1. 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

2. Fig. 1 Circular Flow Diagram of a Free Market

3. 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)

4. (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) ($)
Total Revenue (TR) ($)

5. 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

6. 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)

7. 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}

8. 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.

9. (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)

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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)

20. 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.