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UNIT ONE

Engineering Economics:

Engineering economics is a subset of economics for application of economic principles and


calculations to engineering projects.
It is important to all fields of engineering because no matter how technically sound an
engineering project is; it will fail if it is not economically feasible. Engineers seek solutions
to problems, and the economic viability of each potential solution is normally considered
along with the technical aspects.
Fundamentally, engineering economics involves formulating, estimating, and evaluating the
economic outcomes when alternatives to accomplish a defined purpose are available.
Engineering economic analysis is often applied to various possible designs for an engineering
project in order to choose the optimum design, thereby taking into account both technical and
economic feasibility.
Engineering Economics highlights the importance of economics in engineering and helps
engineers in financial decision making. It provides comprehensive coverage of the subject
from basic principles to state-of-the-art concepts and applications.

Nature and Scope of Engineering Economics:

 Engineering Economics deals with both micro-economics and macro-economics.


 It helps in making decision-making for the engineering projects.
 It is normative in approach and focus on the optimum utilization of resources.
 It applies economic tools and concepts in engineering projects and operations.
 It enables the engineers to formulate different strategies for the engineering projects.
Law of Demand:

Law of demand expresses the inverse relationship between quantity demanded and the price
of the commodity. It states that quantity demanded is inversely proportional to the price of
the commodity. The rise or fall in price of the commodity will lead to decrease or increase in
the quantity demanded respectively.
Qs is inversely proportional to P
Qs = K/P
Where K is the constant

Types of Demand:

Negative Demand – Negative demand is a type of demand which is created if the product is
disliked in general. The product might be beneficial but the customer does not want it. For
example – Dental work where people don’t want problems with their teeth and use preventive
measures to avoid the same. Insurance, which people should have but they delay buying an
insurance policy. Similarly, people would like to avoid heart attacks and hence may pay for a
full body check up where the results might be negative, but still the customer has to pay. The
marketer has to solve the issue of no demand by analyzing why the market dislikes the
product and then counter acting with the right marketing tactics.
Unwholesome demand – Unwholesome demand is the other side of Negative demand. In
negative type of demands, customer does not want the product even though product might be
necessary for the customer. But in unwholesome demand, the customer should not desire the
product, yet the customer wants the product badly. Best examples of unwholesome demand
are cigarettes, alcohol, pirated movies, guns etc.
No demands – Certain products face the challenge of no demand. The best example for the
same can be education courses where there is very low demand or no demand at all. Such
cases are very hard to counter.
Latent Demand – Latent demand is, as the name suggests, a demand which the customer
realizes later. Thus, while buying the product, he might not desire some features. But later on,
he might think about those features and buy the product. The best example of latent demand
is normal phones vs. smart phones. People nowadays want more and more features in the
smart phone. They might settle for a normal phone, but then later on they get the itch to buy a
smart phone. Similarly, people might buy a petrol car. But most likely their second car will
be a diesel car. A marketing managers job is to find out the features which people might be
looking for later and market them to the customer in such a manner that he immediately
wants them.
Declining demand – Declining demand is when demand for a product is declining. For
example, when CD players were introduced and IPOD came in the market, the demand for
walkman went down. Although there was still a demand for the product, the demand was a
declining demand. A marketer’s job in such a case is to think ways to revive the product so
that the demand is not declining.
Irregular demand – Irregular demand can be demand which is not consistent. The best
example of irregular demand is seasonal products like umbrellas, air conditioners or resorts.
These products sell irregularly and sell more during peak season whereas their demand is
very low during non seasons. The best way to counter irregular demand is to introduce
incentives for the customer to buy the product.
Full demand – In an ideal environment, a company should always have full demand. Full
demand means that the demand is meeting the supply potential of the company. It also means
that the markets are happy with the products of the company and that people want to buy
from the same company. The marketing challenge in this type of demand is to maintain the
same level of interest in the product and the company.
Overfull demands – Overfull demands happen when the companies manufacturing capacity
is limited but the demand is more than the supply. This can be observed in the cement
industry occasionally. Generally, most cement industries have limited manufacturing
capacity. And hence, brand switching in cement industry is high. Many companies use de
marketing techniques to counter act overfull demands. This is because if the company keeps
marketing, but it is not able to supply the material, then the company might suffer badly in
brand equity.

