UNIT I: INTRODUCTION TO ENGINEERING

ECONOMY

Definition of Economics, Concept of Costs, Break Even Analysis, Law of Supply

and Demand, Budget and budgetary provisions in Micro and Macro Economics,
Economic laws, their nature and trends, relation between Science, Engineering,
Technology and Economics.

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 Unit I: Introduction to Engineering Economy

Economics
Economics is the social science that studies the production,
distribution and consumption of goods and services. The term
economics comes from the Greek word oikonomia, (“management of
households”) from (oikos, “house”) + (nomos, “Custom” or “law”).
Thus, it refers to managing a household with limited funds.

All economic activities start from the existence of human wants.

With the help of resources a person fulfils his wants and gets
satisfaction. Thus, economics is the study of wants, efforts and
satisfaction. In modern economy, wants, efforts and satisfaction are
linked through money.

Economics is growing very rapidly as the years pass. As new

ideas are being discovered and the old theories are being revised, it
is not possible to give a definition of economics which has a general
acceptance.

The set of definitions given by various economists are generally

classified under four heads:

 Economics as a science of wealth:

Adam Smith, the founder of economics, described Economics as a

body of knowledge which relates to wealth. Accordingly to him if a
nation has large amount of wealth, it can help in achieving its
betterment. He defined economics as “The study of nature and causes
of generating wealth of a nation”. He emphasized the production and
expansion of wealth as the subject matter of economics.

 Economics as a Science of Material Welfare/ Neo-Classical View:

Alfred Marshall in his book, ‘Principles of Economics’ defined

Economics as: “Study of mankind in the ordinary business of life. It
examines that part of individual and social actions which is closely
connected with the attainment and with the use of material requisites
of wellbeing”. This definition clearly states that Economics is on the

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 Unit I: Introduction to Engineering Economy

one side a study of wealth and on the other and more important side
a part of the study of man.

 Economics as a Science of Scarcity and Choice:

Lionel Robbins in his book, ‘Nature and Significance of Economics

Science’ defined Economics as “A science which studies human
behaviour as a relationship between ends and scarce means which
have alternative uses”.

 Economics as a Science of Growth and efficiency:

If we define Economics as a science of administration of scare
resources, then its scope becomes too wide and includes the whole
of economics life and not merely that part of it which is connected
with the market price.
The modern economists define economics as “A science of
growth and efficiency”. According to Samuelson, “ Economics is
the study of how people and society end up closing, with or without
the use of money, to employ scarce productive resources that could
have alternative uses, to produce various commodities and
distribute them for consumption now or in the future among
various persons and groups in society”. It analyses the cost and
benefits of improving patterns of resource allocation.
Efficiency here implies technical efficiency and economic
efficiency in the use of scarce resources for producing a given level
of output. The term efficiency also relates to the efficiency of whole
economics system. If one section of the society is made better off
without making the other section worse off, we can say the
economic system is operating efficiently.
Thus, Economics can be defined as “A social science which is
concerned with the proper use and allocation of resources for the
achievement and maintenance of growth with stability and
efficiency”.

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 Unit I: Introduction to Engineering Economy

Engineering Economics: Nature & Scope.

Engineers are planners and builders. They are also problem
solvers, managers and decision makers. Engineering economics
touches each of these activities. All engineering project plans and
production s techniques are critically reliant upon adequate
financial parameters depending upon their nature and scale.
Problems are ultimately defined by financial proportions and
decisions are appraised on the basis of their monetary costs.
Though engineering economics is closely related to
conventional applied micro and macroeconomics, it has its own
history and speciality as distinct discipline. Specifically,
engineering economics is devoted to problem solving and decision
making at the operational level to satisfy the tactical objectives
and strategic effectiveness of different engineering projects, plans,
designs etc. for the overall benefit of the whole mankind.

