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- In the next set of videos, we'll be looking at costs and how to describe a
firm's costs. We'll also take a look at how a firm maximizes its profit. In this
section, we're looking at profit maximization under competition. In a
later section, we'll cover profit maximization under monopoly. Let's get
going. So the key question that we want to answer is this, "How do firms behave?" And
a guiding assumption is going to be that profit is the main motivation for a firm's
actions. Now this is not literally 100% true. Nevertheless, for most firms, most of
the time, profit is going to be a key motivator. For firms with a lot of
competitors, competition alone is going to compel them to maximize profit because
firms with a lot of competitors that don't maximize profit, they're going to be out of
business pretty quickly. For firms with more market power or monopoly power -
they're not compelled to maximize profit. Nevertheless, the owners are still going
to want profit. Who doesn't like profit? So for most firms, most of the time, this is
going to be a good assumption. The key question then becomes, how? How do firms
maximize profit? And the basic answer is by choosing price and quantity. By
choosing what price is set and what quantity to set. Now some firms have more
control over their price than others. In the next chapter, we're going to be
looking at a monopoly, which can choose price and quantity with some restrictions.
In this chapter, we're going to be looking at a competitive firm, which takes prices
as given - it doesn't have much control over its price - we'll explain why in a moment,
and it chooses quantities. So for a competitive firm, quantity is going to be
the key choice which determines how much profit the firm makes.
So we're focusing in this chapter on one type of firm, the competitive firm, the
firm in a competitive market. Now what are the characteristics of this firm and
market? Well, the product that the firm sells is similar across many different
sellers. So think about this stripper oil well. This small oil well, it produces
oil, which is pretty much the same as the oil produced by the well next door, which
is pretty much the same as the oil produced by a well in Saudi Arabia, which
is pretty much the same as the oil produced from Mexico or from the North Sea
and so forth. Oil is pretty much the same across all over the world. Or think about
wheat, or soy beans, or steel, or concrete, or paper. All of these are
competitive markets - the product is similar across sellers. In addition, in
all of these markets there are many buyers and sellers and they're each small
relative to the total market.
So this stripper oil well produces only a small fraction of the
world's total production of oil. A wheat farm, any given wheat farm produces only a
small fraction of the total production of wheat. Alternatively, we may have the case
where there are many potential sellers. So even if a firm, a grocery store in a small
town, is the only grocery store in the small town, it's still in a competitive
market, because if it were to raise its price, there are many potential sellers who
in the long run could sell in that same town. So that's a competitive firm. It's
producing a product which is similar across sellers, there are many buyers and
sellers, each small relative to the total market, or there are many potential
sellers. So let's suppose you own one of those stripper oil wells I showed in the
previous slide. What price are you going to set? Well, fortunately your problem is
going to be really easy because a firm in a competitive market has no control over
its price. The market determines each firm's price. So
let's take a look at the market for oil, and suppose that the world demand and
supply are such that quantity demanded is equal to quantity supplied at a price of
$52, at which point 82 million barrels of oil a day are bought and sold. Now let's
think about the demand for your oil. The oil produce by your stripper oil well. The
demand for your oil is going to be perfectly elastic at the market price. Now
what does that mean? What that means is suppose that you tried to sell your oil at
a price above the market price, let's say $55 per barrel. Are you going to sell any
oil? No! Not even your mother thinks that the oil from your well is so special that
she would be willing to pay more for it. She can get oil which is identical or
virtually identical at a price of $50 per barrel, so she's unlikely to be want to pay
$55. And if your mother won't pay extra then nobody will. So if you try to set a
price higher than the market price, you're not going to sell any oil at all, zero.
Now you can sell as much oil as you want below the market price, but why would you
want to do that? Because in fact you could sell all the oil you want at the market
price. Now why can you sell all the oil that you want at the market price? Simply
because your production, let's say 10 barrels a day, or 20 or 30, it's so small
relative to the world production of 82 million barrels of oil per day, that
however much you produce from your single well, that's not going to influence the
price of oil. So you can double, triple your production, the price of oil is still
going to $50 per barrel. So your only choice, then, to maximize
profit is going to be a choice over quantity. You look at the market price, you
see, "Oh, the price of oil today is $50 per barrel," and your decision is going to
be how much do I want to produce at that price? Do I want to produce 2 barrels,
3 barrels, 4, 10, 20, how much? That is going to be your key
question, and that's the key question we'll take up next time when we also add into
this diagram your costs.
- [Announcer] If you want to test yourself, click "Practice Questions." Or,
if you're ready to move on, just click, "Next Video."
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