Maximizing Profit under Competition
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Not Synced♪ [music] ♪
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Not Synced- [Alex] We learned last time
that a firm -
Not Syncedin a competitive market
doesn't have much control -
Not Syncedover it's price.
-
Not SyncedIt must accept the market price.
-
Not SyncedSo its decision about profit
maximization turns into a decision -
Not Syncedabout what quantity to choose,
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Not Syncedand that's what we're going
to be focusing on now. -
Not SyncedSo what is profit?
-
Not SyncedProfit is total revenue
minus total cost. -
Not SyncedTotal revenue is just price
times the quantity sold. -
Not SyncedTotal cost has two parts.
-
Not SyncedFirst are the fixed costs.
-
Not SyncedThese are costs
that do not vary with output. -
Not SyncedSo, for example, suppose you
are the owner -
Not Syncedof this small oil well
and you have to pay rent -
Not Syncedfor the land
on which the oil well sits. -
Not SyncedThose rental costs --
you have to pay them -
Not Syncedregardless of how much
the oil well is producing. -
Not SyncedEvery month you have to pay
some rental cost -
Not Syncedwhether you're producing
one barrel of oil per month, -
Not Synced10 barrels of oil per month,
11 barrels of oil per month. -
Not SyncedIt doesn't matter.
-
Not SyncedYou still have to pay
the same rental cost. -
Not SyncedIndeed, even if you don't produce
any oil that month, -
Not Syncedif your oil well breaks down,
you still have to pay -
Not Syncedthose rental costs.
-
Not SyncedSo the rental costs
are fixed costs. -
Not SyncedThey don't vary
with the quantity produced. -
Not SyncedBy the way, notice
that even if you owned the land, -
Not Syncedif you could have rented it
to someone else, -
Not Syncedthen that would be
an opportunity cost. -
Not SyncedSo your calculation of profit
should also include -
Not Syncedopportunity costs.
-
Not SyncedThat's what makes the economic
calculation of profit, by the way, -
Not Synceddiffer by the accounting
definition of profit. -
Not SyncedThe economic notion of profit
includes opportunity costs. -
Not SyncedOkay, what else?
-
Not SyncedWell, variable costs --
these are the cost -
Not Syncedthat do vary with output.
-
Not SyncedSo for example, the electricity cost
for pumping oil -- -
Not Syncedthe more oil you pump,
the faster you get your rig to go, -
Not Syncedthe more electricity
you're going to use up. -
Not SyncedIf you run it 24 hours a day,
you're going to use -
Not Syncedmore electricity
than if you only run the pump -
Not Synced12 hours a day.
-
Not SyncedTransportation cost --
you got to go and get the oil, -
Not Syncedtruck it out of there,
move it and so forth. -
Not SyncedSo these costs are all costs
which vary with output, -
Not Syncedwhich typically will increase
the more output that you produce. -
Not SyncedThose are your variable costs.
-
Not SyncedSo just to summarize on cost,
total cost is equal -
Not Syncedto your fixed costs
plus your variable costs -
Not Syncedand these depend upon output.
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Not SyncedOkay, so how do we maximize profit?
-
Not SyncedWell, we're not going
to use calculus in this class, -
Not Syncedbut for those of you
who do know calculus, -
Not SyncedI want to do a quick aside --
show you actually how useful -
Not Syncedcalculus is and show you
an easy way -
Not Syncedof answering this problem.
-
Not SyncedSo we know the profit
is total revenue minus total cost -
Not Syncedand both of these are functions
of the quantity produced. -
Not SyncedNow in calculus
how do we maximize a function? -
Not SyncedThink back to your calculus class.
-
Not SyncedYou take the derivative
of that function -
Not Syncedand you set it equal to zero.
-
Not SyncedSo in this case,
we want to take the derivative -
Not Syncedof profit with respect
to quantity and set that -
Not Syncedequal to zero.
-
Not SyncedSo derivative of profit
respect to quantity -- -
Not Syncedthat's just the derivative
of total revenue -
Not Syncedwith respect to quantity
minus the derivative of total cost -
Not Syncedwith respect to quantity.
