Here is an example to help you understand the theory of the firm. Suppose I am a firm that makes sweaters. I produce swe

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Here is an example to help you understand the theory of thefirm. Suppose I am a firm that makessweaters. I produce sweaters using knitting needles, yarn, and mytime. If I don't make sweaters, my nextbest alternative is working on a garbage truck which I can do for$3 an hour. It costs $1 to buy a pair ofknitting needles (they last one day and then fall apart), and $1for the yarn to make one sweater. Thefollowing chart describes the costs to me of knitting variousnumbers of sweaters.
Numbers ofsweaters/day
Total hours spentknitting TC AC MC1 1 $5.00 $5.00 $5.002 2 9.00 4.50 4.003 3 1/6 13.50 4.50 4.504 5 20.00 5.00 6.505 8 30.00 6.00 10.006 12 43.00 7.16 13.00
You might want to graph AC and MC as a function of q.There are a number of things to notice about this chart. What thechart shows are the costs ofproducing various quantities of sweaters, taking into account theopportunity cost of my time. I've assumedthat as I produce more sweaters per day, I have to pace myself andtake a little bit longer per sweater tokeep from making mistakes. Notice that when MC is below AC, ACfalls. When MC is above AC, ACrises. Also notice that the sum of all previous MCs equals TC. Whatis Pe? Answer: $4.50. What is theminimum point of AC in terms of quantity, qe? There are twoquantities of qe because we have assumedaway fractions of a sweater. (If TC, AC, and MC, were continuousfunctions, that is, if we allowed formaking fractions of a sweater, then the actual qe would be between2 and 3.) If price were Pe (4.50) I wouldbe indifferent between making 2 or 3 sweaters. In both cases, Iwould just break even, making zero profits.Suppose I made 2 sweaters--my revenue would be $9. I would spend $3in raw materials ($2 for the yarnand $1 for the needles) so my income for the 2 hours of work wouldbe $6. This would be just enough toget me to knit sweaters rather than ride the garbage truck.Actually, I would be indifferent. So, when theprice of sweaters hits $4.51, I become a sweater maker but we roundit to $4.50 making the assumptionthat when I'm indifferent I choose sweaters. What does my supplycurve look like?Suppose the price of sweaters is $10.00. How many sweaters will Imake? The answer is that Ichoose to make sweaters up until the point where P = MC, which inthis case is 5 sweaters per day. Mysweater revenue will be $50. I will have to spend $6 on yarn andneedles per day, leaving me with $44 tolive on. My profits, however, are only $20, since I will have tospend 8 hours per day knitting that I could
have spent on the garbage truck at $3 per hour (or $24). Verifythat my profits will be smaller if I choose aquantity other than 5.If everybody who can make sweaters can also drive a garbage truckfor $3 per hour, what will thesupply curve of sweaters look like? What determines the number ofpeople in the world making sweaters?What happens when there is an increase in demand? In the long-run,people will leave garbage trucks forsweaters. Do you see why?Additional Questions:1. How will the analysis change if there is an increase in demandfor garbage truck workers that drives upthe wage of garbage men to $4?2. What will be the effect on sweater prices?3. How would your answer change if instead, I found a job that paid$4 and hour, but all other sweatermakers still had $3 as their next best alternative?4. How would the analysis change if I figured out a way to cut thetime in half that it takes to do theknitting?5. What if everybody figured it out?