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♪ [music] ♪

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

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

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

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In this section, we're looking at

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profit maximization 
under competition.

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In a later section, we'll cover

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profit maximization 
under monopoly.

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Let's get going.

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

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"How do firms behave?"

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And a guiding assumption is 
going to be that

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

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Now this is not literally 100% true.

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Nevertheless, for most firms, 
most of the time,

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profit is going to be 
a key motivator.

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

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to compel them to maximize profit

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because firms with 
a lot of competitors

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that don't maximize profit, 


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

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For firms with more market power 
or monopoly power --

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they're not compelled 
to maximize profit.

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Nevertheless, the owners 
are still going to want profit.

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Who doesn't like profit?

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So for most firms, 
most of the time,

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this is going to be 
a good assumption.

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

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And the basic answer is
by choosing price and quantity.

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By choosing what price is set 
and what quantity to set.

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

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

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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,

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which takes prices as given --

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it doesn't have much control 
over its price --

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

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So for a competitive firm, 


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quantity is going to be 
the key choice

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which determines how much profit 
the firm makes.

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

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the competitive firm, 
the firm in a competitive market.

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Now what are the characteristics 
of this firm and market?

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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] ♪