Regarding institutional economics this is a ppt

1. Baumol’s theory of sales revenue
maximisation
• Prof. Baumol, an American economist, in his book Business Behaviour,
Value and Growth (1967) has presented a managerial theory of the
firm based on sales maximization.
• He discusses two models of sales maximisation: a static model and a
dynamic model.
• Baumol’s contention is that, in a public limited company, the
management aims at maximising the sales revenue subject to
attaining some minimum profit to satisfy the shareholders
• Why is the management interested in maximising the sales revenue
and not the profit?. Profit maximisation would only increase the
dividends to the shareholders and in no way help the management.

2. Assumptions
• This 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.

3. 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.
• Being a consultant to a number of firms, Baumol observes that revenue or
sales maximisation rather than profit maximisation is consistent with the
actual behaviour of firms.
• Baumol cites evidence to suggest that short-run revenue maximisation may
be consistent with long-run profit maximisation. But sales maximisation is
regarded as the short-run and long-run goal of the management

4. Reasons for his arguments
• 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. Large sales, growing over time, give prestige to the managers, while large
profits go into the pockets of shareholders.
4. Its own distributors and dealers might stop taking interest in it.
5. Consumers might not buy its product because of its unpopularity.
6. Firm reduces its managerial and other staff with fall in sales.
7. But if firm’s sales are large, there are economies of scale and the firm
expands and earns large profits.
8. Salaries of workers and management also depend to a large extent on
more sales and the firm gives them bonus and other facilities.

5. • 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 (in rupee, dollar, etc.). Sales can increase
up to the point of profit maximization where the marginal cost equals
marginal revenue.

6. Baumol’s model is illustrated in the following
figure (without advertising)

7. • TR and TC curves represents total revenue and total cost, respectively.
Profit is the difference b/w TR and TC. Curve P is inverted ‘U’ and
represents that profit increases until production reaches Q1 and
declines thereafter. A profit maximising firm would produce at Q1.
Whereas, if the manager of the firm wants to maximise sales revenue,
then the output would be Q3, at which the TR is maximum
• This substantially reduce the profit level so, let us assume that the
shareholders fix the minimum profit to be earned as N. Accordingly,
the sales maximising output would be Q2.

8. Baumol’s model with advertising
• We have shown above how price and output are determined in a
static single period model without advertising
• In an oligopolistic market structure, however, price and output are
subject to non-price competition
• Baumol considers in his model with advertising as the typical form of
non-price competition and suggests that the various forms of non-
price competition may be analysed on similar lines.
• In his analysis of advertising, Baumol makes the following
assumptions

10. • Firm’s objective is to maximize sales, subject to a minimum profit
constraint.
• Advertising causes a shift in the demand curve and hence the total
sales revenue rises with an increase in advertisement expenditure
• Price remains constant — a simplifying assumption.
• Production costs are independent of advertising. This is rather an
unrealistic assumption since increase in sales may put output at a
different cost structure

11. Baumol views on Dynamic Model:
• Baumol’s also gives a dynamic model. The major criticism of the static model is
that profit is exogenously determined by the shareholders. In the dynamic model
the profit is endogenously determined.
• The assumption of the dynamic model are
• 1. The firm attempts to maximise the rate of growth of sales over its lifetime.
• 2. Profit supplies the finances to attain higher sales volume, so profit
endogenously determined.
• 3. Sales growth may be financed through external sources, such as market
borrowing, but profit is the surest way to do it, so profit is endogenously
determined.
Conclusion:
• Through this dynamic model, Baumol shows that the sales volume increases as
profit increases. This satisfies both the manager and shareholder.

12. Criticisms
• Although Baumol’s sales maximization model is found to be theoretically sound and
empirically practicable, economists have pointed out the following shortcomings in his
model.
1. It has been argued that in the long-run, Baumol’s sales maximization hypothesis and
the conventional hypothesis would yield identical results, because the minimum
required level of profits would coincide with the normal level of profits.
2. Baumol’s theory does not distinguish between firm’s equilibrium and industry
equilibrium. Nor does it establish industry’s equilibrium when all the firms are sales
maximizers.
3. it does not clearly bring out the implications of interdependence of the firm’s price
and output decisions. Thus, Baumol’s theory ignores not only actual competition
between the firms but also the threat of potential competition in an oligopolistic
market.
4. Baumol’s claim that his solution is preferable to the solutions offered by the
conventional theory, from a social welfare point of view, is not necessarily valid