Elasticity of Demand:

The degree to which demand for a good or service varies with its price.
Normally, sales increase with drop in prices and decrease with rise in prices. As
a general rule, appliances, cars, confectionary and other non-essentials show elasticity of
demand whereas most necessities (food, medicine, basic clothing) show inelasticity of
demand (do not sell significantly more or less with changes in price).

Price elasticity of demand measures the responsiveness of demand after a change in price

The formula for calculating the co-efficient of elasticity of demand is:

Percentage change in quantity demanded divided by the percentage change in price

Since changes in price and quantity usually move in opposite directions, usually we do not
bother to put in the minus sign. We are more concerned with the co-efficient of elasticity of
demand.

Values for price elasticity of demand

1. If price elasticity of demand (E) = 0 demand is perfectly inelastic - demand does not
change at all when the price changes – the demand curve will be vertical.
Price (P)

When, Change in Quantity Demanded (Q) = 0

Quantity Demanded (Q)

2. If price elasticity of demand (E) = infinity, demand is perfectly elastic - price does not
changes still demand is changing – the demand curve will be horizontal.

P When, Change in Price (P) = 0

3. If price elasticity of demand (E) = 1, (i.e. the % change in demand is exactly the same
as the % change in price), then demand is unitary elastic.

P
When, % Change in Price (P) = % Change in
Quantity Demanded (Q)

4. If price elasticity of demand (E) > 1, i.e. % Change in Q > % Change in Y, then
demand curve will be relatively elastic.

P
When, % Change in Price (P) < % Change in
Quantity Demanded (Q)

Q
5. If price elasticity of demand (E) < 1, i.e. % Change in Q < % Change in Y, then
demand curve will be relatively elastic.

P
When, % Change in Price (P) > % Change in
Quantity Demanded (Q)

Factors affecting price elasticity of demand

 The number of close substitutes – the more close substitutes there are in the market,
the more elastic is demand because consumers find it easy to switch
 The cost of switching between products – there may be costs involved in switching. In
this case, demand tends to be inelastic. For example, mobile phone service providers
may insist on a12 month contract.
 The degree of necessity or whether the good is a luxury – necessities tend to have an
inelastic demand whereas luxuries tend to have a more elastic demand.
 The proportion of a consumer’s income allocated to spending on the good – products
that take up a high % of income will have a more elastic demand
 The time period allowed following a price change – demand is more price elastic, the
longer that consumers have to respond to a price change. They have more time to
search for cheaper substitutes and switch their spending.
 Whether the good is subject to habitual consumption – consumers become less
sensitive to the price of the good of they buy something out of habit (it has become
the default choice).
 Peak and off-peak demand - demand is price inelastic at peak times and more elastic
at off-peak times – this is particularly the case for transport services.
 The breadth of definition of a good or service – if a good is broadly defined, i.e. the
demand for petrol or meat, demand is often inelastic. But specific brands of petrol or
beef are likely to be more elastic following a price change.

Significance of Elasticity of Demand:

1. Determination of price policy:


While fixing the price of this product, a businessman has to consider the elasticity of demand
for the product.

He should consider whether a lowering of price will stimulate demand for his product, and if
so to what extent and whether his profits will also increase a result thereof.

If the increase in his sales is more than proportionate, to the reduction in price his total
revenue will increase and his profits might be larger.
On the other hand, if increase in demand is less than proportionate to fall in price, his total
revenue we will fall and his profits would be certainly less.

Therefore, knowledge of elasticity of demand may help the businessman to make a decision
whether to cut or increase the price of his product or to shift the burden of any additional cost
of production on to the consumers by charging high price.

