competition,
the demand curve (DD’) slopes
downward.

In Figure-2, the quantity supplied is OQ at price OP. When price increases to OP1, the quantity
supplied increases to OQ1. This is because the producers are able to earn large profits by supplying
products at higher price. Therefore, under perfect competition, the supply curves (SS’) slopes
upward.
In Figure-3, it can be seen that at price OP1, supply is more than the demand. Therefore, prices will
fall down to OP. Similarly, at price OP2, demand is more than the supply. Similarly, in such a case,
the prices will rise to OP. Thus, E is the equilibrium at which equilibrium price is OP and equilibrium
quantity is OQ.

Price and output determination under monopoly

Monopoly refers to a market structure in which there is a single producer or seller that has a control
on the entire market.

This single seller deals in the products that have no close substitutes and has a direct demand,
supply, and prices of a product.

Therefore, in monopoly, there is no distinction between and industry and an organization because
one organization constitutes the whole industry.

In Figure-9, it can be seen that more quantity (OQ 2) can only be sold at lower price (OP2). Under
monopoly, the slope of AR curve is downward, which implies that if the high prices are set by the
monopolist, the demand will fall. In addition, in monopoly, AR curve and Marginal Revenue (MR)
curve are different from each other. However, both of them slope downward.

The negative AR and MR curve depicts the following facts:

i. When MR is greater than AR, the AR rises

ii. When MR is equal to AR, then AR remains constant

iii. When MR is lesser than AR, then AR falls

Single organization constitutes the whole industry in monopoly. Thus, there is no need for separate
analysis of equilibrium of organization and industry in case of monopoly. The main aim of
monopolist is to earn maximum profit as of a producer in perfect competition.

Unlike perfect competition, the equilibrium, under monopoly, is attained at the point where profit is
maximum that is where MR=MC. Therefore, the monopolist will go on producing additional units of
output as long as MR is greater than MC, to earn maximum profit

In Figure-11, if output is increased beyond OQ, MR will be less than MC. Thus, if additional units are
produced, the organization will incur loss. At equilibrium point, total profits earned are equal to
shaded area ABEC. E is the equilibrium point at which MR=MC with quantity as OQ.
Price and output determination under monopolistic competition

In monopolistic competition, the market has features of both perfect competition and monopoly. A
monopolistic competition is more common than pure competition or pure monopoly.

Features of Monopolistic Competition

1.   Large number of sellers: In a market with monopolistic competition, there are a large

number of sellers who have a small share of the market.

2. Product differentiation: In monopolistic competition, all brands try to create

product differentiation to add an element of monopoly over the competing products. This
ensures that the product offered by the brand does not have a perfect substitute. Therefore, the
manufacturer can raise the price of the product without having to worry about losing all its
customers to other brands. However, in such a market, while all brands are not perfect
substitutes, they are close substitutes for each other. Hence, the seller might lose at least some
customers to his competitors.

3. Freedom of entry or exit: Like in perfect competition, firms can enter and exit the market
freely.

4. Non-price competition: In monopolistic competition, sellers compete on factors other than

price. These factors include aggressive advertising, product development, better distribution,
after sale services, etc. Sellers don’t cut the price of their products but incur high costs for
the promotion of their goods. If the firms indulge in price-wars, which is the possibility under
perfect competition, some firms might get thrown out of the market.
In monopolistic competition, since the product is differentiated between firms, each firm does not have
a perfectly elastic demand for its products. In such a market, all firms determine the price of their own
products. Therefore, it faces a downward sloping demand curve. Overall, we can say that the elasticity
of demand increases as the differentiation between products decreases

The conditions for price-output determination and equilibrium of an individual firm are as follows:
 1. MC = MR

2. The MC curve cuts the MR curve from below.

In Fig. 1, we can see that the MC curve cuts the MR curve at point E. At this point,

 Equilibrium price = OP and

 Equilibrium output = OQ
Now, since the per unit cost is BQ, we have

 Per unit super-normal profit (price-cost) = AB or PC.

 Total super-normal profit = APCB

 If firms in a monopolistic competition earn super-normal profits in the short-run, then new
firms will have an incentive to enter the industry. As these firms enter, the profits per firm
decrease as the total demand gets shared between a larger number of firms. This continues
until all firms earn only normal profits. Therefore, in the long-run, firms, in such a market, earn
only normal profits.

