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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

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is similar across 
many different sellers.

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So think about 
this stripper oil well.

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This small oil well, 
it produces oil,

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which is pretty much the same

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as the oil produced 
by the well next door,

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which is pretty much the same

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as the oil produced 
by a well in Saudi Arabia,

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which is pretty much the same 
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
across all over the world.

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

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All of these are 
competitive markets --

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the product is similar 
across sellers.

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In addition, in all 
of these markets

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there are many buyers and sellers

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

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So this stripper oil well produces
only a small fraction

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of the world's 
total production of oil.

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A wheat farm, any given wheat farm

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produces only a small fraction 
of the total production of wheat.

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Alternatively, we may have the case

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where there are 
many potential sellers.

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So even if a firm, a grocery store 
in a small town,

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is the only grocery store 
in the small town,

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it's still in a competitive market,

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because if it were 
to raise its price,

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there are many potential sellers

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who in the long run 
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 
which is similar across sellers,

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there are many buyers and sellers,

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each small relative 
to the total market,

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or there are 
many potential sellers.

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So let's suppose you own one of
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 
is going to be really easy

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because a firm 
in a competitive market

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has no control over its price.

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The market determines 
each firm's price.

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

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and suppose that the world demand 
and supply

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are such that quantity 
demanded is equal

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to quantity supplied
at a price of $52,

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

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

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The oil produce 
by your stripper oil well.

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The demand for your oil 


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is going to be perfectly elastic 
at the market price.

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Now what does that mean?

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What that means is suppose that 
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?
No!

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Not even your mother thinks that
the oil from your well

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

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She can get oil which is identical 
or virtually identical

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at a price of $50 per barrel,

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

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

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

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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,

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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 
at the market price.

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Now why can you sell all the oil
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, 
or 20 or 30,

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it's so small relative 
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 
from your single well,

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

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So you can double, triple 
your production,

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

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So your only choice, 
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, 


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you see, "Oh the price of oil today
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 
at that price?

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

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That is going to be 
your key question,

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

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when we also add into this diagram 
your costs.

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- [Announcer] If you want to test
yourself,

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click "Practice Questions."

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

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♪ [music] ♪