Chapter-1

The word economics is derived from Greek word ‘Oeconomicus’. In Greek ‘oeco’ means household and
‘nomicus’ means study. So, literally it is the study of household management.

According to the Greek philosopher Xenophon, economics is the study of household management.
In the view of Aristotle, economics is not only the science of household management but also the
science of exchange. He regarded economics as an important pillar of politics.

The Mercantilists, who were leader of economic thought, took wealth and foreign trade as the base of
economics. At that time, there was a slogan ‘More gold, More wealth, More power’.

Before 18th century, economics was treated as religion. But after the publication of Adam smith’s book-
“An Enquiry into the Nature and Causes of Wealth of nation in 1776 A.D., Economics got its independent
identity.

Definition of Economics

Economics grew up as a science with the growth of human society. It is concern with the economic
behavior of human being.
Different Economists have defined economics differently. It is a very wide subject, so it cannot be
restricted to a boundary of fixed definition. Barbara Wotton said that "Whenever six economists are
gathered, there are seven opinions."
Jacob Viner said that ‘Economics is what economists do.’

 Definition – 1 (Economics as a science of wealth)

The earliest definition of economics was in terms of wealth. In 1776, Adam Smith (Scottish
philosopher and economist), the father of economics and leader of classical economists defined
"Economics as a science which studies about the nature and causes of wealth nation." According
to him, wealth is everything that means wealth is end all i.e. man of wealth.
 Definition – 2(Economics as a science of material welfare)
Alfred Marshall (British economists), a leader of neo–classical economists focused that wealth is
not end all but it is only a means to an end. He has published a well-known book “Principle of
Economics” in 1890 A.D. According to him “Economics is a study of mankind in the ordinary
business of life, it examines that part of individual and social action which is most closely
connected with the attainment and with the use of material requisites of well-being.”
  Definition – 3(Economics as a science of scarcity and choice)

Lionel Robbins (British economist), He gave most scientific and logical definition of economics in
his book “An Essay on the nature and significance of economic science” in 1932 A.D. According
to him "Economics is the science which studies human behavior as a relationship between ends
and scarce means which have alternative uses." Hence, economics is the science of scarcity and
choice, and it studies how the scarce resources are allocated among different ends.

Fundamental Principles of Economics

Economics deals with people and reflection of how they interact with each other in making decisions
regarding their lives. We study economics by observing the principles of decision making of the
individuals who make up the economy, how they interact with one another and how the economy
works as a whole.

1. People face Trade-offs:

Trade-off means balancing two things that we need or want but which are opposite to each other. In our
real life, we always face trade-off while making decision about something. It is because to get one thing
that we like, we usually have to sacrifice another thing that we like. So making decisions requires trading
off one goal against another.

2. The cost is something is what you give up to get it:

Because people face tradeoffs, making decisions requires comparing the costs and benefits of
alternative courses of action. The opportunity cost of an item is what a person given up to get the item.

3. Rational People Think at the Margin:

In economics, it is assumed that people are rational and rational people make the best decisions by
thinking at the margin (edge) or comparing additional cost for extra benefits. Rational people
systematically and purposefully do the best they can, to achieve their objectives.

4. People Respond to Incentive:

An Incentive is something that induces the people to do something. People make decisions by
comparing costs and benefits, their behavior may change when the costs or benefits change. That is,
people respond to incentives. When the price of mutton rises, for instance, people decide to eat more
chicken.

5. Trade between the countries can make each country Better Off:
Countries as well as individuals benefit from the ability to trade with one another. Trade allows country
to specialize in what they do best and to enjoy a greater variety of goods and services. Trade promotes
proper utilization of economic resources and results higher level of employment and growth with better
living standard to the people.
6. Markets Are Usually a Good Way to Organize Economic Activity:
Market possesses the power of resource allocation. Most nations of the world have adopted the use of
the market power as a tool for allocating resources rather than other alternatives such as central
planning. This is because the market allocates resources through the decentralized decisions of many
firms and households as they interact in markets for goods and services.

