[MUSIC] Hi, professor Navarro here. In this fourth lecture we're going to unlock some of the mysteries of the supply curve and so called Production Theory. In this lecture there are a number of very important ideas that we want to come to grips with. Such as the difference between short run and long run cost, and the critical concepts of marginal costs, and the law of diminishing returns. I will also introduce you to a very powerful concept known as economies of scale. As we examine the various possible shapes of cost curves and the important difference between economic versus accounting profits. [MUSIC] Listen to this sound. [SOUND] Can you identify it? What is it? If you guessed that I'm shaking a can of nuts and bolts, you're right. It's what this lecture is about. The nuts and bolts of supply and production theory. In fact, to at least some of you, this lesson is going to seem like an unending stream of dry definitions destined to be forgotten sixteen nanoseconds after you've finished you final exam. But let me say two things about that. First, the definitions and concepts we will learn in this lesson are indeed nuts and bolts. But we will need them to hold together a great many of the real world micro economic applications that will soon follow. So ignore them at your own peril. Second, even though much of this material is of a nuts and bolts nature I also believe that even this material can be made relevant to your own personal and professional experiences. Let me try to start proving that with this admittedly somewhat goofy scenario. Suppose then that tomorrow morning you wake up and find yourself as the main character in a Steven Spielberg movie called, Back to the Business Future. You're a refugee from the new millennium, circa 2000 AD, and you find yourself smack dab in the middle of 1972 shortly before the OPEC oil cartel slapped an embargo on the American economy. Your only possessions, besides the now quite out of style clothes on your back, are the design and engineering blueprints of a highly energy efficient automobile. Blueprints that your mad scientist buddy stuffed in your hands just before he accidentally catapulted you back to one of the worst decades in American economic history. Some friend, huh? Now to round out this plot, let's assume that the only way you can save the planet from a rapacious foreign cartel and also get back home to your family and friends, is to make a few million bucks producing these energy efficient cars. How do you do it? Well, the first thing you have to settle upon is your recipe for producing the car. In economics, we call this the production function, and algebraically, it looks like this. Q is your output, and K, L, and R are your factor inputs. Specifically, Q is the quantity of cars you want to produce. K is the capital or plant and equipment that you will need for the production. L is the number of employees or quantity of labor. And R is a catch-all term for other things like raw materials and energy. As for that F term, that is the state of the current technology. The more advanced the technology, the more output you'll be able to produce for a given mix of labor, capital, and resource inputs. In technical terms, the production function specifies the maximum output that can be produced with a given quantity of inputs for a given state of engineering and technical knowledge. So in order to make your millions, what combination of inputs are you going to choose, and by implication, what would be the size of your automobile plant? Those are two questions we will be able to at least partly answer later in this lesson. But before we do that let's make a further distinction, the distinction between the short run and the long run. To illustrate the short run, suppose the factory for your energy efficient auto is already up and running and producing 10,000 cars a year. Further suppose that the organization of petroleum exporting countries, the OPEC cartel, slaps an embargo on the US and quadruples the price of oil, just as it did in 1973 and 1974. At this point, demand starts to increase dramatically for your cars, as consumers seek to substitute your Gas Miser for their gas guzzlers. What do you do? In the short run, you add two more shifts, hire more workers, and use more energy and raw materials as you try to run your plant around the clock to meet increased demand. In fact, in the short run, this is your only option because it would take over a year to build a new factory. And that's the definition of the short run. The period in which firms can adjust production only by changing variable factors such as materials and labor, but cannot changed fixed factors such as capital. In contrast, the long run is a period sufficiently long enough so that all factors in the production function, including capital, can be adjusted. In this case it is the time it would take for you to expand your existing factory or build a new one. This distinction between the short and long run is important in production theory, because each period has its own kind of cost analysis.
