Introduction to the Competitive Firm

How does a company really behave? We tend to assume profit — the bottom line — is the main motivation for a firm’s actions. For most firms most of the time, this is a good assumption, especially in a competitive market. With this video, you will explore how a company maximizes profit in a competitive environment where there are many buyers and sellers.
This idea comes with a few surprises. Does a company really control what price it sets? Or does the market determine the price? Here’s a clue. If you owned an oil well, even your mother wouldn’t buy your oil if she could get the same oil somewhere else for less money. Watch and find out why.
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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.

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