Snob Effect

Negative network externality in which a consumer wishes to own an

exclusive or unique good.
Increase in number of customers reduces demand and Price (rupees
per unit)
hence the price decreases.
300,000

Demand
Snob effect decreases the quantity demanded in the market curve
with decrease in price.
Less elastic demand makes it possible for firms to raise Pure price effect
prices. 150,000
D2

D6
0
2 4 6 8 10 12 14
Quantity Snob effect
Production Process
Production
Supply side- behavior of producers.
Understanding consumer behavior helps in understanding producer behavior.

Production decisions of a firm

Production technology: A firm produces output by using different combination

of inputs.
Cost Constraints: A firms always want to minimize the cost of production.
Input choices: Firms chose how much each input to be used to produce an
output depends on the production technology and cost of inputs.
The technology of production
Firms produce output by using inputs
Factors of production

Labour Capital Materials

Land, Raw
Skilled
building material

Unskilled Infrastruct
Machinery ure
 The production function

Production function: Function showing the highest output that a firm can
produce for every specified combination of inputs.

q = F(K,L)

Usage of the combination of inputs depend

on technology. With technological Rightward Shift in supply curve
innovations, the firm can obtain higher
output with the same input.
Short vs. long run supply
Short run: Period of time in which quantities of one or more
production factors cannot be changed.
In the short run there is at least one factor that cannot be varied; such factor is
called a fixed input.
Capital
In the short-run, firms vary the intensity with which they utilize the inputs.

Long run: Amount of time needed to make all production inputs

variable.
In the long run, the firms vary the firm size.
 Production with one variable input- short
run
When capital is fixed then a firm can increase its output only by increasing its
labour input.
Amount of Labour (L) Amount of Capital (K) Total Output (q)
0 10 0
1 10 10
2 10 30
3 10 60
4 10 80
5 10 95
6 10 108
7 10 112
8 10 112
9 10 108
10 10 100
 Average and Marginal product
Average product: Output per unit of particular input. (q/L)
Amount of Labour Amount of Capital Total Output (q) Average
Average
AverageProduct
Product
Product Marginal Product
Marginal Product
(L) (K) (q/L)
(q/L)
(q/L) (q/L)
(q/L)
0 10 0 --- --
1 10 10 10
10
10 = (10-0)/(1-0)=10
= (10-0)/(1-0)=10
2 10 30 15
15
15 20
20
=20
3 10 60 20
20
20 30
30
4 10 80 20
20 20
20
5 10 95 19
19 15
6 10 108 18
18 13
13
7 10 112 16
16 4
8 10 112 14
14 00
9 10 108 12
12 -4
-4
10 10 100 10 -8

Marginal product: Additional Output produced as an input is increased by one

unit. (q/L)= MPL
 Output per
month
Slopes of product curves 112
D

C Total product
curve

Total product: Output of the firm increases 60 B

with increase in labour and reaches the A
maximum output; thereafter it starts falling.
O 1 2 3 4 5 6 7 8 9 10
Marginal product is tangent to the total Labour per month
Output per
product curve at that point. worker per
30 month
Tangent to curve is the point of
maximization, so MPL is the maximum 20
E

change in output by addition of one more Average

unit of labour. product curve

10

Average product is the slope of the line from Marginal

product curve
origin to the point in total product curve. 0
1 2 3 4 5 6 7 8 9 10
Labour per month
Average and Marginal products
Output starts decreasing when Marginal product becomes
negative.

If APL increases in L, then MPL > APL.

If APL decreases in L, then MPL < APL.

Average product is equal to marginal product at its maximum

i.e. when average product neither increases nor decreases in labor.
Three stages of production
Stage 1: Marginal product reaches its maximum, then falls as diminishing returns
set in but average product rises and reaches its maximum.

Stage 2: The stage from average product at its maximum till marginal product
reaches zero. Average product decreases but is still positive.

Stage 3: The stage after which marginal product is negative.

Stage 2: Average product is

rising
Law of diminishing marginal returns
Principle that the use of an input increases with other inputs fixed, the resulting
additions to output will eventually decrease.

Law of diminishing returns is applicable to short or long run?