In general, for items having inelastic demand, the producer will fix a higher price and items
whose demand is elastic the businessman will fix a lower price.

2. Price discrimination:
Price discrimination refers to the act of selling the technically same products at different
prices to different section of consumers or in different in sub-markets.

The policy of price-discrimination is profitable to the monopolist when elasticity of demand


for his product is different in different sub-markets.

Those consumers whose demand is inelastic can be charged a higher price than those with
more elastic demand.

3. Shifting of tax burden:


To what extent a producer can shift the burden of indirect tax to the buyers by increasing
price of his product depends upon the degree of elasticity of demand.

If the demand is inelastic the larger part of the indirect tax can be shifted upon buyers by
increasing price. On the other hand if the demand is elastic than the burden of tax will be
more on the producer.

4. Taxation and subsidy policy:


The government can impose higher taxes and collect more revenue if the demand for the
commodity on which a tax is to be levied is inelastic.

On the other hand, in ease of a commodity with elastic demand high tax rates may fail to
bring in the required revenue for the government.

Govt., should provide subsidy on those goods whose demand is elastic and in the production
of the commodity the law of increasing returns operates.

5. Importance in international trade:


The concept of elasticity of demand is of crucial importance in many aspects of international
trade.

The success of the policy of devaluation to correct the adverse balance of payment depends
upon the elasticity of demand for exports and imports of the country.

The policy of devaluation would be benificial when demand for exports and imports is price-
elastic.
A country will benefit from international trade when: (i) it fixes lower price for exports items
whose demand is price elastic and high price for those exports whose demand is inelastic (ii)
the demand for imports should be inelastic for a fall in price and inelastic for arise in price.

The terms of trade between the two countries also depends upon the elasticity of demand of
exports and imports of two countries. If the demand is inelastic, the terms of trade will be in
favour of the seller country.

6. Importance in the determination of factors prices:


Factor with an inelastic demand can always command a higher price as compared to a factor
with relatively elastic demand.

This helps the trade unions in knowing that where they can easily get the wage rate increased.
Bargaining capacity of trade unions depend upon elasticity of demand for workers services.

7. Determination of sale policy for supper markets:


Super Markets is a market where in a variety of goods are sold by a single organization.
These items are generally of mass consumption.

Therefore, the organization is supposed to sell commodities at lower prices than charged by
shopkeepers in the other bazaars.

Thus, the policy adopted is to charge a slightly lower price for items whose demand is
relatively elastic and the costs are covered by increased sales.

8. Pricing of joint supply products:


The goods that are produced by a single production process are joint supply products. The
cost of production of these goods is also joint.

Therefore, while determining the prices of these products their elasticity of demand is
considered.

The price of a joint supply product is fixed high if its demand is inelastic and low price is
fixed for that joint supply product whose demand is elastic.

9. Effect of use of machines on employment:


Ordinarily it is thought that use of machines reduced the demand for labour. Therefore, trade
unions often oppose the use of machines fearing unemployment.

But this fear is not always true because use of machines may not reduce demand for labour. It
depends on the price elasticity of demand for the products.

The use of machines may reduce the cost of production and price. If the demand of the
product is elastic then the fall in price will increase demand significantly.

As a result of increased demand the production will also increase and more workers will be
employed.
In such cases concept of elasticity of demand help the management to pacify the trade unions.
But if the demand of the product is inelastic then use of more machines will cause
unemployment.

10. Public utilities:


The nationalization of public utility services can also be justified with the help of elasticity of
demand.

Demand for public utilities such as electricity, water supply, post and telegraph, public
transportation etc. is generally inelastic in nature.

If the operation of such utilities is left in the hand of private individuals, they may exploit the
consumers by charging high prices. Therefore, in the interest of general public, the
government owns and runs such services.

The public utility enterprises decide their price policy on the basis of elasticity of demand. A
suitable price policy for public utility enterprises is to charge from consumers according to
their elasticity of demand for public utility.