13. Tragedy of commons
• A common resource or "commons" is any resource, such as water or land,
that provides users with tangible benefits but which nobody has an
exclusive claim.
• Areas like rivers, forests, village ponds, water bodies, parking lots and train
compartments are referred to as Common Property Resources (CPR) or Common
Pool Resources in academic and governance domain.
• How are they situated in our social domain? How are they defined, governed
and what are problems arising around them? This was the concern of many
social and environmental scientists including anthropologists in the 60’s and
70’s decade
• Resources are classified by their physical nature, ownership and use pattern. A
property right is a claim of benefit that is legally and socially recognized and
respected by the communities and state. There are four forms of properties
prevalent in society, they are private, public or state, common property and open
access.
• A distinction is made between property rights and tenure. Property right brings
some kind of management status to the ownership of property, but tenure refers
to acts of pure ownership with no references to management

14. • The public good or property resources are not owned by any
individual or firm, and people in general are not excluded from using
or enjoying them. They allow collective use and consumption, often
indivisible.
• Examples of public property is natural and environmental resources,
national parks, rivers, waterways, oceans, marine fisheries in
exclusive economic zones (EEZ) etc.
• Other examples are state owned minerals units, municipal
corporations, and national highway authority owning public roads.
• Therefore, public goods are also considered as state property, as it is
the exclusive owner of the resources or properties.

15. Common property
• The most commonly talked commons are grazing lands, village ponds,
Non Timber Forest produces and forests, etc.
• Common represents all natural resources used for human welfare,
which are not necessarily owned by an individual or a group of
individuals.
• A definition of Common Property Resources quite acceptable to
thinkers of Economics is: ‘A property on which well defined collective
claims by an exclusive group are established, the use of the resources
is subtractive, having the characteristic of a public good such as
indivisibility, shall be termed as Common Property Resources
(Kadekodi, 2004).

16. Tragedy of commons
• The discussion on Commons started way back in years of 1950s after
seeing the rapidly degrading and depleting condition of Common all
around.
• Basically most of countries had adopted capitalistic model of
development, which emphasized privatization and rapid exploitation
of natural resources.
• But initially it did not get much attention, many thinker were looking
at it as problem of economics and technology.
• But a seminr paper in 1968, by G Hardin in Science journal brought
the Common to centre stage of discussion in welfare economic and
other social science disciplines.

17. • Tragedy of Commons’ paper by Hardin (1968) in Science journal about
the management of CPRs, predicted overexploitation and ultimate
degrading of common resources due to the users’ rational incentive
to maximize utility.
• The tragedy of commons is an economic problem where the
individual consumes a resource at the expense of society.
• The tragedy of the commons is an economic theory claiming
that individuals tend to exploit shared resources so that
demand outweighs supply, and it becomes unavailable for the
whole
• He suggested that either privatization or state can provide solution to
this so-called ‘commons dilemma’

18. • Hardin used an example of grazing pasture to explain his view point. He said if a
pasture is open to all. It is to be expected that each herdsman will try to keep as
many cattle as possible on the commons.
• Historically, such an arrangement would have worked reasonably satisfactorily for
centuries
• But in present period, that is, when social stability has becomes a reality. At this
point, the inherent logic of the commons remorselessly generates tragedy. As a
rational being, each herdsman seeks to maximize his gain.
• Explicitly or implicitly, more or less consciously, he asks, “What is the utility to me
of adding one more animal to my herd?” This utility has one negative and one
positive component
1. The positive component is a function of the increment of one animal. Since the
herdsman receives all the proceeds from the sale of the additional animal, the
positive utility is nearly + 1.
2. The negative component is a function of the additional overgrazing created by
one more animal. Since, however, the effects of overgrazing are shared by all
the herdsmen, the negative utility for any particular decision making herdsman
is only a fraction of – 1
• Adding together the component partial utilities, the rational herdsman concludes
that the only sensible course for him to pursue is to add another animal to his
herd

19. • And another... But this is the conclusion reached by each and every
rational herdsman sharing a commons. Therein is the tragedy. Each
man is locked into a system that compels him to increase his herd
without limit - in a world that is limited.
• Ruin is the destination towards which all men rush, each pursuing his
own best interest in a society that believes in the freedom of the
commons.
• Freedom in a commons brings ruin to all

20. Theory of collective action
• Collective action is considered to be the solution to manage private, public,
or common property resources for effective decision making and
implementation.
• The basic social philosophy of collective action is participatory
development as against individual development
• Various disciplines explain the collective action from their perspective, like
economic theory takes the course of minimizing transactions costs,
externalities as a parameter management of CPR.
• Two approaches are followed in economics; first is to opt for a strategy to
minimize economic costs i.e. minimize transactions or information costs in
efficient management of resources. The second argument is reducing the
cost of economics of scale in CPR management

