Carl B. Montano, Ph.D. Professor of Economics Lamar University TEACHING/LEARNING FOR KEEPS: A SYSTEMS APPROACH TO THE BASIC ECONOMICS OF THE FIRM Carl B. Montano, Ph.D. Professor of Economics Lamar University

Fig. 1 Circular Flow Diagram of a Free Market

Fig. 2 A Business as a Physical Production Process Technology INPUTS (I) OUTPUTS (Q) (land, labor, capital & enterprise) (goods and/or services) FIRM (production structures & processes)

(production structures Fig. 3 A Business as a Financial Process with Cost-side and Revenue-side Technology INPUTS (I) OUTPUTS (Q) (land, labor, capital & enterprise) (goods and/or services) FIRM (production structures & processes) Cost Side Revenue Side Total Costs (TC) ($) Total Revenue (TR) ($)

Fig. 4 Classifying Costs into Explicit and Implicit A. Owned (or self-employed) Inputs B. Not owned/self-employed Inputs INPUTS (I) OUTPUTS (Q) (land, labor, capital & enterprise) (goods and/or services) FIRM (production structures & processes) Total Costs (TC) ($) Total Revenue (TR) ($) A. Implicit Costs B. Explicit Costs

Fig. 5 Classifying (Short-run) Costs into Fixed and Variable A. Fixed Inputs (usually plant & equipment) (FI) B. Variable Inputs (usually labor & materials) (VI) INPUTS (I) OUTPUTS (Q) (land, labor, capital & enterprise) (goods and/or services) FIRM (production structures & processes) Total Costs (TC) ($) Total Revenue (TR) ($) A. Total Fixed Costs (TFC) B. Total Variable Costs (TVC)

Fig. 6 The Revenue Side of the Financial Process Technology INPUTS (I) OUTPUTS (Q) (land, labor, capital & enterprise) (goods and/or services) FIRM (production structures & processes) Total Costs (TC) ($) Total Revenue (TR) ($) TR = Output (Q) x Price (P) {$/unit of Q}

Fig. 7 The (Short-run) Input-Output Process or Production Function A. Fixed Inputs (usually plant & equipment) (FI) B. Variable Inputs (usually labor & materials) (VI) ∆Q INPUTS (I) OUTPUTS (Q) (land, labor, capital & enterprise) (goods and/or services) FIRM (production structures & processes) ∆VI Total Product (TP) Average Product (AP) = Total Product (Q)/Variable Input (VI) Marginal Product (MP) = ∆Q/∆VI The Law of Diminishing Returns or Productivity: As additional unit of the Variable Input (VI) (e.g. labor) is added to the Fixed Input (FI) (i.e., plant of given capacity), sooner or later the productivity (AP or MP) of the Variable Input (VI) will diminish or decrease.

(production structures Fig. 7a Graph of the (Short-run) Input-Output Process or Production Function A. Fixed Inputs (usually plant & equipment) (FI) B. Variable Inputs (usually labor & materials) (VI) ∆Q INPUTS (I) OUTPUTS (Q) FIRM (production structures & processes) (land, labor, capital & enterprise) (goods and/or services) ∆VI Total Product (TP) Total Product (TP) TP Variable Input (VI) Diminishing MP Average Product (AP) & Marginal Product (MP = ΔTP/ΔVI) MP AP Variable Input (VI)

Fig. 8 The Cost Side of the Financial Process A. Fixed Inputs (usually plant & equipment) (FI) ∆VI Technology ∆Q B. Variable Inputs (usually labor & materials) (VI) INPUTS (I) OUTPUTS (Q) (land, labor, capital & enterprise) (goods and/or services) FIRM (production structures & processes) ∆TVC Total Costs (TC) ($) Total Revenue (TR) ($) Total Costs (TC) = TFC + TVC A. Total Fixed Costs (TFC) Divide both sides of the equation by Output (Q): TC/Q = (TFC + TVC)/Q = TFC/Q + TVC/Q Average Total Cost (ATC) = Average Fixed Cost (AFC) + Average Variable Cost (AVC) B. Total Variable Costs (TVC) Marginal Cost (MC) = ∆TVC / ∆Q = ∆TC / ∆Q

