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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 [br]the firm sells

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is similar across [br]many different sellers.

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So think about [br]this stripper oil well.

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This small oil well, [br]it produces oil,

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which is pretty much the same

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as the oil produced [br]by the well next door,

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which is pretty much the same

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as the oil produced [br]by a well in Saudi Arabia,

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which is pretty much the same [br]as the oil produced from Mexico

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or from the North Sea and so forth.

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Oil is pretty much the same[br]across all over the world.

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Or think about wheat, or soy beans,[br]or steel, or concrete, or paper.

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All of these are [br]competitive markets --

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the product is similar [br]across sellers.

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In addition, in all [br]of these markets

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there are many buyers and sellers

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and they're each small relative [br]to the total market.

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So this stripper oil well produces[br]only a small fraction

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of the world's [br]total production of oil.

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A wheat farm, any given wheat farm

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produces only a small fraction [br]of the total production of wheat.

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Alternatively, we may have the case

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where there are [br]many potential sellers.

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So even if a firm, a grocery store [br]in a small town,

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is the only grocery store [br]in the small town,

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it's still in a competitive market,

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because if it were [br]to raise its price,

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there are many potential sellers

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who in the long run [br]could sell in that same town.

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So that's a competitive firm.

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It's producing a product [br]which is similar across sellers,

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there are many buyers and sellers,

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each small relative [br]to the total market,

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or there are [br]many potential sellers.

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So let's suppose you own one of[br]those stripper oil wells

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I showed in the previous slide.

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What price are you going to set?

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Well, fortunately your problem [br]is going to be really easy

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because a firm [br]in a competitive market

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has no control over its price.

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The market determines [br]each firm's price.

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So let's take a look at [br]the market for oil,

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and suppose that the world demand [br]and supply

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are such that quantity [br]demanded is equal

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to quantity supplied[br]at a price of $52,

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at which point 82 million barrels [br]of oil a day are bought and sold.

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Now let's think about [br]the demand for your oil.

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The oil produce [br]by your stripper oil well.

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The demand for your oil [br]

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is going to be perfectly elastic [br]at the market price.

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Now what does that mean?

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What that means is suppose that [br]you tried to sell your oil

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at a price above the market price,

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let's say $55 per barrel.

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Are you going to sell any oil?[br]No!

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Not even your mother thinks that[br]the oil from your well

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is so special that she would be [br]willing to pay more for it.

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She can get oil which is identical [br]or virtually identical

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at a price of $50 per barrel,

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so she's unlikely [br]to be want to pay $55.

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And if your mother won't [br]pay extra then nobody will.

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So if you try to set a price higher[br]than the market price,

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you're not going to sell [br]any oil at all, zero.

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Now you can sell as much oil [br]as you want below the market price,

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but why would you want to do that?

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Because in fact you could sell

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all the oil you want [br]at the market price.

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Now why can you sell all the oil[br]that you want at the market price?

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Simply because your production,

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let's say 10 barrels a day, [br]or 20 or 30,

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it's so small relative [br]to the world production

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of 82 million barrels of oil per day,

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that however much you produce [br]from your single well,

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that's not going to influence [br]the price of oil.

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So you can double, triple [br]your production,

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the price of oil is still going [br]to $50 per barrel.

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So your only choice, [br]then to maximize profit

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is going to be a choice over quantity.

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You look at the market price, [br]

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you see, "Oh the price of oil today[br]is $50 per barrel,"

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and your decision is going to be

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how much do I want to produce [br]at that price?

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Do I want to produce 2 barrels, [br]3 barrels, 4, 10, 20, how much?

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That is going to be [br]your key question,

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and that's the key question [br]we'll take up next time

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when we also add into this diagram [br]your costs.

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- [Announcer] If you want to test[br]yourself,

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click "Practice Questions."

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Or if you're ready to move on,[br]just click, "Next Video."

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♪ [music] ♪