Management Model of Baumol

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Outline

This study deals with the aspect of management model of Baumol in the context of Low Cost Airlines (LCA), with particular emphasis on the management theory of pricing as advocated by William Baumol. It is seen that the elasticity of demand does play an important role, as does the fact of trigger pricing. In the present context of deregulation and globalisation of global air traffic, pricing has assumed centre stage and airline operators are free to choose their own pricing strategies, often creating scope for price wars and undercutting in an unrestrained climate of liberalisation. However, criteria such as competitive markets with a cap on pricing, subaddivity and sustainability need to be maintained in order to operate without stricter governance and regulatory measures. Finally, it is felt that pricing and revenue maximisation needs to be differentiated and seen contextually in the airlines market place. Although the Baumol theory speaks of maximising revenue, it does not specify how exactly a start up enterprise could begin earning profits, given the kind of unabated competitive spirit which characterises airlines trade and the various add on advantages in terms of open skies policy, code sharing, leasing out aircrafts, etc.

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In his book, Entrepreneurship, Management and the Structure of Payoffs, Baumol has stressed the positive aspects of entrepreneurship. According to him, it is the restricted usage of entrepreneurship in the market that has contributed, in no small measure for its present stature.

Should wider visibility and use of entrepreneurship be made, it could contribute significantly to economic growth and all round progression.

Introduction

It is seen that the Baumol Model is more concerned about revenue maximisation, rather than profit maximisation. Therefore, the principal focus would be on pricing, which ultimately affects revenue generation in modern business scenarios. If we were to consider a market of perfect competition, it is seen that there are no restrictions to entry or exit of players, prices are determined through natural interaction of forces of demand and supply, there is smooth and straightforward trail of transactions, and no one player is able to control pricing and supply to the detriment of other players in the particular industry. Thus under such circumstances, players would look towards maximising revenue generation through enhancing volumes and maintaining price controls, without resorting to undercutting, price wars or other unethical practices. If one were to take the specific example of credit card industry it is seen that “This possible reduction in competition among general purpose card networks might have hindered and delayed the development and implementation of improved network products and services, and might have lessened consumer choice. If allowed to continue, the possibly anticompetitive structure and practices of the associations could threaten competition in the development and marketing of new general purpose card products, such as products that integrate credit, debit, and stored value functions.” (Baye 1998, p.2).

Airlines practices prior to deregulatory climate

In the context of airlines prior to deregulation, activities in the airlines industry was an antithesis of these perfect, or competitive markets. Airlines were monopolised by respective governments, or big business houses, which actively discouraged competition through a restrictive and regulatory regime, meant essentially to avoid private enterprises to enter a prerogatively public domain, but later the governments, especially in US and EU countries were forced to deregulate and share powers with new private and entrepreneurial airliners.

Over the years, as a result of their autocratic policies, in the new deregulated scenario, the central command of airlines business soon shifted to non-governmental hands, not only in dominant countries but even, to a large extent, at a globalised level. However, when considering the Baumol model it is necessary to believe that it is primarily seen that “pricing is the driver of revenues and volumes but may face a cost volume constraint.” (McNutt 2008, p.21).

Elasticity of demand

The question of elasticity of demand also comes into play. It is seen that if the product line is highly elastic (as could be seen from Low cost Airlines), the sales could be increased by lowering prices. LCA operate in such kind of environments, where price elasticity in the deregulated and decontrolled environment could allow individual operators to choose differential ticketing rates, spurred by low operating costs through use of e-ticketing, lowered aircraft maintenance charges, leased instead of own aircrafts and other benefits of operating on lower budgets.

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The Baumol Model advocates the use of free and unbridled entry to, and exit from the markets. The stipulation of free admission is fulfilled if access does not require any sunk costs. This implies that there would be no bias against entrants in favour of ruling firms, but new entrants would have to obey and attune themselves to the dictates of existing firms. In a free and competing market, firms need not be big, small or autonomous in their decision making or produce similar products. Perfect competition is applicable as a guide only where scale of economics is absent, so that a large number of rival firms can benefit from business endeavours. Competing markets contain only a few large firms, and since there are no regulatory norms, differentiations in costs could only be justified by quality, or pricing. But, if a firm’s marketing strategies need to be implemented without impediments, it is necessary that elasticity of markets be determined, and equivalent elastic pricing model be applied, in terms of the emerging markets. Increase in revenues and low pricing would impinge upon future business in highly competitive and decentralised market environment.

Baumol model
(McNutt 2008, p.22)

From the above it is seen that though initially, the elasticity does have an impact in terms of higher revenue generations, at a later stage it becomes necessary to shift consumption to better products or services. Thus it could be said that high prices may remain so, due to advertisements and publicity, loyal consumers, etc., and therefore, the decreases in prices are not of much consequences. However, it does assume significance if and when price reductions are made, such that prices remain above the trigger pricing and yet are able to generate revenues. In the context of low cost airlines, this is of significant importance, since airliners need to know what maximum prices they could provide for their services.