7. Governments Can Improve Market Outcomes:

Markets are usually a good way to organize economic activity. It is true if only the government plays a
crucial role to settle markets. Govt. provides legal safety to the economic agents i.e. producers, firms
and consumers. Government can play vital role in promoting efficiency and equity. In case of market
failure, a well-designed government policy can enhance the economic policy.

9. Price Rise when the Government Prints Too Much Money:

The variation in prices of goods and services also depends on the quantity of money supply in the
economy. When the govt. creates large amount of money and let them go in the circulation, the prices
of goods and services rise. The continuous and sustained rise in price level in called inflation. If such a
situation is not timely checked, it brings an adverse effect in the economy.

10. Society Faces Short-Run Trade-off between Inflation and Unemployment:

Prof. A.W. Phillips and other economists argues that there is tradeoff between inflation and
unemployment. It is mainly caused by short run effects of monetary injections. For example, when
money supply increases in the economy it stimulates the overall level of spending and thus, increases
AD. Increased AD pushes price level one side and on the other side it encourages to produce more
quantity of goods and services to the firms. As a result, employment increases (i.e. unemployment
decreases).

New Approaches to Economics

The global crisis wake-up to policy makers around the world. Market and government failures have led
to the most pressing financial, economic and employment crisis of our lifetimes. The idea of a growth
model with a single general equilibrium has been challenged. At the same time, major global trends i.e.
globalization and shifting wealth, population growth and ageing, environmental challenges and natural
resources constraints, and skill-biased technological change – have put additional pressure on our
economies.

It needs to tackle these challenges from a different perspective and to present more integrated and
coherent answers to interlinked policy issues.
  Economic growth
 Regional imbalances
 Under-pricing of risk
 Rising inequality
 Environment problem etc.

Origin of Engineering Economy

The study of engineering economy draws upon knowledge of engineering and economics to address the
problems of allocating scarce resources. Its definition suggests that the goal of engineers should transfer
resources (natural) for the economic benefit of human being. The focus on scarce resources welds
engineering to economics.

In 1930, L. Grant published “Principles of Engineering Economy” and discussed about the importance
of judgment factors, short–term investment, and long–term investments in capital goods based on
compound interest calculations. His many contributions resulted in the recognition that, he is called
the father of engineering economy.

Later on, the modern approaches like; discounted cash flow, capital rationing, risk & sensitivity analysis
etc. are being used to reflect today’s concerns for resource conservation & effective utilization of public
funds on engineering economics.

Engineering Economics: What and Why?

Engineering economics is the field of those activities which are concerned with the systematic
evaluation of the costs and benefits of proposed technical and business projects design. Engineering
decision covers a wide variety of areas ranging from choosing airport locations to improving production
methods and determining budget requirements. Since all government and corporate decisions are
influenced by financial considerations, one of the most effective and important tools available to
engineers is economic analysis.

Conceptually, engineering economic analysis is the same as that in most other types of technical
analysis. It is mathematical modeling with emphasis on the economic effects in the primary analytical
technique to select between defined feasible alternatives. Thus, engineering economy requires the
application of technical and economic analysis with the goal of deciding best meets technical
performance criteria and uses scarce capital in a prudent manner.

The domain of such decision–making activity ranges from the engineer who uses advanced computer
technology to design new products, structures, systems and services to the chief executive officer (CEO)
considering a major business venture that may transform the organization in the years ahead.

Definition - 1

"Engineering economics is the art of directing the great sources of power in nature for the use and
convenience of man."- - Tredgold

Definition – 2
"Engineering economics is the application of economic techniques to the evaluation of engineering
alternatives. The role of engineering economics is to assess the appropriateness of a given project,
estimate its value and justify it from an engineering standpoint." – John M. Watts

Study and Important Usages of Engineering Economics

In the operation of capital funds on any project, engineers and managers can use the study of
engineering economy to assist decision making situation from the following ground;

1. Selecting between alternatives designs for a component, machine, structure, system, product or
service during the engineering design process.