Evolution or History of Engineering Economics:

Engineering economic as a discipline has transformed over the
years. Before 1940, engineers were mainly concerned with design,
construction and operation of machines, structures and processes.
They were given less attention to the resources, humans and
physical, that produced final products.
The evolution of engineering economics as a discipline can be
analysed through two approaches, classical and modern as
explained below:
Its origin can be termed way back to the beginning of the 19th
century, in the pioneering works of an eminent American civil
engineer, Arthur. M. Willington in his epic “The Economic Theory
of the Location of railways” (1887).
This is followed by two engineers C.L fish and O. B. Goldman in
1920’s. C.L. Fish formulated as investment model related to the
broad market in his book “Engineering Economics” (1923) and is
“Financial Engineering” 1920 Goldman proposed a compound

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 Unit I: Introduction to Engineering Economy

interest procedure for determining comparative values of

alternative investment.
The confines of classical engineering economics were stalked
out in 1930 by E.L Grant in “Principles of Engineering Economy”.
Grant discovered the importance of judgement factors and short-
run investment evaluation as well as conventional comparisons of
long-run investments in capital goods based on the compound
interest calculation. His many contributions resulted in the
recognitions that E.L Grant can truthfully be called the “Father of
Engineering Economics”.
Modern approaches to discounted cash flow and capital
rationing were influenced by the work of Joel Dean. He
incorporated the theories of Keynes and other economists to
develop ways to analyse the effects of supply and demand for
investment fin in allocating resources.
Current developments are pushing the frontiers of engineering
economics to encompass new method of risk, sensitivity and
intangible analysis. Traditional methods are being refined to
reflect today’s concerns for resources conservation and effective
utilization public funds.

Meaning & other definitions:

Engineering Economics is a subject which deals with the
methods that enable one to take economic decisions towards
minimizing cost and/or maximizing benefits to business
organisations.
Engineering economics is the applications of economic
techniques to the evaluation of design and engineering
alternatives. The role of engineering economic is to assess the
appropriateness of a given project, estimate its value and justify
from as engineering stand point.
According to Blank and Tarquin, “Fundamentally engineering
economy involves, formulating, estimating and evaluating
economic outcomes when alternatives to accomplish a defined
purpose are available”. Another way to define engineering

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 Unit I: Introduction to Engineering Economy

economics is as a collection of mathematical techniques that

simplify economic comparisons.
Principles of Engineering Economics:
The development, study and application of any discipline must
begin with a basic foundation. The foundation for engineering
economics is a set of seven principles or fundamental concepts that
provides a comprehensive doctrine for developing the
methodology.
 Principle I: Develop the Alternatives.
The choice is among the alternatives. The alternatives are to be
identified and then defined for subsequent analysis. Developing
and defining the alternatives for direct evaluation is important
because of the resulting impact as the quality of the decision.
 Principle II: Focus on the Differences.
Only the difference in expected future outcomes among the
alternatives is relevant to their comparison and should be consider
when making the decision. If all prospective outcomes of the
feasible alternatives were exactly the same, then there would be no
basics or need for comparison.
 Principle III: Use a consistent view point.
The prospective outcomes of the alternatives, economic and
other should be consistently developed from a defined view point.
It is important that the view point for a particular decisions be first
defined and then used consistently in the description, analysis and
comparison of alternatives.
 Principle IV: Use a common unit of measure.
Using a common unit of measurement to enumerate as many of
prospective outcomes as possible will make easier the analysis and
comparison of alternatives.
 Principle V: Consider all relevant criteria.
Selection of preferred alternative requires the use of certain
criteria. The decision process should consider both the customer
enumerated in the monetary unit and those expressed in some
other unit of measurement made explicit in a descriptive manner.

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 Principle VI: Make uncertainty explicit.

Uncertainty is inherent in projecting or estimating the future
outcomes of the alternatives recognised in their analysis and
comparison.
 Principle VII: Revise of the decision.
Improved decision making results from an adoptive process. To
the extent practicable, the initial projected outcomes of the
selected alternatives should be subsequently compared with the
actual results achieved. A sound engineering economic analysis
procedure incorporates the basic method and involves many
practical problems.
However, engineering economics deals with the following:

i) Identify alternative uses for limited resources and obtained

appropriate data.
ii)Analyse the data to determine the preferred alternative.

Nature of Engineering Economics:

The nature of engineering economics is based on the following
points:
1. Decision making based on comparisons.
2. Standardised tool.
3. Conventional Macro-economics.
4. Selection of preferred courses of action.