11. Explanation of paradox of poverty:


Exceptionally good harvest brings poverty to the farmers and this situation is called ‘Paradox
of Poverty’.

This paradox is easily explained by the inelastic nature of demand for most farm products.
Since the demand is inelastic, prices of farm products fall sharply as a result of large increase
in their supply in the year of bumper crops. Due to sharp fall in prices, the farmers get less
income even by selling larger quantity.

This paradox of poverty is the basis of regulation and control of farm products prices.
Government fixes the minimum prices of farm products because the demand for farm
products is inelastic. Thus, the concept of elasticity of demand helps the government in
determining its agricultural policies.

12. Output decisions:


The elasticity of demand helps the businessman to decide about production. A businessman
chooses the optimum product- mix on the basis of elasticity of demand for various products.

The products having more elastic demand are preferred by the businessmen. The sale of such
products can be increased with a little reduction in their prices.

Exceptions to the Law of Demand:


The law of demand does not apply in every case and situation. The circumstances when the
law of demand becomes ineffective are known as exceptions of the law. Some of these
important exceptions are as under.

1. Giffen goods:
Some special varieties of inferior goods are termed as Giffen goods. Cheaper varieties of this
category like bajra, cheaper vegetable like potato come under this category. Sir Robert Giffen
of Ireland first observed that people used to spend more their income on inferior goods like
potato and less of their income on meat. But potatoes constitute their staple food. When the
price of potato increased, after purchasing potato they did not have so many surpluses to buy
meat. So the rise in price of potato compelled people to buy more potato and thus raised the
demand for potato. This is against the law of demand. This is also known as Giffen paradox.

2. Veblen Goods:
This exception to the law of demand is associated with the doctrine propounded by Thorsten
Veblen. A few goods like diamonds etc are purchased by the rich and wealthy sections of the
society. The prices of these goods are so high that they are beyond the reach of the common
man. The higher the price of the diamond the higher the prestige value of it. So when price of
these goods falls, the consumers think that the prestige value of these goods comes down. So
quantity demanded of these goods falls with fall in their price. So the law of demand does not
hold good here.

3. Conspicuous necessities:
Certain things become the necessities of modern life. So we have to purchase them despite
their high price. The demand for T.V. sets, automobiles and refrigerators etc. has not gone
down in spite of the increase in their price. These things have become the symbol of status.
So they are purchased despite their rising price. These can be termed as “U” sector goods.

4. Ignorance:
A consumer’s ignorance is another factor that at times induces him to purchase more of the
commodity at a higher price. This is especially so when the consumer is haunted by the
phobia that a high-priced commodity is better in quality than a low-priced one.

5. Emergencies:
Emergencies like war, famine etc. negate the operation of the law of demand. At such times,
households behave in an abnormal way. Households accentuate scarcities and induce further
price rises by making increased purchases even at higher prices during such periods. During
depression, on the other hand, no fall in price is a sufficient inducement for consumers to
demand more.

6. Future changes in prices:


Households also act speculators. When the prices are rising households tend to purchase large
quantities of the commodity out of the apprehension that prices may still go up. When prices
are expected to fall further, they wait to buy goods in future at still lower prices. So quantity
demanded falls when prices are falling.

7. Change in fashion:
A change in fashion and tastes affects the market for a commodity. When a broad toe shoe
replaces a narrow toe, no amount of reduction in the price of the latter is sufficient to clear
the stocks. Broad toe on the other hand, will have more customers even though its price may
be going up. The law of demand becomes ineffective.
Reasons behind Law of Demand:

(1) Income Effect:


