Greetings. In one of our previous videos we discussed the fact that firms want to maximize profits. We talked a little bit about all these profits. So these are economic profits. So the cost curves include in there, the opportunity cost, and what they could be doing in their next best alternative. That's all in that thing. So we had this idea that the goal for firms is to maximize profits, and profits we simply wrote as total revenue minus total cost. We figured out earlier we'd get a pretty good idea of how to do total revenue, because earlier, we looked at what firms might make. For example if this is the demand curve, and this was the price that they sold their product, and this was the quantity. Then total revenue would just be equal to price times quantity and of course on this graph price times quantity. If you multiply those two out that's like multiplying base times height, the area of this rectangle would be total revenue. Good. We've got total revenue. Graphically, we know how to draw total revenue. Now, we've got to do total cost and we started to think earlier that total cost comes from where. Cost comes from production. You cannot just wish that you have output, you have to actually go about doing some work to get it. Okay. You have to hire inputs. You have to combine inputs in some systematically efficient manner to produce outputs and then sell those to get that revenue, but cost comes from inputs. So in this video we're going to think about where all these curves come from. Let's introduce new notation. From now on, we're going to use capital Q. Capital Q denotes market output. It's like the Q we had on that demand curve when we had demand and supply there, that was the total market demand for gasoline or oil whatever it is, and we're going to use lowercase Q to denote the output of an individual firm. First of all, why are we doing this? Well, because as we continued to push our way through this course we're going to start realizing that in fact in many markets there's more than one supplier. When we get to the second module of the second course which would be the sixth module of the overall. We're going to talk about something called monopolies. A monopoly is a situation when there's only one firm. In that case, the firm is the market, but in most markets there's many people. There's hundreds of thousands of farmers in a very active corn market. There's lots and lots and lots of different producers. There's many not thousands but there's dozens of people companies producing mid-size automobiles. We know a couple of a big-time players there, the Honda Accord and the Toyota Camry maybe the largest sellers in that midsize automobile market, but there are lots of people selling mid-size automobiles. So there's going to be situations where we need to have a lower q to talk about individual players, and then the sum of all the output will be the market. So what we'll do is to say this means this implies that cap Q is the summation from i equals 1 to n of the outputs of each of the i firms where in this case where n is the total number of firms. Okay. We're going to switch gear and mostly for the rest of this module three, we're just going to use lowercase q because we're going to be talking about production at an individual firm level. Thinking about the cost curves for a firm that's in some market trying to make a living. So we're going to think about production, and in order to do that I'm going to say that we have this idea that output is some function of inputs, and that functional form we're going to talk about the minute. It's f means, it's a functional operator at some algebraic, some polynomial, some complex form, that tells us how we can combine inputs to get outputs. We're going to start by making life relatively simple for us. We're going to assume that we just have two inputs, and those two inputs are labor which we'll call L and capital. In economics, we use capital K didn't know capital because C is reserved for cost. Cost function, total cost, marginal cost, all of these sorts of things you use the C there. So we use K for this. This implies that output is some function of these two inputs, labor and capital. In the real world, and we're going to talk about this in a minute, there could be lots of inputs, okay. Many different inputs, natural resources, entrepreneurial cash, all things. Could be different resources that the firm could use, but we're trying to make it as easy as possible here and we're going to lump them into two categories. Economists believe that in this particular model L for labor, thinks about variable inputs and K for capital, thinks about things like brick-and-mortar something you can't change too quickly. We'll get to talk about that in a minute. So what we want to do is figure out what does this production function look like, and how are we ever going to figure that out? Well, it turns out to figure out what the production function it looks like, we could go out and hire engineers. That's what engineers are good at. Engineers could say okay, you want to make just try. So we're going to start with this example because I said it was going to use it. Out of the edge of town here, is this giant Kraft plant and this Kraft plant looks like this. It's big. Okay. Suppose you got yourself in a hot air balloon, and take this hot air balloon ride over this Kraft plant, and you're looking at this Kraft plant and you're saying, you know what, I can see there's a big parking lot out front and then this parking lot, people are parking their cars, and they're walking in. There are workers coming in, carrying their lunch box, going into the factory. At the same time, I can see that over on this side there is a loading dock where there's big semi tractors, and they're dumping off products, inputs. Okay. So this Kraft plant, let's pull this Kraft plan is making mayonnaise. They make a lot of stuff at the Kraft plant. It's huge. They're the number one. In fact, they're the sole source of Velveeta in North America. They produce half of all of the macaroni and cheese sold in the United States at this Kraft plant in Champaign, and they also make mayonnaise. So we're going to think about mayonnaise. Simple product, okay. Inputs are coming in. Here at this loading dock, trucks are coming in and they're dropping off eggs and glass jars, and crates full of labels to stick on the glass jars, and all stuff are going in here. In the front-door, workers are coming in. So now you being an economist you also have a background in statistics and you've been gathering data. From your hot air balloon you can count how many workers came in, and you can count how many jars of mayonnaise went in. How many eggs went in. How many glass jars went in. All of these things go in. At the same time at the back you see bonanza. You see trucks being loaded with