In Fig. 3 above, the average revenue (AR) curve touches the average cost (ATC) curve at point X. This
corresponds to quantity Q1 and price P1. Now, at equilibrium (MC = MR), all super-normal profits are zero
since the average revenue = average costs. Therefore, all firms earn zero super-normal profits or earn
only normal profits.

Price and output determination under oligopoly

Oligopoly occurs when a few firms dominate the market for a good or service. This implies that when
there are a small number of competing firms, their marketing decisions exhibit strong mutual
interdependence. By mutual interdependence we mean that a firm's action say of setting the price
has a noticeable effect on its rival firms and they are likely to react in the some way. Each firm
considers the possible reaction of rivals to its price and product development decisions.
Temptation of more profits and rivalry leads to independent pricing. Independent pricing under
these conditions, will lead to price wars between rivals; the ultimate result maybe either price in
stability and continuous wars or price stability when a satisfactory price is found.

Fight for profit cannot go on indefinitely. Thus, price war leads to price rigidity or price stability in the
oligopoly market.

Under independent pricing, actual price may be fixed between extreme limit of competitive price or
monopoly price.

But the general belief among economists is that independent pricing cannot last long and it is bound
to lead to either price leadership by leading firm or some type of collusion between the rival firms.

Firms by experience may realize that independent pricing creates uncertainty and insecurity among
rivals. Therefore, there is a constant tendency to come together.

Pricing under collusion (Collusive oligopoly):

When competing firms make some kind of agreement about pricing and output they are said to
collude. The agreements may be formal or facit.

But formal or open agreements are illegal in most countries. The agreement between oligopolist are
generally tacit or secret.

In case of perfect collusion under oligopoly there can be centralized cartel or market sharing cartel
situations.

Centralized cartels:
Under centralized cartel system the price and output decisions for the whole industry as well as of
every firm are taken by central Cartel Board so as to achieve maximum joint profits. Cartel board
fixes the output quota of each member firm.

Total profits are distributed among the firms according to prior agreement. The total output of the
industry and price are the determined in such a way that the total cost of production is minimum.
It will be seen from the figure that when firm A produces OQ 1 and firm B produces OQ1 the marginal

costs of the two firms are equal. The output quota of firm A will be OQ 1 and of firm B will be OQ1. It

is worth noting that the total output OQ will be equal to the sum of OQ 1 and OQ2.

Thus, the determination of output OQ and price OP and the outputs OQ 1 and OQ2 by the two firms A

and B will ensure the maximum joint profits for the member firms constituting the cartel. It will be

seen from Fig. 29.1 (a) that with output OQ and cartel price OP. the profits made in firm A are equal

to PFTK and with output OQ, and cartel price OP the profits made in firm B are equal to PEGH.

Market -Sharing Cartels:

The formation of perfect cartels, as described above, has been quite rare in the real world even

where their formation is not illegal. In a perfect cartel not only the price but also the output to be

produced by each member of a cartel is decided by a central management authority and profits

made in all of them are pooled together and distributed among the members according to the terms

of a prior agreement.

But when cartels are loose, instead of being perfect, the distribution of profits and fixation of

outputs of individual firms are not determined in a manner perfect cartel does. In a loose type of

cartel the market-sharing by the firms occurs

Shut down points

A shutdown point is a level of operations at which a company experiences no benefit for continuing

operations and therefore decides to shut down temporarily (or in some cases permanently). It
results from the combination of output and price where the company earns just enough revenue to
cover its total variable costs. The shutdown point denotes the exact moment when a company’s
(marginal) revenue is equal to its variable (marginal) costs—in other words, it occurs when the
marginal profit becomes negative.

At this point, there is no economic benefit to continuing production. If an additional loss occurs,
either through a rise in variable costs or a fall in revenue, the cost of operating will outweigh the
revenue. At that point, shutting down operations is more practical than continuing, even if the
company continues to experience losses in other areas, such as fixed costs. 

The shutdown point does not include an analysis of fixed costs in its determination. It is based
entirely on determining at what point the marginal costs associated with operation exceed the
revenue being generated by those operations.