21. • Practices such as crop rotation, seasonal grazing, and
enforceable sanctions against overuse and abuse of the
resource meant collective action arrangements readily
overcame the tragedy of the commons.
• collective action requires the involvement of a group of people,
a shared interest within the group and some kinds of common
action which works in pursuit of that shared interes

22. Asymmetric information
• In a perfect competitive market structure, one of the key assumptions
defining the market is that of complete and symmetric information among
the parties involved in the transaction.
• That is, we assumed no seller knows more about a product’s characteristics
than a buyer, and no buyer knows more about the product’s costs than a
seller
• Such an assumption is unrealistic due to the fact that in real life, one party
to a transaction often has more information than another about the
characteristics of the good or service to be traded. This condition is
referred to as that of asymmetric information
• For instance, the seller of a product usually knows more about the quality
of the good than the buyer; workers usually know more about their
abilities than the potential employers; in the market for second-hand cars,
sellers have more information regarding the true status of the car than the
buyer;

23. • “Asymmetric information is a situation in which economic agents
involved in transaction have different information, as when a private
motor cycle seller has more detailed information about the its quality
than the prospective purchaser, or an employee will know more
about their ability than their employer”.
• The concept of asymmetric information was first analysed by George
Akerlof in his 1970 paper titled “The market for lemons: quality
uncertainty and the market mechanism”
• He considered an example of automobile market. Asymmetric
information exists, when amongst different parties in the trade,
unequal information set persists. That is, if we assume there are
buyers and sellers in the market, then under asymmetric information,
one agent will have greater (or lesser) information than the other

24. Market for lemons
• Let us consider a market where buyers and sellers have different
information regarding the quality of the product offered for sale
• in the market for second-hand cars, also called the market for lemons,
sellers of the second-hand cars have more information about the real value
of the car than the buyer.
• Consider a market where there are 100 sellers and 100 buyers for used
cars. Everyone knows that all the used cars are not of same quality and
there is 50 per cent chance of getting a car in good condition (‘Plums’) and
50 per cent chance of getting a car in bad condition (‘lemons’).
• However, the owner of the cars know the actual quality of the car, but the
buyers have no clue about which one is plum and which one is lemon.
Moreover it is not easy to verify the quality of car from the market

25. • Let the owners of the lemon want to sell it at Rs. 1,00,000 and the
owners of the plums want to sell at Rs. 2,00,000.
• Let the buyer of the car is ready to pay Rs. 2,40,000 if the car is a
plum but Rs. 1,20,000 if the car is a lemon.
• If there is no problem in verifying the quality of car from the market,
then the lemons will be sold at some price between Rs. 1,00,000 to
Rs. 1,20,000 and the plums will be sold at some price in between Rs.
2,00,000 to Rs. 2,40,000
• Since buyers cannot observe the quality of car to be purchased, they
will have to guess about the quality of an average car. Given that
there is only 50 per cent chance of getting a plum (i.e., a car is equally
likely to be a plum or a lemon), the expected value of the car for a
typical buyer is:
E(B)= ½*240000+ ½*120000= 180000

26. • However, at that price the owner of the lemons will be only willing to sell the car (Because
E(B)=180000> E(S lemon)=100000)but not the owner of the plums (because(B)=180000< 200000)
• The price that the buyers are willing to pay for an average car is less than the price that the sellers
of plum expect from the transaction
• So at a price of Rs. 180000, only lemons would be offered for sale
• Even though the price at which buyers are willing to buy plums exceeds the price at which sellers
are willing to sell them, no such transaction for plums will take place
• This is the problem of market failure.
• There is an externality problem between the sellers of plums and lemons, which result in the
market failure.
• When an individual is trying to sell lemons he affects the buyers’ perception on the quality of
average car in the market. This lowers the price that the buyers are willing to pay for an average
car in the market.
• This further discourages the sellers of plums. This is an externality problem.
• Thus in the presence of information asymmetry, if too many low quality items are offered for sale,
it changes the buyers’ perception (and dampens the willingness to pay) on the average product,
and thus making difficult for the sellers of high quality items to offer their products in the market

27. Principal agent problem
• We often study a simplified model with only one agent on either side
of the market to understand asymmetric information problems.
• The party who proposes the contract is called the principal and the
party who either accepts or rejects the contract is called the agent.
• Agents are the individuals employed by the principal to achieve
principal’s objective
• In the presence of information asymmetries, often preferences of the
principal and agents are not aligned and agents tend to pursue their
own goals rather than the goals of the principals. For instance, the
employee (or the agent) on duty has incentive to shirk effort, which
his employer (or the principal) fails to observe.