It is seen that with the separation of ownership control and management, heralding the era of professionalised management, proficient managers began to realise that it would be necessary to increase offtake volumes and turnover to stay ahead in business.

Spawned by the development of Management Discretionary theories, which advocated that managers are empowered and are therefore, at liberty to exercise decision making without having to consult ownership, managers may need to make economic decisions that may even have traits of ownership, especially in areas of demand determination, pricing, profits and performance.

Next coming to elasticity of demand, it is seen that when pricing is an important constituent in revenue business model. It is seen that although the net total gains is higher for products with elastic demands, with falling prices it could be envisaged that, with greater consumer demands, the net revenues would fall in tandem with falling prices. It is seen that elasticity of demand may be important in the event of low cost airliners because, in the event there is a conspicuous increase in fare charged by competitive airlines, other things remaining the same, travellers would still prefer the more economical airliners. Yet another aspect with regard to LCA would be in terms of the fact that once the travellers begin to enjoy benefits and privileges, they would clamour for more such benefits, and in case they are denied these during

subsequent flights, this may have repercussions on low cost airliners’ revenues and future profits. However, this could be offset if the market is a growing one or there are larger “price discrimination” that could take care of various elasticities of demand. (McNutt 2008, p.25).

According to Baumol, entrepreneurship is important since it replaces an age-old staid, strait-jacketed and slow progressive economy with a more vibrant and dynamic one. Entrepreneurship denotes change for better economic wealth, which is necessary for countries to achieve leadership status. With the thawing of the Cold War, it became necessary to seek faster economic growth. Countries in the Eastern Bloc, like China, Japan, Korea, began establishing large manufacturing units, which in turn generated employment opportunities and also oligopolistic competition.

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In such settings, the administration could control company profits through price mechanisms, taxation and enforcement of strict regulatory regimes. Therefore, volume off takes became important, which could not only ensure use of spare capacity, offsetting large fixed overhead costs, but could also help bring about economies of scale, thus increasing demand and lowering prices in the long run.

For any business, it is necessary to generate profits to stay in business. But there are limits, in terms of competition, government, taxation, etc. Thus, demand could be increased by lowering prices, in elastic markets. This is evidenced in areas of food commodities, pleasure travelling and other segments.

In his book, Entrepreneurship, Management and the Structure of Payoffs, Baumol examines the validity of entrepreneurship. The fault, according to him, lies more with the pattern of use of entrepreneurial abilities rather than the concept itself. Should it be allowed to be “adopted universally”, its contribution would be significantly larger. (Baumol, 1993, p.2).

Baumol’s theory in terms of maximizing revenues could usher in better capacity utilization, optimize resource management in terms of men, materials and money and also correct demand-price distortions. The detractors of his theory fail to appreciate the fact that demand enhancement needs to be satiated with availability of more goods, and this could cut down inflation rates and lead to speedier economic growth and prosperity, which is in the best interests of all.

Trigger pricing

It would be most appropriate to keep prices lower than that of competitors and rivals at the initial stages of business, thus carving a market share, and then, according to business trends and needs, to make judicious and cautious increases, keeping overall revenue maximization in mind. However, it is also necessary to keep prices well above the trigger pricing, as otherwise it would signal a price war which could be difficult to control. Even taking the case of branded drugs, it is necessary to maintain price differentials with generic drugs, since costs of generic drugs are too low when compared with branded ones. “It is also necessary that branded products should distance their price as far away as constrained by the boundaries of the trigger price from the relatively lower priced generic.” (McNutt 2008, p.24). Thus it would not be wrong to state that free competition in business could be more of a misnomer since the business strategies of bigger players would definitely affect smaller players and pricing could be said to arise out of a number of factors, controllable or uncontrollable. However, as enunciated by Baumol, airlines industry, especially after deregulation, provides classic examples of fly-by-night operators, who entered the market at low pricing fares, make their profits and moved out, almost as quickly as they entered. These entries at lowered rates could cause variations in demand trends. However, this theory is invalidated since it is widely believed that the fear of potential customers and their reactions to prices do not deter entrenched operators or exercise market pressures or control prices. It is seen that higher fares at hub airports support the argument that feeder traffic may be controlled by two major airliners.