Scope of Engineering Economics:

The engineering economics provides scope in the following
areas for further study:
1. Planning
2. Optimum allocations of enterprises capital.
3. Time value of money.
4. Proper evaluation and measurement.
5. Impact of economic and institutional factors.

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 Unit I: Introduction to Engineering Economy

6. Capital budgeting decisions.

7. Cost analysis, capital expression and profitability analysis.
8. Economic feasibility study.
9. Cost and revenue analysis.
10. Cost engineering.
11. Manufacturing sector.

Problems of engineering economics:

Engineering economics deals with 4 basic problems.
1. What to produce (Allocation problem).
2. How to produce (Production or utilization).
3. For whom to produce (Distribution problem).
4. Problem of economic growth.

1) What to produce.
What to produce means engineering economics is related to
the problem of allocation of limited resources among unlimited
ends. It involves the utilization of limited resources to different
sectors.
2) How to produce.
The second problem is how goods will be produced on the
basis of domestic demand. Goods can be produced either by
using labour intensive technology or capital intensive
technology. The choice of technology for production is the
second problem.
3) For whom to produce.
After goods are produced it should be distributed efficiently
among all the sectors.
4) Problem of economic growth.
Unequal distribution of goods encourage the last problem i.e.
the problem of economic growth. If goods are not distributed

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 Unit I: Introduction to Engineering Economy

properly and some sectors are developed and some are not
developed then growth cannot be achieved.
Cost Concepts:
When commodities and services are produced, various
expenses have to be incurred, e.g., purchase of raw materials,
payment to labour, landlord, capitalist, etc. The sum total of the
expenses incurred plus the normal profit expected by the
producer is called the cost of production. The various concepts
of cost are discussed below:
1. Nominal cost and real cost:
Nominal cost is the money cost of production. The real costs
of production are the pain and sacrifices of labour involved in
the process of production.
2. Explicit and implicit costs:
Explicit costs are the accounting costs or contractual cash
payments which the firm makes to other factor owners for
purchasing or hiring the various factors. Implicit costs are the
costs of self-owned factors which are employed by the
entrepreneur in his own business. These implicit costs are the
opportunity costs of the self-owned and self-employed factors
of the entrepreneur, that is, the money incomes which these
self-owned factors would have earned in their next best
alternative uses.
3. Accounting Costs and Economic Cost:
Accounting costs are the actual or explicit costs which are
paid by the entrepreneurs to the owners of hired factors and
services. On the other hand, economic costs not only include
the explicit costs but also the implicit costs of the self-owned
factors or resources which are used by the entrepreneur in his
own business.
4. Opportunity cost:
The opportunity cost (or transfer earnings) of any good is the
expected return from the next best alternative good that is

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 Unit I: Introduction to Engineering Economy

forgone or sacrificed. For example, if a farmer who is producing

wheat can also produce potatoes with the same factors. Then,
the opportunity cost of a quintal of wheat is the amount of
output of potatoes given up.
5. Business Cost and Full Cost:
Business costs include all the expenses which are incurred in
carrying out a business. The concept of business cost is similar
to the accounting or actual cost. The concept of Full cost
includes two other costs: the opportunity cost and normal
profit. Normal profit is a necessary minimum earning which a
firm must get to remain in its present occupation.
6. Private costs and Social Costs:
Private costs are the economic costs which are actually
incurred or provided for by an individual or a firm. It includes
both explicit and implicit costs. Social cost, on the other hand,
implies the cost which a society bears as a result of production
of a commodity. Social cost includes both private cost and the
external cost. External cost includes (a) the cost of free goods or
resources for which the firm is not required to pay for its used,
e.g., atmosphere, rivers, lakes etc. (b) the cost in the form of
‘disutility’ caused by air, water, and noise pollution, etc.
7. Total, Average and Marginal Costs:
Total cost refers to the total outlays of money expenditure,
both explicit and implicit on the resources used to produce a
given output. Average cost is the cost per unit of output which
is obtained by dividing the total cost (TC) by the total output
(Q), i.e., TC/Q = average cost.
Marginal cost is the addition made to the total cost as a result
of producing one additional unit of the product. Marginal cost
is defined as TC/nQ.
8. Fixed Costs and Variable Costs:
Fixed costs are the expenditure incurred on the factors such
as capital, equipment, plant, factory building which remain