28. • Common examples of a principal-agent relationship include corporate
management (agent) and shareholders (principal), politicians (agent)
and voters (principal), or brokers (agent) and markets— buyers and
sellers (principals).
• The principal-agent problem is a conflict in priorities between the
owner of an asset and the person to whom control of the asset has
been delegated.
• Agents who pursue their own goals often take decisions which are
contrary to the goal of the principals
• Arises when one party (principal) delegates an action to another
party (the agent), and there exists information asymmetries between
them

29. • In Principal-Agent relationship, the agent is likely to have more
information than the principal because (i) he will have more
information about his own actions, preferences and abilities, and (ii) it
will cost him less to acquire information about the particulars
affecting the individual tasks assigned to him by the principal
• Hence information is distributed asymmetrically between the two
• It is costly for the principal to measure the characteristics and
performance of agents. So agents could engage in shirking and
opportunistic behaviour
• Agent may have informational advantages in the form of “hidden
actions” and “hidden information”

30. • Hidden actions cannot be accurately observed or inferred by others,
such as is the case, for example, with workers’ (agent’s) effort which
cannot be costlessly measured by employers (principal)
• The problem of hidden information arises when the principal is not in
a position to determine whether the agents’ actions, even if these
could be costlessly observed, are in his interest or not. Situation
where agent has more knowledge about the decision that they have
taken on behalf of principal.

31. Adverse selection
• Asymmetric information makes inefficiencies.
• One reason behind why presence of asymmetric information leads to market failure is due to
adverse selection
• Adverse selection refers to a situation when parties gaining from the presence of asymmetric
information are more likely to enter into a trade than the parties suffering from information
asymmetries.
• Adverse selection refers to the situation where one side of the market cannot observe
the type or quality of the goods of the other side of the market
• In our examples mentioned in the previous section, if buyers of the secondhand cars cannot
distinguish good cars from bad ones, sellers may be inclined to sell only lemons (bad-quality cars).
• If insurance companies have difficulty in evaluating applicants’ health status, they may end up
serving high-health risk policyholders and may not be able to harness the cross subsidies from the
low health risk policyholders and thus may not be able to breakeven due to high insurance claims
from the high risk clients
• If the potential employers have trouble assessing the abilities of workers, they may end up
employing poorly qualified workers

32. • In each of these examples, the informed parties, viz. second-hand car
sellers, insurance buyers, workers, are more willing to trade when
trading is less advantageous to the uninformed parties, viz. second-
hand car buyers, insurance companies, and potential employers,
respectively. This phenomenon is known as adverse selection
• When the affected uninformed parties realise that they face adverse
selection, they may become reluctant to even come forward for
trade, causing a market failure
• Gresham’s Law “Bad money drives out good money”.
• In the model we just examined the low-quality items crowded out the
high-quality items because of the high cost of acquiring information.
• Adverse selection leads to completely destroy the market.

33. Moral hazard
• Moral hazard is also a result of asymmetric information where
asymmetry arises due to hidden action by agents such that the action
of one party is not observed by the other party in trade, which in turn
affects the benefits of the latter.
• For example, in the case of the insurance market, an insured
individual’s risk of death or disability may increase in the post insured
stage because of his unhealthy lifestyle including smoking, excessive
drinking, or a lack of exercise. However, the insurance company is
likely to have difficulty in monitoring his behaviour and adjusting its
premiums accordingly.

34. • A simple illustration explaining moral hazard associated with
asymmetric information problem and how it leads to increase in the
costs is as follows. Consider a case of night security guard in a
company. Since the duty is for the night, nobody observes the actions
of the security guard. This in turn is incentive enough for the guard to
shirk, that is, not guarding properly. Suppose he frequently sleeps
during his duty hours as he knows his actions are not observed. As a
result of this, one night the company suffers a breaking, leading to
huge costs to the company.
• This is due to the presence of moral hazard in the guard’s hidden
behaviour which the firm is unable to observe. Thus the presence of
asymmetric information leads to market failure.

