Introduction to the Competitive Firm

Course Outline

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.

Teacher Resources


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.



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