2. Estimating and analyzing the economic consequences of improvements in a factory operation.

3. Selecting among proposed projects within the annual capital budget limit.

4. Analyzing whether the equipment in the service should replace or not.

5. Choosing between asset lease or purchase options to a product.

Hence, the use of engineering economics study involves technical and economic analysis with a decision
making objective.
Role of Engineers in Decision Making

The techniques & methodology of engineering economy can assist engineers in decision making process
from the following grounds:

 Understanding the problem

 Defining the objective
 Collection of relevant information/data
 Development of feasible alternatives
 Identification of the criterion for decision making
 Selection of the best alternative
 Evaluation of each alternative
 Effective implementation etc.

In decision making process, the role of engineers may also be different situations like;

 Equipment & process selection.

 Equipment replacement.
 New product & production expansion
 Cost reduction
 Capital budget allocation.
 Service improvement.
 Project evaluation etc.

Hence, engineers generally attack to practical problems with appropriate solution in decision making
process.
Principle of Engineering Economics

1.Develop the alternatives

The feasible alternatives need to be identified and then defined for subsequent analysis. A decision
involves making a choice among two or more alternatives. If there is only one alternative, no choice is
required. Developing and defining the feasible alternatives for evaluation is important because of the
resulting impact on the quality of the decision. Engineers and managers should place a high priority on
this responsibility.
"Remember! Quality derives from quantity."

2. Focus on the differences

The expected differences in future outcomes among the alternatives are relevant to their comparison
and should be considered in the decision making. If all prospective outcomes of the feasible alternatives
are exactly same, we would be indifferent among the alternatives and could make a decision using
random selection.
"Be very neutral and impartial between the alternatives."

3. Use a consistent viewpoint (Economic viewpoint)

To determine prospective (future) outcomes of the feasible alternatives, the viewpoint should be
consistently developed and defined. It is important that the viewpoint for the particular decision is
defined and then used consistently in the description, analysis and comparison of the alternatives.
"What is your viewpoint? Be consistent."

4. Use a common unit of measure

Common unit of measurement should follow to evaluate prospective outcomes of the feasible
alternatives which will make easier the analysis and comparison. For economic consequences, a
monetary unit is the common measure. If expected consequences cannot translate or estimate by using
monetary unit, you should describe these consequences explicitly.
"Remember! Standard unit of currency makes economic comparison."

5. Consider all relevant criteria (Social and environmental aspect)

Selection of a preferred alternative requires the use of all relevant criteria. In engineering economic
analysis, the primary criterion relates to provide maximum monetary return to the owners. But other
objectives like social, cultural, environmental justice etc. should become the basis for additional criteria
in the decision–making process.
"Try to underpin your decision from all perspectives."
6. Make uncertainty explicit

Uncertainty is inherent in projecting (or estimating) magnitude and impact of future outcomes of the
feasible alternatives and should be recognized in their analysis and comparison. Thus, dealing with
uncertainty is an important aspect of engineering economic analysis.
"Expose yourself, there may uncertainty everywhere"

7. Revisit your decision (Self-evaluation)

Improve decision results from an adaptive process, due to this the projected outcomes of the selected
alternative and actual results achieved should be subsequently compared. Organizational discipline is
needed to ensure that post–evaluations of implemented decisions are routinely accomplished and the
results used to future decision making.
"Practice makes a man perfect"

Scope of Engineering Economics

Engineering economics, previously known as engineering economy, is a subset of economics concerned

with the use and "...application of economic principles" in the analysis of engineering decisions. ... It is
pragmatic by nature, integrating economic theory with engineering practice.

Demand and Supply: Meaning of Demand and supply, Determinants of demand and Supply.

Demand Forecasting: Purpose of Forecasting Demand, Determinants of demand forecasting, Methods

of Demand Forecasting, Criteria for the good forecasting method.