Fig. 9 The Revenue Side of the Financial Process Technology ∆Q INPUTS (I) OUTPUTS (Q) (land, labor, capital & enterprise) (goods and/or services) FIRM (production structures & processes) Total Costs (TC) ($) Total Revenue (TR) ($) ∆TR Total Revenue (TR) = Output (Q) sold x Market Price (P) Divide both sides by Output (Q): TR/Q = (Q x P) / Q = P {Qs cancel} Average Revenue (AR) = Price (P) Marginal Revenue (MR) = ∆TR / ∆Q

Fig. 10 Mirror Images Between the Physical and Financial Processes A. Fixed Inputs (usually plant & equipment) (FI) ∆VI Technology ∆Q B. Variable Inputs (usually labor & materials) (VI) INPUTS (I) OUTPUTS (Q) (land, labor, capital & enterprise) (goods and/or services) FIRM (production structures & processes) ∆TVC Total Costs (TC) ($) Total Revenue (TR) ($) A. Total Fixed Costs (TFC) TVC is the mirror image of the TP (or Q): When Q is rising at a diminishing rate, TVC is rising at an increasing rate and vice-versa. AVC is the mirror image of the AP: As AP rises (or shifts up), AVC falls (or shifts down) and vice-versa. B. Total Variable Costs (TVC) MC is the mirror image of MP: As MP rises (or shifts up), MC falls (or shifts down) and vice-versa

Fig. 10a TVC as the Mirror Image of TP (or Q) Dr. Carl B. Montano ∆I ∆Q Technology INPUTS (I) OUTPUTS (Q) (land, labor, capital & enterprise) (goods and/or services) FIRM (production structures & processes) (Physical Process) Total Costs (TC) ($) Total Revenue (TR) ($) (Financial Process) ∆TC ∆TR Economic Profit (π) = TR - TC Variable Input (VI) x Price of VI = TVC Output (Q) or Total Product Variable Input (VI) Output (Q) or Total Product

Fig. 10b AVC (or MC) as the Mirror Image of AP (or MP) Dr. Carl B. Montano ∆I ∆Q Technology INPUTS (I) OUTPUTS (Q) (land, labor, capital & enterprise) (goods and/or services) FIRM (production structures & processes) (Physical Process) Total Costs (TC) ($) Total Revenue (TR) ($) (Financial Process) ∆TC ∆TR Economic Profit (π) = TR - TC MC AVC Average Variable Cost (AVC = TVC/Q) Marginal Product (MP=ΔQ/ΔVI) Marginal Cost (MC = ΔTVC/ΔQ) Average Product (AP=Q/VI) and and AP MP Variable Input (VI) Output (Q) or Total Product

Fig. 11 Modeling Economic Profit of a Firm Technology ∆I ∆Q INPUTS (I) OUTPUTS (Q) (land, labor, capital & enterprise) (goods and/or services) FIRM (production structures & processes) Total Costs (TC) ($) Total Revenue (TR) ($) ∆TC ∆TR Economic Profit (π) = TR - TC Divide both sides by Output (Q): π/Q = (TR – TC)/Q = TR/Q – TC/Q Average Profit (Aπ) = Average Revenue (AR) – Average Total Cost (ATC) = P - ATC

Fig. 12 Profit Maximizing (or Loss Minimizing) Criterion Technology ∆I ∆Q INPUTS (I) OUTPUTS (Q) (land, labor, capital & enterprise) (goods and/or services) FIRM (production structures & processes) Total Costs (TC) ($) Total Revenue (TR) ($) ∆TC ∆TR Economic Profit (π) = TR - TC A. Produce output (Q) where π is maximum (or where TR exceeds TC the most) or B. Marginal Analysis: Produce output (Q) where MR = MC