-
Not SyncedNow in economics,
we have special names -
Not Syncedfor these two derivatives.
-
Not SyncedThe derivative of total revenue
with respect to quantity -
Not Syncedis simply called marginal revenue.
-
Not SyncedAnd the derivative of total cost
with respect to quantity -
Not Syncedis called marginal cost.
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Not SyncedSo we want to find the quantity
such that marginal revenue -
Not Syncedminus marginal cost is zero,
or in other words, -
Not Syncedwe want to find the quantity
such that marginal revenue -
Not Syncedis equal to marginal cost.
-
Not SyncedIn other words, the quantity,
which maximizes profit, -
Not Syncedis the one where marginal revenue
is equal to marginal cost. -
Not SyncedNow I'm about to give you
a more intuitive explanation, -
Not Syncedespecially for those of you
who don't get no calculus, -
Not Syncedbut for those of you who do,
this is just exactly -
Not Syncedwhat you were to do in calculus --
you take the derivative, -
Not Syncedset it equal to zero.
-
Not SyncedOkay let's get some more intuition.
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Not SyncedWhen the firm produces
an additional unit of output, -
Not Syncedthere are additional revenues
and additional costs. -
Not SyncedProfit maximization
is all about comparing -
Not Syncedthese additional
revenues and costs, -
Not Syncedand we have names for these.
-
Not SyncedMarginal revenue is the addition
to total revenue -
Not Syncedfrom selling an additional
unit of output. -
Not SyncedMarginal cost is the addition
to total cost from producing -
Not Syncedan additional unit of output.
-
Not SyncedProfits are maximized at the level
of output where marginal revenue -
Not Syncedis equal to marginal cost.
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Not SyncedNow why is this?
-
Not SyncedWell, let's suppose
that marginal revenue -
Not Syncedis not equal to marginal cost
and let’s show -
Not Syncedthat you can't be profit maximizing
if that's the case. -
Not SyncedFor example, if marginal revenue
is bigger than marginal cost, -
Not Syncedyou're not profit maximizing --
producing more -
Not Syncedwill add to your profit.
-
Not SyncedWhy? Well, remember marginal
revenue is the addition -
Not Syncedto revenue from producing
another unit. -
Not SyncedMarginal cost
is the addition to cost -
Not Syncedfrom producing another unit.
-
Not SyncedIf marginal revenue is bigger
than marginal cost, -
Not Syncedthat says producing that unit
adds more to your revenues -
Not Syncedthan it does to your costs.
-
Not SyncedIn other words,
you could increase profit -
Not Syncedby producing more.
-
Not SyncedSo if marginal revenue
is ever bigger -
Not Syncedthan marginal cost,
you want to produce more. -
Not SyncedOn the other hand,
suppose marginal revenue -
Not Syncedis less than marginal cost,
or to put it the other way, -
Not Syncedsuppose marginal cost is bigger
than marginal revenue. -
Not SyncedWell then, you're not
profit maximizing -
Not Syncedbecause producing less
will add to your profit. -
Not SyncedWhy is this?
-
Not SyncedWell, think about marginal cost.
-
Not SyncedIf you were to produce
one unit less your costs would fall -
Not Syncedby marginal cost,
your revenues would also fall -
Not Syncedby marginal revenue,
but since marginal cost is bigger -
Not Syncedthan marginal revenue,
your costs by producing -
Not Syncedone unit less fall by more
than your revenues fall. -
Not SyncedSo if your costs are going down
by more than your revenues -
Not Syncedare going down,
you're again increasing profit. -
Not SyncedSo if marginal revenue
is ever less than marginal cost, -
Not Syncedyou want to produce less --
you'll be increasing your profit -
Not Syncedby producing less.
-
Not SyncedSo, if marginal revenue
is bigger than marginal cost, -
Not Syncedyou're not profit maximizing.
-
Not SyncedIf marginal revenue is less
than marginal cost -
Not Syncedyou're not profit maximizing.