Cost of Production: Explicit and Implicit costs, Marginal, Incremental and Sunk costs, Opportunity cost,
Short-run cost function, Total Average and Marginal costs, Long-run costs, Break-even analysis.

Theory of Production: Law of Variable Proportions and Laws of returns to scale.

Depreciation: Definite and characteristics of term Depreciation, causes of Depreciation, computation of

Depreciation.

Market Structures and Pricing Theory: Perfect competition, Monopoly, Monopolistic competition, and
Oligopoly.

Investment Decision: Capital Budgeting, Methods of Project Appraisal (Payback Period, IRR, NPV, BCR).

Overview of Financial Markets: Money Market, Stock Market, Mutual Fund.

National Accounting: Meaning, Methods and Current Trends.

Inflation & Deflation: Meaning, Measures and Impact on Indian economy.

Economic System
Economic system is the institutional framework within which a society or country carries on its
economic activities. Economic systems are three types:
(a) Private enterprise system
(b) Pure socialistic system
(c) Combination of both

(A) Private Enterprise System (Capitalistic or Free Market or Laissez–faire Economic System)

Under this system, all firms, factories and other means of productions are the property of private
individuals and firms. They are free to use them with a view to make profit. The desire for profit is
the sole consideration to the property owners. What to produce, how to produce and for whom to
produce? All these central economic problems are settled by the forces of demand and supply
freely.
 (B) Pure Socialistic System (Planned Economic System)

On the other extremity, we have pure socialistic system where there is no private property.
Resource, goods and services are owned and controlled by the government. Production takes place
in government enterprises and the government specifies the conditions under which exchange can
occur.

(B) Combination of Both (Mixed Economic System)

The private enterprise system is decentralized whereas socialistic system is highly centralized. Present
days, economy is mixture of socialism and private enterprises. According to mixed economy, some part
of an economy's output will be produced by the profit oriented private sectors and another part will be
produced in a socialistic manner by the public sector (government). There are also non–profit sectors
like hospitals, schools, etc.

Features:
–Co–existence between public and private sectors
–Role of government directions
–Government regulation and control to private sectors
–Consumer's sovereignty protected
–Government protection to labor
–Reduction of economic inequalities
–Control of monopoly etc.

Applied Economics

"Economics is the science which studies human behavior as a relationship between given ends and
scarce means which have alternative uses."

Economics is the "study of how societies use scarce resources to produce valuable commodities and
distribute them among different people."

Applied economics is the study of economics in relation to real world situations, as opposed to the
theory of economics. It is the application of economic principles and theories to real situations, and
trying to predict what the outcomes might be.

Engineering economics, previously known as engineering economy, is a subset of economics for

application to engineering projects. Engineers seek solutions to problems, and the economic viability of
each potential solution is normally considered along with the technical aspects.

Applied Economics is the application of economic theories and econometrics in specific areas. In
another words, it is typically characterized by the application of the core, i.e. economic theory and
econometrics to address practical issues in a range of fields including; demographic economy, labor
economics , business economics, industrial organization, agricultural economics, development
economics, education economics, health economics, monetary economics, public economics, and
economic history.

The process often involves a reduction in the level of abstraction of this core theory. There are a variety
of approaches including not only empirical estimation using econometrics, input-output analysis or
simulations. It is a concept with multiple meanings. Among broad methodological distinctions, one
source places it in neither positive nor normative economics but the art of economics, glossed as "what
most economists do".

The ultimate aim of applied economics is to increase human welfare by the investigation and analysis of
economic problems over the real world.

The application of economic analysis for both - public and private sector seeks to publish quantitative
studies and the results of which are used in the practical field that may help to bring economic theory
nearer to reality.

Production Possibilities Frontier (PPF)/ Production Possibilities Curve (PPC)

Or Transformation Curve

What is the 'Production Possibility Frontier' – PPF?

The production possibility frontier (PPF) is a curve which shows all maximum output possibilities for two
goods when given a set of inputs consisting of resources and other factors are fully utilized.
Factors such as labor, capital and technology, among others, will affect the resources available, which
will dictate where the production possibility frontier lies.

