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♪ [music] ♪

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

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firm's costs. We'll also take a look at how
a firm maximizes its profit. In this

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

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

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

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a guiding assumption is going to be that
profit is the main motivation for a firm's

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

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

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competitors, competition alone is going to
compel them to maximize profit because

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

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business pretty quickly. For firms with
more market power or monopoly power -

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

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

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

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

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

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

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looking at a monopoly, which can choose
price and quantity with some restrictions.

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

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as given - it doesn't have much control over
its price - we'll explain why in a moment,

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and it chooses quantities. So for a
competitive firm, quantity is going to be

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the key choice which determines
how much profit the firm makes.

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

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

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

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sellers. So think about this stripper oil
well. This small oil well, it produces

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

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

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

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and so forth. Oil is pretty much the same
across all over the world. Or think about

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

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competitive markets - the product is
similar across sellers. In addition, in

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

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relative to the
total market.

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

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

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small fraction of the total production of
wheat. Alternatively, we may have the case

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where there are many potential sellers. So
even if a firm, a grocery store in a small

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town, is the only grocery store in the
small town, it's still in a competitive

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market, because if it were to raise its
price, there are many potential sellers who

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

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producing a product which is similar
across sellers, there are many buyers and

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sellers, each small relative to the total
market, or there are many potential

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

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previous slide. What price are you going
to set? Well, fortunately your problem is

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

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its price. The market
determines each firm's price. So

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

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

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

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

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

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

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

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

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

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

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$55. And if your mother won't pay extra
then nobody will. So if you try to set a

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

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Now you can sell as much oil as you want
below the market price, but why would you

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

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

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

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relative to the world production of 82
million barrels of oil per day, that

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

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

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going to $50 per barrel.
So your only choice, then, to maximize

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

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

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

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

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

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this diagram your costs.

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- [Announcer] If you want to test
yourself, click "Practice Questions." Or,

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

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♪ [music] ♪