When the price of a commodity falls the consumer can buy more quantity of the commodity
with his given income. Or, if he chooses to buy the same amount of quantity as before, some
money will be left with him because he has to spend less on the commodity due to its lower
price.
In other words, as a result of fall in the price of a commodity, consumer’s real income or
purchasing power increases. This increase in real income induces the consumer to buy more
of that commodity. This is called income effect of the change in price of the commodity. This
is one reason why a consumer buys more of a commodity when its price falls.
(2) Substitution Effect:
The other important reason why the quantity demanded of a commodity rises as its price falls
is the substitution effect. When price of a commodity falls, it becomes relatively cheaper than
other commodities. This induces the consumer to substitute the commodity whose price has
fallen for other commodities which have now become relatively dearer. As a result of this
substitution effect, the quantity demanded of the commodity, whose price has fallen, rises.
(3) Utility Maximising Behaviour:
When a person buys a commodity he exchanges his income for the commodity in order to
maximise his satisfaction. He continues to buy goods and services so long as marginal utility
of his money is less than the marginal utility of his commodity. This is known as Utility
maximising behaviour that triggers the Law of Demand.
Demand forecasting:

Demand forecasting is the activity of estimating the quantity of a product or service that
consumers will purchase. Demand forecasting involves techniques including both informal
methods, such as educated guesses, and quantitative methods, such as the use of historical
sales data or current data from test markets. Demand forecasting may be used in
making pricing decisions, in assessing future capacity requirements, or in making decisions
on whether to enter a new market.

Need for Demand forecasting:

The need for forecasting significantly increases in this period of time due to the rapid changes
in technology, government involvement in the econ, social and political changes, and
globalization. It is essential to obtain an estimate of the changes as accurately as possible for
companies to survive, to strive for operational excellence and to have a competitive
advantage.

Techniques of Demand forecasting:

There are two approaches to determine demand forecast – (1) the qualitative approach, (2) the
quantitative approach. The comparison of these two approaches is shown below:

Description Qualitative Approach Quantitative Approach

Applicability Used when situation is vague & Used when situation is stable &
little data exist (e.g., new products historical data exist
and technologies)
(e.g. existing products, current
technology)

Considerations Involves intuition and experience Involves mathematical techniques

Techniques Jury of executive opinion Time series models

Sales force composite Causal models

Delphi method

Consumer market survey

Qualitative Forecasting Methods

Qualitative Method Description

Jury of executive The opinions of a small group of high-level managers are


pooled and together they estimate demand. The group uses
opinion their managerial experience, and in some cases, combines
the results of statistical models.

Sales force composite Each salesperson (for example for a territorial coverage) is
asked to project their sales. Since the salesperson is the one
closest to the marketplace, he has the capacity to know what
the customer wants. These projections are then combined at
the municipal, provincial and regional levels.

Delphi method A panel of experts is identified where an expert could be a


decision maker, an ordinary employee, or an industry expert.
Each of them will be asked individually for their estimate of
the demand. An iterative process is conducted until the
experts have reached a consensus.

Consumer market The customers are asked about their purchasing plans and
survey their projected buying behaviour. A large number of
respondents is needed here to be able to generalize certain
results.

Quantitative Forecasting Methods

There are two forecasting models here – (1) the time series model and (2) the causal model. A
time series is a s et of evenly spaced numerical data and is obtained by observing responses at
regular time periods. In the time series model , the forecast is based only on past values and
assumes that factors that influence the past, the present and the future sales of your products
will continue.

On the other hand, t he causal model uses a mathematical technique known as the regression
analysis that relates a dependent variable (for example, demand) to an independent variable
(for example, price, advertisement, etc.) in the form of a linear equation.

Causal models are a specific method for demand forecasting that relies on data obtained in
the current stage of economic development. It explores the relationship between a certain
event and its effect on consumers. Thus, the data can produce trends which can be used to
determine the future demand.

The time series forecasting methods are described below:

Description
Time Series
Forecasting
Method
Naïve Approach Assumes that demand in the next period is the same as demand
in most recent period; demand pattern may not always be that stable

For example:

If July sales were 50, then Augusts sales will also be 50

Moving Averages MA is a series of arithmetic means and is used if little or no trend is


(MA) present in the data; provides an overall impression of data over time

A simple moving average uses average demand for a fixed


sequence of periods and is good for stable demand with no
pronounced behavioural patterns.