Understanding and Interpreting the PPF

The PPF is when an economic organization has limited resources and must decide between two
alternatives. The PPF is depicted graphically as an arc with one commodity on the X axis and the other
commodity on the Y axis. At each point on the arc, there is an efficient number of the two commodities
that can be produced with available resources. Therefore, the organizations look at the PPF and decide
what number of each commodity should be produced to maximize the overall benefit for the economy.

Understanding the Pareto Efficiency and PPF

The Pareto Efficiency is a concept named after Italian economist- Vilfredo Pareto that measures the
efficiency of the commodity allocation on the PPF. The Pareto Efficiency states that any point within the
PPF curve is considered inefficient because the total output of commodities is below the output
capacity. Conversely, any point outside the PPF curve is considered to be impossible because it will take
more resources.

Therefore, any mix of two commodities with given limited resources is only efficient when it lies on the
PPF curve; one commodity on the X axis and one commodity on the Y axis. Pareto Efficiency means; an
economy is operating at maximum potential level and lies on the PPF.
Efficiency also known as "Pareto optimality" is an economic state where resources are allocated in the
most efficient manner and it is obtained when a distribution strategy exists where one party's situation
cannot be improved without making another party's situation worse.

Derivation of the Production Possibility Frontier (PPF)

Consider the economy that produces only two goods: wine and grain. In a given period of time, the
economy may choose to produce only wine, only grain, or a combination of the two according to the
following table:
The PPF shows all efficient combinations of output for that economy when the factors of production are
used to their full potential. The economy could choose to operate at less than capacity somewhere
inside the curve, for example at point a, but such a combination of goods would be less than what the
economy is capable of producing. A combination outside the curve such as point b is not possible since
the output level would exceed the capacity of the economy.

The shape of this production possibility frontier illustrates the principle of increasing cost. As more of
one product is produced, increasingly larger amounts of the other product must be given up. In this
example, some factors of production are suited to producing both wine and grain, but as the production
of one of these commodities increases, resources better suited to production of the other must be
diverted. Experienced wine producers are not necessarily efficient grain producers, and grain producers
are not necessarily efficient wine producers, so the opportunity cost increases as one moves toward
either extreme on the curve of production possibilities.

Suppose a new technique was discovered that allowed the wine producers to double their output for a
given level of resources. Further suppose that this technique could not be applied to grain production.
The impact on the production possibilities is shown in the following diagram:
Economizing Problem

The foundation of economics is the economizing problem: society's wants are unlimited while resources
are limited or scarce. Unlimited wants (Economic wants) are the desires of people to use goods and
services that provide utility which means satisfaction.
The fundamental issue that arises for a society denotes scarcity of goods and services compared to the
demand for them by consumers. Solving the economizing problem for a business involves making
decisions about how best to allocate resources given the business objectives? Economizing problem
explains profit maximization and cost minimization approaches.

Profit Maximization and Cost Minimization

Microeconomics focused on Profit Maximization and Cost Minimization. Profit maximization implies cost
minimization; however cost minimization doesn't necessarily mean profit maximization. Profit
maximization is a combination of both revenue maximization and cost minimization because profits
(denoted by π) are equal to the difference between total revenue and total costs i.e. π = TR - TC

In the short run economy, one of the two hypothetical inputs has to be fixed. In order to solve the profit
maximization problem in the short run, requires equality between marginal revenue and marginal cost
with respect to the variable input.
A profit maximizing choice can only be found with decreasing returns to scale (DRS); with increasing
returns to scale (IRS) or constant returns to scale (CRS), no profit maximizing choice can be calculated.

Increasing returns to scale: Double the inputs results in more than double the output.
(With Cobb-Douglas production functions, the sum of the exponents is greater than 1)

Constant returns to scale: Doubling inputs results in double the output.