Fig. 13a Marginal Analysis – An Intuitive Explanation Technology ΔQ INPUTS (I) OUTPUTS (Q) (land, labor, capital & enterprise) (goods and/or services) FIRM (production structures & processes) Total Costs (TC) ($) Total Revenue (TR) ($) π = TR - TC ΔTR Marginal Analysis: Produce Output (Q) where MR = MC MR = ΔTR ΔQ

Fig. 13b Marginal Analysis – An Intuitive Explanation Technology ΔQ INPUTS (I) OUTPUTS (Q) (land, labor, capital & enterprise) (goods and/or services) FIRM (production structures & processes) Total Costs (TC) ($) Total Revenue (TR) ($) ΔTC π = TR - TC ΔTR Marginal Analysis: Produce Output (Q) where MR = MC MC = ΔTC ΔQ MR = ΔTR ΔQ NOTE that the denominators of MR and MC are the same, i.e., ΔQ. Therefore, comparing MR and MC amounts to comparing money ($) flowing in (MR) versus money ($) flowing out (MC) of the firm. If MR > MC → Profit (π) is rising If MR < MC → Profit (π) is falling If MR = MC → Profit (π) is maximum

Fig. 14 Marginal Analysis – An Intuitive Explanation Technology ΔI ΔQ INPUTS (I) OUTPUTS (Q) (land, labor, capital & enterprise) FIRM (production structures & processes) (goods and/or services) Total Costs (TC) ($) Total Revenue (TR) ($) ΔTC ΔTR π = TR - TC Marginal Analysis: Produce at Output (Q) where MR = MC MC = ΔTC ΔQ MR = ΔTR ΔQ There must be a maximum point somewhere here Profit (π) NOTE: If something is rising, and then declining (like a roller-coaster), it must have hit a peak (or maximum) before it declined. Output (Q) or Quantity Supplied If MR > MC → Profit (π) is rising ► Increase Output (Q) If MR < MC → Profit (π) is falling ► Decrease Output (Q) If MR = MC → Profit (π) is maximum ► STOP! Produce this Output (Q)

Fig. 15 MANAGER’S MODEL OF A FIRM Dr. Carl B. Montano ∆I ∆Q Technology INPUTS (I) OUTPUTS (Q) (land, labor, capital & enterprise) (goods and/or services) FIRM (production structures & processes) (Physical Process)1 Total Costs (TC) ($) Total Revenue (TR) ($) (Financial Process)2 ∆TC ∆TR Economic Profit (π) = TR - TC PROFIT MAXIMIZING (OR LOSS MINIMIZING) RULES: A. Produce at output (Q) where Economic Profit (π) = TR - TC is maximum TC = TFC + TVC - - - - - - - - - - TR = Q x P OR Marginal Analysis: Produce at output (Q) where MC = ΔTC (or ΔTVC) - - - - - [MR = MC] - - - - - MR = ΔTR ΔQ ΔQ Cost per unit Profit per unit Revenue per unit TC = TFC + TVC π = TR - TC TR = Q x P Q Q Q Q Q Q Q Q ATC = AFC + AVC Aπ = AR - ATC AR = P = P - ATC ------------------- 1Subject to the Law of Diminishing Productivity in the short-run: As additional unit of the variable input (e.g., labor) is added to the fixed input (i.e., “plant” of given capacity), sooner or later the productivity (AP or MP) of the variable input will diminish. NOTE that improvement in Technology will shift the Production Function (or Input-Output relationship) upwards. Accordingly, the Average Product (AP = Q/I) and Marginal Product (MP = ΔQ/ΔI) curves will shift upwards. 2The physical processes are mirrored in the financial: (a) The shape of the TVC (and TC) curves (i.e., rising at an increasing rate) reflects the influence of the Law of Diminishing MP; (b) Whenever the AP & MP curves shift upwards, the ATC & MC curves correspondingly shift downwards; and vice-versa.