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 Unit I: Introduction to Engineering Economy

fixed in the short run and cannot be changed. Therefore, fixed

costs are independent of output in the short run i.e., they do not
vary with output in the short run. Even if no output is produced
in the short run, these costs will have to be incurred. Variable
costs are costs incurred by the firms on the employment of
variable factors such as labour, raw materials, etc., whose
amount can be easily increased or decreased in the short run.
Variable costs vary with the level of output in the short run. If
the firm decided not to produce any output, variable costs will
not be incurred.
9. Short-run and Long-run Cost:
Short-run costs are the costs which vary with the change in
output, the size of the firm remaining the same. Short-run costs
are the same as variable costs. On the other hand, long-run
costs are incurred on the fixed assets, like plant, building,
machinery, land etc. Long-run cost are the same as fixed-costs.
However, in the long-run even the fixed costs become variable
costs as the size of the firm or scale or production is increased.
Relation between Marginal Cost (MC) and Average Cost (AC):
The relationship between MC and AC may be explained as
follows:

1. When MC falls, AC also falls but at lower rate than that of

MC. So long as MC curve lies below the AC curve, the AC
curve is falling.
2. When MC rises, AC also rises but at lower rate than that of
MC. That is, when MC curve lies above AC curve, the AC
curve is rising.
3. MC intersects AC at its minimum. That is, MC = AC at its
minimum.

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 Unit I: Introduction to Engineering Economy

Partial Equilibrium:
Partial equilibrium is a condition of economic
equilibrium which takes into consideration only a part of the
market, ceteris paribus, to attain equilibrium.
As defined by Leroy lopes, "A partial equilibrium is one
which is based on only a restricted range of data, a standard
example is price of a single product, the prices of all other
products being held fixed during the analysis."
The supply and demand model is a partial equilibrium
model where the clearance on the market of some
specific goods is obtained independently from prices and
quantities in other markets. In other words, the prices of
all substitutes and complements, as well as income levels
of consumers, are taken as given. This makes analysis much
simpler than in a general equilibrium model which includes an
entire economy.
Here the dynamic process is that prices adjust until supply
equals demand. It is a powerfully simple technique that allows
one to study equilibrium, efficiency and comparative statics.
The stringency of the simplifying assumptions inherent in this
approach make the model considerably more tractable, but may
produce results which, while seemingly precise, do not
effectively model real-world economic phenomena.
Partial equilibrium analysis examines the effects of policy
action in creating equilibrium only in that particular sector or
market which is directly affected, ignoring its effect in any other
market or industry assuming that they being small will have
little impact if any. Hence this analysis is considered to be
useful in constricted markets.
Léon Walras first formalized the idea of a one-period
economic equilibrium of the general economic system, but it
was French economist Antoine Augustin Cournot and English
political economist Alfred Marshall who developed tractable
models to analyse an economic system.

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Assumptions in partial equilibrium:

1. Commodity price is given and constant for the consumers.
2. Consumers' taste and preferences, habits, incomes are also
considered to be constant.
3. Prices of prolific resources of a commodity and that of other
related goods (substitute or complementary) are known as well
as constant.
4. Industry is easily availed with factors of production at a known
and constant price compliant with the methods of production
in use.
5. Prices of the products that the factor of production helps in
producing and the price and quantity of other factors are
known and constant.
6. There is perfect mobility of factors of production between
occupation and places.

Difference between Partial and general equilibrium:

Partial Equilibrium General Equilibrium

• Developed by Alfred Marshall. • Léon Walras was first to develop it.

• Related to single variable • More than one variable or economy as

a whole is taken into consideration

• Based on two assumptions: • It is based on the assumption that

1. Ceteris Paribus
2. Other sectors are not
affected due to change in
one sector.
• Other things remaining constant,
price of a good is determined
various sectors are mutually
interdependent.
There is an effect on other sectors due to
change in one.
• Prices of goods are determined
simultaneously and mutually.
Hence all product and factor markets are
simultaneously in equilibrium.

