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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- [Alex Taborrok] 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,
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