final product to head out and you can count every one of those final products as they are running them out. That's amazing. It's true that what we're interested in trying to figure out is, what is the functional form of combining inputs to get outputs and it's true that engineers, an engineering consulting company could get down there and get all sorts of data and work this thing and right out to the right number, but if you've got good data, statistically, you can just replicate the same thing. You can figure it out with a good statistical program. You've got good data on all the inputs that went in and all the outputs that went out and put them into the right computer program and they'll tell you what the functional form was. That's what we want. We've got to have this. We have to understand a little bit where these forms come from. We have to introduce another definition here, okay. This definition is going to be crucial for the rest of the course. We're going to talk about something called the short run and the long run. Short run which from now on I'm going to use SR, is the period of time. When at least one input is fixed, and the long run to an economist, is the period of time when all inputs are variable. The short run is the period of time when you have something you just can't change. For us in our production function, where we've got quantity is some function of labor and capital. We're going to say that labor is always variable, but capital is fixed in the short run. Capital is fixed in the short run. Suppose you're out there at that Kraft plant, and you're making production decisions, and all of a sudden you get a notice from the people at the corporate headquarters, that says, "Hey, fourth of July is coming up, we've got a big weekend, there's going to be a run on mayonnaise, we need to increase our mayonnaise production by about 10-12 percent each day for the next week." So if you're really going to increase your output, what's output? Output over here. If you're going to increase output of mayonnaise, you got to increase inputs. You cannot just wish for more jars of mayonnaise. Well, what inputs can you change? Well, capital is what we call brick and mortar, you can't change your factory in a couple of days, but that day you could definitely change labor. You could put out an offer, we need 15 people to volunteer for two hours overtime, because we need to produce a few extra bucks of mayonnaise, every night for the next five nights, who wants to come work overtime? People will make that. You can change labor very quickly, but you can't change capital that quickly. So in our little paradigm we're thinking about, you're stuck with some inputs in what we call the short-run. They may be something as simple as logical to you as the brick and mortar, it's very difficult for Kraft because they got over a 100,000 square-foot factory out there, and it's true that they could increase production if they add them another 40,000 square feet, but they can't just do that today. So people are going to be making decisions in what we call the short-run, where they have to live with certain inputs that they can't change anymore, they can change other inputs. Now, this is an example that is going to help drive our outcomes as we go through the rest of the course, because there are certain times where firms whether they're large firms like Kraft, or even a small firm like say, somebody selling pizzas on Green Street in Champaign here on Campustown. They may say I'm not making any money more, I got to get out of here, but it may be that they have at lease that they can't break for at least 30 days. So they're stuck with that facility for 30 more days. That may make them a decision that says, look, I'm still going to hang a sign on the door that says, we are closed, or they might say, well, I better keep operating for those 30 days, because at least I'll make enough money operating to put a little bit towards that lease that I'm going to have to pay at the end, whereas if I shut the door now I just have to write the whole check off of the lease. So we're going to think long and hard about decisions that come in the short-run, when you have something you can't get out from underneath, versus the decisions that come in the long run, when you have all the freedom to move all of your variables. Economists like to think of the long run. It's like the board of directors time frame, the board of Kraft could sit down and make a decision that says: Yes. We think we need to enlarge the Champaign facility. They have the ability in that time period. Their time period is big. They have the ability to say, well, we're going to make a change in capital. We know it won't go online for 22 months, but we do want to start changing this process. So I want to talk a bit about this final question in this particular issue, and that is, how long is the long run? Is it three-quarters? Is it a year? What's the long run? The answer to that question is we don't know. It varies by industry. Think about my little example of Larry's Tree Trimming Service. Larry's Tree Trimming Service, I grew up, and got myself a chainsaw, that chainsaw is my capital. My labor, I got a chainsaw, I got the sweat on my brow, I'm out trimming trees. Now, if I wanted to I could expand my business and get a second chainsaw, maybe a different type whenever, a little bit longer. How long would it take for me to change my capital in that business? Well, I don't know. It takes 30 minutes for me to drive to home depot and get a larger chainsaw. I have now doubled my plant and equipment. So my capital has gone up very quickly, so the long run for Larry's Tree Trimming Service is pretty quick. On the other hand, the example that economists love to point out for the long run that's pretty long is gasoline refineries. It's estimated that from the time you break ground on a new gasoline refinery, to the time you get your first drop of usable gasoline is about four years. So the long run in that sector is wildly different than the long-run in Larry's Tree Trimming Service. Every industry is different, whether you're making bookbinding, or putting down 737 maxes, or whatever it is that you're doing, there's going to be a different time frame, but all we need to worry about is those decisions about the long run mean that we can change everything, and one of those changes it's going to be crucial. By changing everything it might mean we just want to change it to zero. When can I get out of this industry? If I don't like where I am right now, I want to move, get out of there. Well, that's going to be what we call a long run, the time frame when you can actually change your brick and mortar. You find a buyer for that brick and mortar, you find somebody else who wants to set up a warehouse operation, or whatever, but you can get out. Thanks.