-
Not SyncedYou can only profit maximize
if marginal revenue -
Not Syncedis equal to marginal cost.
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Not SyncedNow let's put all this in a diagram
beginning with marginal revenue. -
Not SyncedNow for a competitive firm,
this is going to be easy -
Not Syncedbecause remember,
that a competitive firm -
Not Syncedis small relative
to the total market. -
Not SyncedThat means it can double
its production easily -
Not Syncedand not push down the market price.
-
Not SyncedAs a result,
for a competitive firm, -
Not Syncedmarginal revenue is equal
to the market price. -
Not SyncedSo for example, suppose the firm
is producing two units of output -
Not Syncedand it decides to produce
a third unit, -
Not Syncedwhat's the additional revenue
from that third unit? -
Not SyncedIt's the price.
-
Not SyncedIt's the price it gets
for that barrel of oil. -
Not SyncedWhat about if it produces
a fourth barrel of oil? -
Not SyncedWhat does it get?
What's the addition to revenue? -
Not SyncedIt's the price of a barrel of oil.
-
Not SyncedWhat about the fifth unit?
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Not SyncedAgain, the price is the addition
to revenue, is marginal revenue. -
Not SyncedSo, marginal revenue
for a competitive firm -
Not Syncedis equal to the price
and it's flat -- -
Not Syncedit doesn't change when the firm
changes its output -
Not Syncedbecause the firm is small
relative to the market. -
Not SyncedNow what about marginal cost?
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Not SyncedWell, a typical shape
of a marginal cost curve -
Not Syncedwould be upward sloping like this.
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Not SyncedAgain, think about
our stripper oil well. -
Not SyncedWe can produce more
from that oil well, -
Not Syncedbut there's a limit.
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Not SyncedWe can only run it so quickly.
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Not SyncedWe have to push it really hard
when we start to produce more. -
Not SyncedSo we can easily produce,
you know, three or four units, -
Not Syncedbut in order to produce six,
seven, eight or nine barrels of oil -
Not Syncedfrom that oil well,
we're going to have to run it -
Not Syncedreally quickly, we're going
to have to put in -
Not Synceda lot of electricity,
we're going to have to do -
Not Synceda lot of maintenance and so forth.
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Not SyncedSo our costs will tend to increase.
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Not SyncedWe can't produce
an unlimited amount of oil -
Not Syncedat the same cost
from this oil well. -
Not SyncedOur costs are going to go up,
are going to rise, -
Not Syncedour additional costs
are going to rise -
Not Syncedthe more we want to produce
from that oil well. -
Not SyncedSo this is a typical shape
of a marginal cost curve. -
Not SyncedNow, where's profit maximization?
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Not SyncedWell, profit is maximized
where marginal revenue -
Not Syncedis equal to marginal cost.
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Not SyncedIn this case,
for a competitive firm, -
Not Syncedmarginal revenue is equal to price.
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Not SyncedSo profit is maximized
where price is equal -
Not Syncedto marginal cost
or at this point right here. -
Not SyncedNow let's think
about that intuitively. -
Not SyncedOn the left hand side
this is the additional revenues -
Not Syncedfrom selling a barrel of oil.
-
Not SyncedThese are the additional costs
from selling a barrel of oil. -
Not SyncedSo you want to compare --
revenues bigger than costs, -
Not Syncedtherefore sell more.
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Not SyncedRevenues bigger than costs,
therefore sell more. -
Not SyncedRevenues bigger than costs.
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Not SyncedYou keep selling more
until you reach this point. -
Not SyncedDo you want to go further? No.