(With Cobb-Douglas production functions, the sum of the exponents is 1)

Decreasing returns to scale: Doubling of inputs results in less than double the output.
(With Cobb-Douglas production functions, the sum of the exponents is less than 1)
Long run profit maximization problems are solved by setting the Marginal Rate of Technical Substitution
(MRTS), equal to the ratio of the input costs. i.e. The TRS is equal to the marginal product of input1
divided by the marginal product of input2.

i.e. MRTS = MPL/MPK

MPL = Marginal Production of Labor

MPK = Marginal Production of Capital

Cost minimization problems are solved by finding the intersection of the isocost and isoquant lines. An
isocost line includes all combinations of inputs which cost the same amount (a given amount).
Cost minimization problems (unlike those of profit maximization) can always be solved, regardless of the
returns to scale. Short run cost minimization problems are easier to solve because one of the inputs has
to be fixed. Cost functions are used to solve this type of problem, therefore it is helpful to be able to
distinguish returns to scale based on average cost graphs. The average cost curve in the long run looks
something like this.

Economic Efficiency

It is the ratio of value of output obtained from an economic process to the value of input necessary to
produce them. Higher the value of output per rupee's worth of resource input denotes greater efficiency
in the process.
Efficiency signifies level of performance that describes the lowest amount of inputs to create the greatest
amount of outputs. Efficiency relates to the use of all inputs in producing any given output including
personal time and energy. Efficiency is a measurable concept that can be determined by the ratio of useful
output to total input. It minimizes the waste of resources such as physical materials, energy and time
while successfully achieving the desired output. So, it is also called Allocative/distributive efficiency.

Economic efficiency is the situation in which impossible to generate a larger welfare/output from the
available resources. In other words, the situation where some people cannot be made better-off by
reallocating the resources without making others worse-off.

Economic efficiency implies an economic state in which every resource is optimally allocated to serve each
individual or entity in the best way while minimizing waste and inefficiency. When an economy is
economically efficient, any changes made to assist one entity would harm another. In terms of production,
goods are produced at their lowest possible cost as are the variable inputs of production.

Productive efficiency

Productive efficiency is concerned with producing goods and services with the optimal combination of
inputs to produce maximum output for the minimum cost.
To be productively efficient, the economy must be produced on its production possibility frontier.(PPF)
(i.e. it is impossible to produce more of one good without producing less of another).
Points A and B are productively efficient.

Point C is inefficient because the economy could produce more goods or services with no opportunity
cost.

A firm is said to be productively efficient when it is producing at the lowest point on the average cost
curve (where Marginal cost meets average cost).

Productive efficiency is closely related to the concept of Technical Efficiency. A firm is technically
efficient when it combines the optimal combination of labor and capital to produce a good i.e. cannot
produce more of a good without more inputs.
Allocative efficiency
This occurs when goods and services are distributed according to consumer preferences. An economy
could be productively efficient but people don’t get satisfaction as per need basis by the produce goods
this would be allocative inefficient.
Allocative efficiency occurs when the price of the good (willing to pay) = MC of production

Allocative efficiency occurs when there is an optimal distribution of goods and services. This involves
taking into account consumer’s preferences.
A more precise definition of allocative efficiency is that where the price equals the Marginal Cost (MC) of
production. This is because the price that consumers are willing to pay is equivalent to the marginal
utility that they get. Therefore, the optimal distribution is achieved when the marginal utility of the good
equals the marginal cost.
Firms in Perfect competition are said to produce at an allocatively efficient level.
Monopolies can increase price above the marginal cost of production and are allocatively inefficient.
Monopoly sets a price of Pm. This is allocatively inefficient because Price is greater than MC.

Alloactive efficiency would occur at the point where the MC cuts the Demand curve,
i.e. Price = MC.

Note:
Producing on the production possibility frontier is not necessarily allocatively efficient because a PPF
is not concerned with distribution.
An economy can be productively efficient but have very poor allocative efficiency
Allocative efficiency is concerned with the optimal distribution of resources.