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,
just click, "Next Video."

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