Output per
month C
In short run, one of the inputs is fixed, so additions 112
of the other input cannot be utilized fully. B

A
In long run or with technological inventions, Total product
total output can shift up along with marginal 60
curves

product curve.
Output is increasing from A to B to C with
increase in labour. 1 2 3 4 5 6 7 8 9 10
Labour per
month
Production with two variables-long run
Isoquants: Curve showing all possible combinations of inputs that yield the
same output.
Isoquants shows the flexibility that firms Capital per year
have when making production decisions.
5

Substitution among Inputs: The slope of each 4

isoquant indicates how the quantity of one
input can be traded off against the quantity of 3

other, while output is held constant. 2 Q3= 90

1
Q2= 75
Q1= 55
Marginal rate of technical 0
substitution = -K/L (for a 1 2 3 4 5 6

fixed level of q) Labor per year

Marginal rate of technical substitution
As more and more labour is added to replace capital,
the labour becomes less productive and capital
becomes more and more productive. 16 A
14

Diminishing MRTS: Isoquants are convex, i.e. 12 -6

productivity decreases as more and more of one 10 B

Capital per year

1
type of input is added. 8
-4
D
Movement along isoquant: Output remains constant 6 1
-2
4
E
1 Q=75
-1
2 1
(MPL)(L ) + (MPK)(K)=0 0
1 2 3 4 5 6
(MPL)/ (MPK) = -(K )/ (L)= MRTS Labour per year
Marginal rate of technical substitution
-(MPL)/ (MPK) = -(K )/ (L)= MRTS

Marginal rate of technical substitution between two inputs is equal to the

ratio of the marginal products of the inputs.

Production functions:
12
Perfect substitutes: MRTS is constant. 10

Capital per year

Same output can be produced with all 8

capital or all labour. 6

4
2
q1 q2 q3
0
1 2 3 4 5

Labour per year

Fixed- proportion production function
Leonitief production function: Inputs act 8

as perfect complements. 7

Each level of output requires a fixed 6

amount of both the factors of production. 5

Capital per year

Factors cannot be substituted. 4

3
L-shaped Isoquants
2
1

0
1 2 3 4 5 6

Brown line shows technically efficient combination of inputs. Labour per year
Vertical and horizontal segments have either marginal product of capital
or marginal product of labour as zero.
Returns to scale
The rate at which output increases as inputs are increased
proportionately.
Capital
(machine hours)
Increasing returns to scale: Output more
than doubles when all inputs are doubled.
Most of infrastructure companies like
electricity, water supply. 3

Fixed cost is generally very high. 2

1 30
10 20
0
1 2 3
Labour (hours)
Returns to scale
Constant returns to scale: Situation in which Decreasing returns to scale: Output less
output doubles when all inputs are doubled. than doubles when all inputs are
doubled.
Size of the firm does not affect the
productivity of its factors. This phenomena is observed in due to
coordination problems.
Capital Capital
(machine hours) (machine hours)

3 3

2 2 30
1 30 1
20 10 20
10 0
0
1 2 3 1 2 3
Labour (hours)
Labour (hours)
The Cost of Production
How combination of inputs are chosen to minimize the cost.
What are the costs that a firm face?
Labour costs Capital costs
Opportunity cost: Cost associated with opportunities that are
foregone when a firms resources are not put to their best alternative
use.
Economic cost: Cost to a firm of utilizing economic resources in
production, including opportunity cost.
Costs that a firm can control and those it cannot
The Cost of Production
Sunk Costs: Expenditure that has been made and cannot be recovered.
It should not influence the firms decision.

What is the opportunity cost for the goods with sunk cost?

Prospective sunk cost: It is an investment decision.

It is an economic cost.

Economic cost: It can be broadly divided into fixed cost and variable
cost.
The Cost of Production
Fixed Costs: Cost that does not vary with the level of output.
This cost can be eliminated by going out of business.

Variable Costs: Cost that varies as output varies.

This cost can be eliminated by going out of business.

Fixed cost and variable cost are differentiated based on time period.
Over a short time period every cost is fixed.
Over a long time period, most of the costs are variable.
The Cost of Production
Marginal Costs: Incremental cost- It is the increase in cost that result from
producing one extra unit of output.
What type of cost changes over time?

Variable Costs MC = VC/ q MC = TC/ q

Average total Costs: It is the firms total cost divided by its level of output.
ATC = TC/ q
Average fixed costs: Fixed cost divided by the level of output.
AFC = FC/ q
Average variable costs: Variable cost divided by the level of output.
AVC = VC/ q
Firms cost
Output Fixed cost Variable Total Cost MC (Rs. AFC (Rs. AVC (Rs. ATC (Rs.
(Units per (Rs. per Cost (Rs. (Rs. per Per unit) Per unit) Per unit) Per unit)
year) year) per year) year)
0 50 0 50 - - - -
1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
 Cost (rupees
per year)
TC
400
VC
Cost curves
300

Fixed Cost curve: Fixed cost does not vary with

output. 175
A
Variable Cost curve: It increases with increase in
output. 100
FC
Total Cost curve: Vertical addition of FC and VC. 0
2 4 6 8 10 12
Output (units per year)
100 Cost (rupees
per unit) MC
Average Fixed Cost curve: Average fixed cost
declines as the rate of output increases. 75
ATC

Average Variable Cost curve: Average variable 50

AVC
cost decreases and then increases. A

Marginal curve crosses AVC and ATC at its 25

minimum. AFC
0
2 4 6 8 10 12
Output (units per year)