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- In the next set of videos, we'll be[br]looking at costs and how to describe a

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firms cost. We'll also take a look at how[br]a firm maximizes its profit. In this

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section, we're looking at profit[br]maximization under competition. In a

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later section, we'll cover profit[br]maximization under monopoly. Let's get

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going. So the key question that we want to[br]answer is this, "How do firms behave?" And

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a guiding assumption is going to be that[br]profit is the main motivation for a firms

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actions. Now this is not literally 100%[br]true. Nevertheless, for most firms most of

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the time profit is going to be a key[br]motivator. For firms with a lot of

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competitors competition alone is going to[br]compel them to maximize profit because

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firms with a lot of competitors that don't[br]maximize profit they're going to be out of

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business pretty quickly. For firms with[br]more market power or monopoly power

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they're not compelled to maximize profit.[br]Nevertheless, the owners are still going

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to want profit. Who doesn't like profit?[br]So for most firms most of the time this is

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going to be a good assumption. The key[br]question then becomes how? How do firms

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maximize profit? And the basic answer is[br]by choosing price and quantity. By

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choosing what price is set and what[br]quantity to set. Now some firms have more

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control over their price than others. In[br]the next chapter, we're going to be

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looking at a monopoly which can choose[br]price and quantity with some restrictions.

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In this chapter, we're going to be looking[br]at a competitive firm which takes prices

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as given it doesn't have much control over[br]its price. We'll explain why in a moment

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and it chooses quantities. So for a[br]competitive firm quantity is going to be

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the key choice which determines[br]how much profit the firm makes.

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So we're focusing in this chapter on one[br]type of firm, the competitive firm, the

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firm in a competitive market. Now what are[br]the characteristics of this firm and

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market? Well, the product that the firm[br]sells is similar across many different

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sellers? So think about this stripper oil[br]well. This small oil well, it produces

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oil, which is pretty much the same as the[br]oil produced by the well next door, which

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is pretty much the same as the oil[br]produced by a well in Saudi Arabia, which

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is pretty much the same as the oil[br]produced from Mexico or from the North Sea

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and so forth. Oil is pretty much the same[br]across all over the world or think about

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wheat, or soy beans, or steel, or[br]concrete, or paper. All of these are

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competitive markets. The product is[br]similar across sellers. In addition, in

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all of these markets there are many buyers[br]and sellers and they're each small

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relative to the[br]total market.

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So this stripper oil well produces[br]only a small fraction of the

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world's total production of oil. A wheat[br]farm, any given wheat farm produces only a

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small fraction of the total production of[br]wheat. Alternatively we may have the case

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where there are many potential sellers so[br]even if a firm, a grocery store in a small

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town is the only grocery store in the[br]small town it's still in a competitive

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market because if it were to raise its[br]price there are many potential sellers who

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in the long run could sell in that same[br]town. So that's a competitive firm. It's

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producing a product which is similar[br]across sellers there are many buyers and

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sellers. Each small relative to the total[br]market or there are many potential

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sellers. So let's suppose you own one of[br]those stripper oil wells I showed in the

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previous slide what price are you going[br]to set? Well, fortunately your problem is

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going to be really easy because a firm in[br]a competitive market has no control over

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its price. The market[br]determines each firms price. So

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let's take a look at the market for oil[br]and suppose that the world demand and

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supply are such that quantity demanded is[br]equal to quantity supplied at a price of

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$52 at which point 82 million barrels of[br]oil a day are bought and sold. Now let's

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think about the demand for your oil. The[br]oil produce by your stripper oil well. The

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demand for your oil is going to be[br]perfectly elastic at the market price. Now

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what does that mean? What that means is[br]suppose that you tried to sell your oil at

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a price above the market price let's say[br]$55 per barrel. Are you going to sell any

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oil? No! Not even your mother thinks that[br]the oil from your well is so special that

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she would be willing to pay more for it.[br]She can get oil which is identical or

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virtually identical at a price of $50 per[br]barrel so she's unlikely to be want to pay

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$55 and if your mother won't pay extra[br]then no body will. So if you try to set a

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price higher than the market price you're[br]not going to sell any oil at all, zero.

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Now you can sell as much oil as you want[br]below the market price but why would you

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want to do that? Because in fact you could[br]sell all the oil you want at the market

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price. Now why can you sell all the oil[br]that you want at the market price? Simply

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because your production let's say 10[br]barrels a day, or 20 or 30 it's so small

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relative to the world production of 82[br]million barrels of oil per day that

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however much you produce from your single[br]well that's not going to influence the

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price of oil. So you can double, triple[br]your production the price of oil is still

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going to $50 per barrel.[br]So your only choice then to maximize

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profit is going to be a choice over[br]quantity. You look at the market price you

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see, "Oh, the price of oil today is $50[br]per barrel," and your decision is going to

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be how much do I want to produce at that[br]price? Do I want to produce 2 barrels,

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3 barrels, 4, 10, 20 how[br]much? That is going to be your key

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question and that's the key question we'll[br]take up next time when we also add into

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this diagram your costs.

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- [male voice] If you want to test[br]yourself, click "Practice Questions," or

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if you're ready to move on,[br]just click, "Next Video."

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