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 Unit I: Introduction to Engineering Economy

General Equilibrium Theory:

In economics, general equilibrium theory attempts to
explain the behaviour of supply, demand, and prices in a whole
economy with several or many interacting markets, by seeking
to prove that the interaction of demand and supply will result
in an overall general equilibrium. General equilibrium theory
contrasts to the theory of partial equilibrium, which only
analyses single markets.
General equilibrium theory studies both economies using
the model of equilibrium pricing and seeks to determine in
which circumstances the assumptions of general equilibrium
will hold. The theory dates to the 1870s, particularly the work
of French economist Léon Walras in his pioneering 1874
work Elements of Pure Economics
General equilibrium analysis is an extensive study of a
number of economic variables, their interrelations and
interdependences for understanding the working of the
economic system as a whole. It brings together the cause and
effect sequences of changes in prices and quantities of
commodities and services in relation to the entire economy.
An economy can be in general equilibrium only if all
consumers, all firms, all industries and all factor-services are in
equilibrium simultaneously and they are interlinked through
commodity and factor prices. As Stigler has said: “The theory of
General Equilibrium is the theory of interrelationship among
all parts of the economy.”
General equilibrium exists when all prices are in
equilibrium; each consumer spends his given income in a
manner that yields him the maximum satisfaction; all firms in
each industry are in equilibrium at all prices and output; and
the supply and demand for productive resources (factors of
production) are equal at equilibrium prices.

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ASSUMPTIONS:

The general equilibrium analysis is based on the following

assumptions:

(1) There is perfect competition both in the commodity and factor

markets.

(2) Tastes and habits of consumers are given and constant.

(3) Incomes of consumers are given and constant.

(4) Factors of production are perfectly mobile between different

occupations and places.

(5) There are constant returns to scale.

(6) All firms operate under identical cost conditions.

(7) All units of a productive service are homogeneous.

(8) There are no changes in the techniques of production.

(9) There is full employment of labour and other resources.

LIMITATIONS OF GEN. EQUILIBRIUM:

The general equilibrium analysis of the economy has several
limitations:
1. It is based on a number of unrealistic assumptions which are
contrary to the actual conditions prevailing in the world. Perfect
competition, the very basis of this analysis, is a myth.

2. It is a static analysis. All consumers and producers in this

analysis consume and produce the same products day in and day
out without any time-lag. Their tastes, preferences, and aims are the

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same, and their economic decisions are in perfect harmony with

each other.

In reality, nothing of this sort happens. Producers and consumers

never act and think alike. Changes are taking place continuously in
tastes and preferences. There are no constant returns to scale and
no two factor services are homogeneous. Thus cost conditions differ
from producer to producer. Since the given conditions are
continuously changing, the movement towards general equilibrium
is ever thwarted and its attainment has ever remained a wishful
ideal.

3. Prof. Stigler regards general equilibrium as a misnomer.

According to him, “No economic analysis has ever been general in
the sense that it considered equilibrium studies as more inclusive
than partial equilibrium studies, never that they are complete.
Moreover, the more general the analysis, the less specific its content
must necessarily be.”

MICRO ECOMICS & MACRO ECONOMICS:

 Micro economics uses aggregates relating to individual

households, firms and industries, while macro-economic uses
aggregates which relate them to the economy as a whole.
 The objective of micro economics on the demand side is to
maximise utility whereas on the supply side is to maximise profit
at a minimum cost.
 The word micro has been derived from the Greek word
‘MIKROS’, which means small, hence Micro economics is the
study of individuals and small group of individuals.

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 Unit I: Introduction to Engineering Economy

 On the other hand the word macro is derives from the greek word
‘MAKROS’ which means very large, hence it deals with the
aggregates like total outputs, national income, general price
level, etc.
 The basis of micro economics is the price mechanism which
operates with the help of demand supply forces. These forces
helps in determining the equilibrium prices in the market.
 On the other hand the basis of macroeconomics study is the
national income, output, employment and the general price level
which are determined by aggregate demand and aggregate
supply.
 Micro economics is based on the partial equilibrium whereas
macroeconomics is based on general equilibrium.

Theory of demand:

Engineering Economics By Shaikh Sohail