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Not SyncedHere, costs are bigger
than revenues. -
Not SyncedSo by selling less,
you can reduce your costs -
Not Syncedby more than you'd reduce
your revenues -
Not Syncedand therefore profit goes up
going this way -
Not Syncedand that's why this point,
where marginal revenue -
Not Syncedis equal to marginal cost,
or price is equal to marginal cost, -
Not Syncedthat's the point where profit
is maximized. -
Not SyncedNow remember way back
in the first talk, -
Not Syncedwe wanted to explain
a firm’s behavior. -
Not SyncedSo let's look how maximizing profit
explains the firm’s behavior. -
Not SyncedSuppose the market price
is $50 per barrel. -
Not SyncedWell, then in order
to maximize profit, -
Not Syncedthe firm chooses the quantity --
in this case, -
Not Syncedabout eight barrels of oil --
such that marginal revenue -
Not Syncedis equal to marginal cost,
bearing in mind -
Not Syncedthat for the competitive firm,
marginal revenue is equal to price. -
Not SyncedSo to profit maximize
the firm produces a quantity -
Not Syncedof about eight barrels of oil.
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Not SyncedNow suppose that the market price
goes up to $100. -
Not SyncedNow in order to profit maximize,
the firm increases its production -
Not Syncedalong its marginal cost curve
keeping this relationship the same -
Not Syncedso price is still equal
to marginal cost. -
Not SyncedPrice has gone up to 100,
but because the firm has expanded -
Not Syncedalong its marginal cost curve,
marginal cost has gone up as well. -
Not SyncedSo this again is the profit
maximizing point -
Not Syncedwhen the price is equal to 100.
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Not SyncedWhen the price is equal to 100,
the profit maximizing quantity -
Not Syncedis just under 10 barrels of oil.
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Not SyncedSo profit maximization explains
what the firm does when the price, -
Not Syncedwhen the market price, changes.
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Not SyncedWe now know how to find
the profit maximizing quantity -- -
Not Syncedlook for the quantity
where marginal revenue -
Not Syncedis equal to marginal cost,
which is the same -
Not Syncedfor the competitive firm
where price is equal -
Not Syncedto marginal cost.
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Not SyncedNow we want to ask,
what is the size of the profit? -
Not SyncedThis raises a subtle point.
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Not SyncedYou can be maximizing profits
and actually have a loss. -
Not SyncedThat is, the best that you can do
might be a loss. -
Not SyncedSo we want to show on the diagram
how large your profits -
Not Syncedor how large your losses are
when you are maximizing profits. -
Not SyncedIn order to do that,
we need to introduce -
Not Syncedanother concept
and another curve -- -
Not Syncedaverage cost.
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Not SyncedAverage cost is simply
the cost per unit of output. -
Not SyncedThat is the total cost
divided by Q, -
Not Syncedthe quantity of the output.
-
Not SyncedSo average cost again --
total cost divided by Q. -
Not SyncedAdding the average cost curve
to our graph -
Not Syncedwill let us show profit
on the graph. -
Not SyncedAnd that's what we want to do,
and that's what we'll do -
Not Syncedin the next talk.
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Not SyncedThanks.
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Not Synced- [Narrator] If you want
to test yourself, -
Not Syncedclick, "Practice Questions,"
-
Not Syncedor if you're ready to move on,
just click, "Next Video." -
Not Synced♪ [music] ♪
- Title:
- Maximizing Profit under Competition
- Description:
-
A company in a competitive environment does not control prices. So the key to maximizing profit is choosing how much to produce. To do that, we need to factor in the costs involved in production. So what exactly are the costs? How do these costs influence how you maximize profit? And, remember, if you want to think like an economist, you must factor in opportunity cost!
In this video, we define profit, including how to calculate total revenue and total cost. We also go over fixed costs, variable costs, marginal revenue, and marginal cost
Microeconomics Course: http://mruniversity.com/courses/principles-economics-microeconomicsAsk a question about the video: http://mruniversity.com/courses/principles-economics-microeconomics/profit-maximization-marginal-cost-marginal-revenue#QandA
Next video: http://mruniversity.com/courses/principles-economics-microeconomics/profit-maximization-average-cost
- Video Language:
- English
- Team:
- Marginal Revolution University
- Project:
- Micro
- Duration:
- 13:16
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Martel Espiritu edited English subtitles for Maximizing Profit under Competition | ||
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