A weighted moving average adjusts the moving average method to


reflect fluctuations more closely by assigning weights to the most
recent data, meaning, that the older data is usually less important.
The weights are based on intuition and lie between 0 and 1 for a
total of 1.0

Exponential The exponential smoothing is an averaging method that reacts


Smoothing more strongly to recent changes in demand by assigning a
smoothing constant to the most recent data more strongly; useful if
recent changes in data are the results of actual change (e.g., seasonal
pattern) instead of just random fluctuations

Time Series The time series decomposition adjusts the seasonality by


Decomposition multiplying the normal forecast by a seasonal factor
Supply:

Supply refers to the schedule of the quantities of the good that the firms able and willing to
offer for sale at various prices.
Determinants of supply are – the price of the commodity and the raw material used in
production, state of technology, competition in market and the future expectations related
prices.

Supply Function:

The supply function is the mathematical expression of the relationship between supply and
those factors that affect the willingness and ability of a supplier to offer goods for sale.

Quantity supplied (Qs) = f (Price of the commodity, price of the related goods)
Qs = f (P, Prg)

Law of Supply:

Law of supply expresses the positive relationship between quantity supplied by a supplier and
the price of the commodity. It states that quantity supplied is directly proportional to the price
of the commodity. The rise or fall in price of the commodity will lead to increase or decrease
in the quantity supplied respectively.
Qs is directly proportional to P
Qs = K.P
Where K is the constant

Qs

Elasticity of Supply:

Elasticity of supply is measured as the ratio of proportionate change in the quantity


supplied to the proportionate change in price. High elasticity indicates the supply is sensitive
to changes in prices, low elasticity indicates little sensitivity to price changes, and no
elasticity means - no relationship with price. It is also called price elasticity of supply.

Price elasticity of supply measures the relationship between change in quantity supplied and a
change in price.

 If supply is elastic, producers can increase output without a rise in cost or a time delay
 If supply is inelastic, firms find it hard to change production in a given time period.

The formula for price elasticity of supply is:


Percentage change in quantity supplied divided by the percentage change in price

 When Pes > 1, then supply is price elastic

Qs

 When Pes < 1, then supply is price inelastic

Qs

 When Pes = 0, supply is perfectly inelastic

Qs

 When Pes = infinity, supply is perfectly elastic following a change in demand

Qs

 When Pes = 1, supply is unit elastic

Qs
What factors affect the elasticity of supply?

 Spare production capacity: If there is plenty of spare capacity then a business can
increase output without a rise in costs and supply will be elastic in response to a
change in demand. The supply of goods and services is most elastic during a
recession, when there is plenty of spare labour and capital resources.
 Stocks of finished products and components: If stocks of raw materials and
finished products are at a high level then a firm is able to respond to a change in
demand - supply will be elastic. Conversely when stocks are low, dwindling supplies
force prices higher because of scarcity in the market.
 The ease and cost of factor substitution: If both capital and labour
are occupationally mobile then the elasticity of supply for a product is higher than if
capital and labour cannot easily be switched. A good example might be a printing
press which can switch easily between printing magazines and greetings cards.
 Time period and production speed: Supply is more price elastic the longer the time
period that a firm is allowed to adjust its production levels. In some agricultural
markets the momentary supply is fixed and is determined mainly by planting
decisions made months before, and also climatic conditions, which affect the
production yield. In contrast the supply of milk is price elastic because of a short time
span from cows producing milk and products reaching the market place.
DEFINITION OF 'CETERIS PARIBUS': Latin phrase that translates approximately to
"holding other things constant" and is usually rendered in English as "all other things being
equal". In economics, the term is used as shorthand for indicating the effect of one economic
variable on another, holding constant all other variables that may affect the second variable.
For example: In Law of Demand & Law of Supply

DEFINITION OF ‘MUTATIS MUTANDIS’: Latin phrase meaning is "allowing other


things to change accordingly." This term used as shorthand for indicating the effect of
one economic variable on another, within a system in which other variables that matter will
also change as a result.