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- [Alex Taborrok] In the next [br]set of videos,

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we'll be looking at costs [br]and how to describe a firm's costs.

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

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In this section, we're looking at

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profit maximization [br]under competition.

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In a later section, we'll cover

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profit maximization [br]under monopoly.

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Let's get going.

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So the key question that [br]we want to answer is this,

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"How do firms behave?"

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And a guiding assumption is [br]going to be that

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profit is the main motivation [br]for a firm's actions.

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Now this is not literally 100% true.

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Nevertheless, for most firms, [br]most of the time,

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profit is going to be [br]a key motivator.

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For firms with a lot of competitors,[br]competition alone is going

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to compel them to maximize profit

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because firms with [br]a lot of competitors

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that don't maximize profit, [br]

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they're going to be [br]out of business pretty quickly.

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For firms with more market power [br]or monopoly power --

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they're not compelled [br]to maximize profit.

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Nevertheless, the owners [br]are still going to want profit.

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Who doesn't like profit?

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So for most firms, [br]most of the time,

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this is going to be [br]a good assumption.

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The key question then becomes, how?[br]How do firms maximize profit?

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And the basic answer is[br]by choosing price and quantity.

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By choosing what price is set [br]and what quantity to set.

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Now some firms have more control [br]over their price than others.

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In the next chapter, we're going [br]to be looking at a monopoly,

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which can choose price and quantity[br]with some restrictions.

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

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which takes prices as given --

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it doesn't have much control [br]over its price --

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we'll explain why in a moment, [br]and it chooses quantities.

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So for a competitive firm, [br]

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quantity is going to be [br]the key choice

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

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

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the competitive firm, [br]the firm in a competitive market.

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Now what are the characteristics [br]of this firm and market?

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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 firm's 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 nobody 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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- [Announcer] 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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♪ [music] ♪