35. • Consider the bike theft insurance market again and suppose for
simplicity that all of the consumers live in areas with identical
probabilities of theft, so there is no problem of adverse selection.
• On the other hand, the probability of theft may be affected by the
actions taken by the bike-owners.
• The bike owners don’t bother to lock their bikes or use only a flimsy
lock. Because they are having insurance for a bike. If don’t have
insurance for bike they can use secure lock rather than flimsy lock.
• In general, moral hazard occurs when a party to a transaction takes
hidden actions that remain unobserved by its trading partner and
that affect the benefits or payoff of the latter

36. Signalling
• solution to asymmetric information
• The existence of asymmetric information often leads to the problem of
adverse selection and this leads to market failure. Now what to do when
asymmetric information is prevalent?
• One way in which the buyer and seller can deal with this problem is
through market signalling.
• Signaling is a solution to the problem of asymmetric information in which
the knowledgeable party alerts the other party to an unobservable
characteristic of the good. Often, economic actors will attempt to
communicate their quality via a signal.
• The concept of market signalling is where the buyer or the seller signals the
other uninformed party, to increase their information about the product in
trade.
• To see how market signalling works, let us consider the case of asymmetric
information in the labour market.

37. • In the labour market where high- and low ability workers are present
and are not easy distinguishable, employing somebody can be very
costly to the potential employer
• If an employer hires a low-ability worker for a job requiring high-
ability, he will be in severe loss.
• The high-ability worker can signal the employer about his abilities,
which stand out amongst all the other low-ability candidates.
• Signals could be in the form of better resume, being highly qualified,
education level, showing good etiquettes, speaking in decent
language, etc.
• These mechanisms are often used by the high-ability worker to signal
the potential employer about his (her) potential and makes sure the
employer credit him (her) with a high quality tag

38. Attitude towards Risk
• Risk is generally perceived as the possibility of facing a misfortune or
a loss. In other words, it is the potential that a choice or a decision
made will bring an undesirable outcome
• That is here, risk is involved with uncertainty of happening or not
happening of an event. Such uncertain situations are often connected
to some associated probabilities of occurrence or non-occurrence of
an event.
• Now the question arises, “How do people react to events involving
risk compared to those that are risk-free?” There exists heterogeneity
in people’s preference toward risk

39. Risk aversion
• consider an individual who has an aversion to risk, i.e. one who
strongly dislikes risk.
• Risk averter: not ready to take risk.
• The consumer having a wealth of $10. and he is contemplating a
gamble that give him 50% of winning $5 extra and 50% probability of
losing $5
• His actual wealth is $10 and he may end up with either $5 or $15
• Expected value of his wealth= ½(5)+1/2(15)=$10
• Expected utility will be= 1/2u(5)+1/2u(15)

40. • Mm

41. U(½(15) + ½(5)) = U(10)
1/2U(15)+ ½(U(5)= Expected utility of his wealth
Diminishing marginal utility of wealth as he has more of money
Expected value of wealth= ½(5) + ½(15)= 10
Utility for $5= 10
Utility for $10= 20
Utility for $15 = 25
Expected utility of wealth= ½u(5)+ ½u(15)
=½(10)+½(25)
= 17.5
The expected utility of expected wealth is less than the utility of actual wealth. So
rism averse

42. • The utility function representing a risk-averse individual is not a
straight line but rather is concave
• Concavity of the function implies that its slope is decreasing, which in
turn implies that this individual exhibits diminishing marginal utility
for additional units of payoff
• In other words, the risk-averse consumer is not willing to incur
additional risk for the possibility of a higher valued payoff.

43. Risk lover
• There are some individuals who actually prefer risky activities to risk-
free ones. These individuals are called risk lovers possessing a risk
preferring attitude.

44. Consumer
He is having $10 wealth
He is contemplating a gamble
50% probability of winning $5 extra
50% probability of losing $5
There is 50% probability of ending up with $15 and there is 50% probability
of ending up with $5
Now the expected value of his wealth = .5(5)+.5(15)= 10$
The expected utility = .5u($5)+ .5u($15)

45. Utility for $5= 10
Utility of $10= 20
Utility for $15 =40
Expected utility of his expected wealth $ 15=40
Expected Utility of his expected wealth $5= 10
Expected utility of his expected wealth= ½(10)+½(40)
=25
Since the expected utility of expected wealth {0.5u($5)+0.5u($10)} is greater than the
utility of the actual wealth u($10), this individual prefers to enter into the gamble

47. • Hence, a risk-preferring agent has increasing marginal utility for
additional units of payoff represented by convex utility function. This
simply means that the risk preferring individual is quite willing to take
on additional risk for the possibility of a higher valued payoff

48. Risk neutral
Mu remains constant with extra unit of money
People are indifferent towards risk
The expected utility of wealth is the utility of its expected value
• A risk neutral person shows no preference between a certain income,
and an uncertain income, given they both have equal expected value.
In other words, he will be indifferent between a risky and a risk-free
choice, if both result in same expected value to him