Moreover, the theory of industry structure speaks about market efficiencies, but what constitutes or determines market efficiencies remain well within the domain of the unknown. It is indeed paradoxical that the American Congress’s aim for deregulation was aimed at creating a free and controlless environment but this has only opened the floodgates for more oligopolistic competition, especially among the big players who dominate the scene. “Experimental evidence suggests that perfectly contestable markets will behave as predicted by the theory of perfectly contestable markets, but that the performance of imperfectly contestable markets depends on actual rather than potential competition.“ (Martin 2000, p.43). It could be reasonably said that true competitive culture is in vogue if an entrant is able to enter the industry, either with investments, or free of costs, and be able to sell his wares, and later on depart after recompensing for the initial investments. However, if these conditions are met, it could be said that a probable case for regulation does not arise. “Transaction costs on financial markets suggest that entrants and fringe firms will have a higher cost of capital than incumbents.” (Martin 2000, p.19). However, it is seen that in present empirical context, the advent of new players may not be welcomed, and even if they do, their pricing are strictly governed; it would be difficult to sell at higher or lower prices than what the trade dictates. If it were lower, it is quite possible that the business would eventually fold up with unbearable losses.

High prices may not be allowed by existing, and contemporary airlines, since this would affect their business. Again, the practice of code sharing in airlines could be seen as akin to attempts of Amex, etc “to issue cards on their networks.” (Baye 1998, p.2).

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This has also been the story of low cost airlines, where deregulatory climate has brought differential prices, not for good but to undercut and raise price wars. As a result many well-established airlines had to close shop, and many newcomers began to rule the roost. However, it is seen that it is obligatory on the part of regulators to enforce parity of pricing and no differentials do occur. Thus, in a way entrants are being blocked and the aspect of free competition is lowered. However, it is now necessary to consider the fundamental criterion which rules the present airlines sales or revenue maximisation. It basically comprises of

  1. Maximising revenue and sales with a cap on net profits
  2. Sustainability

Maximising revenue and sales with a cap on net profits

It is believed that proposed entrepreneur would be able to pursue profits opportunities within the industry and, in the event of winding up, would be able to recoup initial outlay. When considered in the light of Low Cost Airlines, it could be said that while the entry has been easier due to a deregulated environment, the chances of staying competitively in business and recouping costs, remains in area of speculation and calculated conjectures. It would depend upon individual firm or airline business to choose its own destiny, in terms of market share and continuance of business. Thus competitive strengths have to be capitalised and market shares carved out. Although the Baumol theory speaks of maximising revenue, it does not specify how exactly a start up could earn profits, given the kind of high competition that governs airlines trade and the various advantages in terms of strategic alliances. Further, it is seen that elasticity of demand takes into account pricing as a principle factor in the business model. Although the net total revenues are higher for products with elastic demands, as prices fall, there is a fear that in product markets where consumers demand more benefits, on the basis of competitive benefits, net total revenues may fall as prices falls.

Sustainability

The rates charged by a firm needs to be sustainable over a period of time and should be such that it does not allow similar firms to set up shop in the business. Thus, what sustainability really means could be seen in terms of recovery of costs plus a small margin towards profits. Charging too high margins would be difficult under the present competitive business in airlines and would also invite competitors, which could severely undermine potential profits. Charging lower than others could trigger a price war with undesirable consequences

Conclusions

It is seen that in the event it may become necessary for regulatory actions to be instituted, common practices need to be enforced in the industry. However, it could be said that Baumol does have a role in modern business which is driven more by revenue generation and turnover figures rather than by actual profit figures.

It could be said that certain competitive aspects of business in LCA or even retail trade are governed by factors exclusive or pricing, revenue or profit sharing, in terms of local regulations, economic variables, political stability and a host of other direct or indirect implications. Under such circumstances, how this theory could hold is as much a matter of conjecture and speculation, as business practices. The influences of trade cartels, lobbying with the establishment and other dubious practices are also not ruled out. Moreover, being rather subjective in scope and approach, the empirical importance of its influence on marketing as a validated function is a matter for expert marketing practitioners to determine and resolve.

Bibliography

BAUMOL, William J. (1993). Entrepreneurship, Management and the structure of payoffs: Chapter 1. Amazon.com. P.2. Web.

BAYE, Michael R.(1998). Overview of Market for General Purpose Card Services. Managerial Economics and Business Strategy. P.2. Web.

BAYE, Michael R.(1998). Visa and MasterCard Impede the Ability of Other Networks to Contract with Issuers. Managerial Economics and Business Strategy. P.15. Web.

MARTIN, Stephen. (2000). Critical Assumptions: No Transactions Costs in Financial Markets. P.19. Web.

MARTIN, Stephen. (2000). The Theory of Contestable Markets: Conclusion. P.43. Web.

MCNUTT, Patrick A. (2008). Signalling Strategy & Management Type. P.21.

MCNUTT, Patrick A. (2008). Signalling, Strategy & Management Type: Introducing Framework T3 and Gems for Business Strategies. P.22.

MCNUTT, Patrick A. (2008). Signalling, Strategy & Management Type: Introducing Framework T3 and Gems for Business Strategies. P.24.

MCNUTT, Patrick A. (2008). Signalling, Strategy & Management Type: Introducing Framework T3 and Gems for Business Strategies. P.25.

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