Certain seasonal businesses, such as Christmas tree farmers, may shut down almost entirely during
the off-season. While fixed costs remain during the shutdown, variable costs can be eliminated.

Baumol’s sales maximization model

The model is based on the following assumptions:

1. There is a single period time horizon of the firm.

2. The firm aims at maximising its total sales revenue in the long run subject to a profit constraint.

3. The firm’s minimum profit constraint is set competitively in terms of the current market value of
its shares.

4. The firm is oligopolistic whose cost curves are U-shaped and the demand curve is downward
sloping. Its total cost and revenue curves are also of the conventional type.

The Model:
Baumol’s findings of oligopoly firms in America reveal that they follow the sales maximisation
objective. According to Baumol, with the separation of ownership and control in modern
corporations, managers seek prestige and higher salaries by trying to expand company sales even at
the expense of profits.

According to Baumol, Sales maximisation is not only a means but an end in itself.

He gives a number of arguments in support of his theory.

1. A firm attaches great importance to the magnitude of sales and is much concerned about
declining.

2. If the sales of a firm are declining, banks, creditors and the capital market are not prepared to
provide finance to it.

3. Its own distributors and dealers might stop taking interest in it.

4. Consumers might not buy its product because of its unpopularity.

5. Firm reduces its managerial and other staff with fall in sales.

6. But if firm’s sales are large, there are economies of scale and the firm expands and earns large
profits.

7. Salaries of workers and management also depend to a large extent on more sales and the firm
gives them bonus and other facilities.

By sales maximisation, Baumol means maximisation of total revenue. It does not imply the sale of
large quantities of output, but refers to the increase in money sales.

Sales can increase up to the point of profit maximization where the marginal cost equals marginal
revenue.

If sales are increased beyond this point money sales may increase at the expense of profits. But the
oligopolistic firm wants its money sales to grow even though it earns minimum profits. Minimum
profits refer to the amount which is less Quantity than maximum profits. The minimum profits are
determined on the basis of firm’s need to maximize sales and also to sustain growth of sales.

Minimum profits are required either in the form of retained earnings or new capital from the
market. The firm also needs minimum profits to finance future sales. Further, they are essential for a
firm for paying dividends on share capital and for meeting other financial requirements.
Thus minimum profits serve as a constraint on the maximisation of a firm’s revenue. “Maximum
revenue will be obtained only” according to Baumol, “at an output at which the elasticity of demand
is unity, i.e. at which marginal revenue is zero.”

This is the condition which replaces the “marginal cost equals marginal revenue profit maximisation
rule.” This is shown in Figure 5 where the profit maximisation firm produces OQ output where MC =
MR at point E. But the sales maximisation firm will produce OQ 1 output where MR is zero.
Baumol’s model is illustrated in Figure 6 where TC is the total cost curve, TR the total revenue curve,
TP the total profit curve and MP the minimum profit or profit constraint line. The firm maximises its
profits at OQ level of output corresponding to the highest point В on the TP curve.

But the aim of the firm is to maximise its sales rather than profits. Its sales maximisation output is OK
where the total revenue KL is the maximum at the highest point of TR.

This sales maximisation output OK is higher than

the profit maximisation output OQ. But sales maximisation is subject to minimum profit constraint.
Suppose the minimum profit level of the firm is represented by the line MP.
The output OK will not maximise sales as the minimum profits OM are not being covered by total
profits KS. For sales maximisation the firm should produce that level of output which not only covers
the minimum profits but also gives the highest total revenue consistent with it.

This level is represented by OD level of output where the minimum profits DC (=OM) are consistent
with DE amount of total revenue at the price DE/OD, (i.e., total revenue/total output). Baumol’s
model of sales maximisation points out that the profit maximisation output OQ will be smaller than
the sales maximisation output OD, and price higher than under sales maximisation.

The reason for a lower price under sales maximisation is that both total revenue and total output are
equally higher while under profit maximisation total output is much less as compared to total
revenue. Imagine if QB is joined to TR in Figure 6. “If at the point of maximum profit”, writes
Baumol, “the firm earns more profit than the required minimum, it will pay the sales maximiser to
lower his price and increase his physical output.”