Unit 04:

Introduction to Economics and Engineering Economy

What Is Economics?

Economics is a social science that focuses on the production, distribution, and consumption
of goods and services, and analyzes the choices that individuals, businesses, governments,
and nations make to allocate resources.

KEY TAKEAWAYS

 Economics is the study of how people allocate scarce resources for production,
distribution, and consumption, both individually and collectively.
 The two branches of economics are microeconomics and macroeconomics.
 Economics focuses on efficiency in production and exchange.
 Gross Domestic Product (GDP) and the Consumer Price Index (CPI) are two of the
most widely used economic indicators.

Understanding Economics

Assuming humans have unlimited wants within a world of limited means, economists analyze
how resources are allocated for production, distribution, and consumption.
The study of microeconomics focuses on the choices of individuals and businesses, and
macroeconomics concentrates on the behavior of the economy as a whole, on an aggregate
level.
One of the earliest recorded economists was the 8th-century B.C. Greek farmer and poet
Hesiod who wrote that labor, materials, and time needed to be allocated efficiently to
overcome scarcity. The publication of Adam Smith's 1776 book, An Inquiry Into the Nature
and Causes of the Wealth of Nations sparked the beginning of the current Western
contemporary economic theories.

Microeconomics

Microeconomics studies how individual consumers and firms make decisions to allocate
resources. Whether a single person, a household, or a business, economists may analyze how
these entities respond to changes in price and why they demand what they do at particular
price levels.

Microeconomics analyzes how and why goods are valued differently, how individuals make
financial decisions, and how they trade, coordinate, and cooperate.
Within the dynamics of supply and demand, the costs of producing goods and services, and
how labor is divided and allocated, microeconomics studies how businesses are organized
and how individuals approach uncertainty and risk in their decision-making.

Macroeconomics

Macroeconomics is the branch of economics that studies the behavior and performance of an
economy as a whole. Its primary focus is recurrent economic cycles and broad economic
growth and development.

It focuses on foreign trade, government fiscal and monetary policy, unemployment rates, the
level of inflation, interest rates, the growth of total production output, and business cycles
that result in expansions, booms, recessions, and depressions.

Using aggregate indicators, economists use macroeconomic models to help formulate

economic policies and strategies.

What Is the Role of an Economist?

An economist studies the relationship between a society's resources and its production or
output, and their opinions help shape economic policies related to interest rates, tax laws,
employment programs, international trade agreements, and corporate strategies.

Economists analyze economic indicators such as gross domestic product and the consumer
price index to identify potential trends or make economic forecasts.

According to the Bureau of Labor Statistics, 38% of all economists in the United States work
for a federal or state agency. Economists are also employed as consultants, professors, by
corporations, or as part of economic think tanks.

ENGINEERING ECONOMICS

All engineering decisions involve number of feasible alternatives or options. These feasible
alternatives must be properly evaluated before implementing them. If there is no alternative,
there is no need of economic study.

Mission of engineers is to transform the resources of nature for the benefit of the human race.
Engineers translate an idea into reality. However an idea may be technically excellent
incorporating sound design, latest technology but if it does not convert into real product or
service that is affordable and fit for purposes satisfying needs and requirements of its end
users, clients, target group, beneficiary group, then it is not worthwhile to invest in such
ventures. The products or services generated should use optimized utilization of various
resources so that cost of production is not high, affordable to users and compete with similar
product and services of competitors in the market.

Engineering economy involves the systematic evaluation of the economic merits of proposed
solutions to engineering problems. To be economically acceptable (i.e. affordable), solutions
to engineering problems must be demonstrate a positive balance of long-term benefits over
long-term costs (Accreditation board for Engineering and Technology).

Meaning of Utility

Utility is power of a commodity to satisfy human wants. It is subjective and introspective

concept. It is subjective and relative concept. It varies with persons, time and places. It is not
internal quality of a commodity rather the mental makeup of a person and intensity of wants
that determine the amount of satisfaction a person derives from a commodity at particular
place and at particular time period. For example, some people like cold drink while others do
not like same way. Secondly, utility is different from usefulness. A commodity may not be
useful; it may have utility for some people. For example, liquor is harmful for health; it may
have high utility for alcoholic. Further, utility has no moral or legal significance. It is
ethically neutral.

Cardinal and Ordinal Utility

There are two approaches to measure utility. Cardinalists (neo-classicists) assume that utility
is measurable and quantifiable entity. It can be measured in numerical terms and hence can be
compared. Prof. Asimakipulas said that cardinal utility function makes it possible to measure
utility, at least conceptually, in the same manner that thermometers measures temperature or
scales measure mass. The units of measurement are imaginary; they are called units or utils.
If the utility of an apple is 40 utils and that of orange is 20 utils, then we can say that apple
has twice as much utility as orange. Since utils is an imaginary unit, it may not be used for
empirical purpose, Marshal suggested to measure utility in terms of money. He said that the
amount of money a person is ready to pay to obtain a unit of a commodity is utility of that
commodity.

The proponents of ordinal school like Allen and Hicks argue that utility derived from a
commodity cannot be measured, much less compared. One can simply say that apple gives
more utility than orange. One cannot say by how much amount, apple gives more utility than
orange. Thus, according to this approach, we can order or rank utility derived from different
commodities but cannot quantify it.

Law of Diminishing Marginal Utility

A psychological generalisation that the perceived value of, or satisfaction gained from, a
good to a consumer declines with each additional unit acquired or consumed. Even the most
delicious food, for example, will appeal less and less to its consumer when he or she has had
enough, and if consumption continues, sickness (disutility) will result.

The law can be traced back to the writings of Gossen and Bentham. It was, however, William
Stanley Jevons who for the first time projected its bearing on the determination of value.

According to this law, as a person purchases more and more units of a commodity, its
marginal utility declines. According to Boulding, ―As a consumer increases the consumption
of any one commodity, keeping constant the consumption of of all other commodities, the
marginal utility of variable commodity must decline.‖ Thus the law says that as a consumer
takes more units of a good, the extra extra utility or satisfaction that he derives from an extra
unit of the good (marginal utility) goes on falling. Total utility increases but at a decreasing
rate.

The law is based upon two important facts. Firstly, while the total wants of a man in
unlimited, each single want is satiable. With increase in consumption of particular good, the
intensity of that particular want diminishes, hence marginal utility of that good decrease.
Secondly, different goods are not perfect substitute for each other in the satisfaction of
various particular wants. When an individual consumes more and more units of a good, the
intensity of his particular want for the good diminishes but if the units of that good could be
devoted to the satisfaction of other wants and yielded as much satisfaction as they did
initially in the satisfaction of first want, marginal utility of the good would not have

Assumptions:

The assumptions of the law of diminishing marginal utility are:

1. All the units of the given commodity are homogenous i.e. identical in size shape, quality,
quantity etc.

2. The units of consumption are of reasonable size. The consumption is normal.

3. The consumption is continuous. There is no unduly long time interval between the
consumption of the successive units.

4. The law assumes that only one type of commodity is used for consumption at a time.

5. Though it is psychological concept, the law assumes that the utility can be measured
cardinally i.e. it can be expressed numerically.

6. The consumer is rational human being and he aims at maximum of satisfaction.

7. The mental condition of the consumer should remain same.

8. The taste, habits, fashion, temperament and income remain the same.diminished.

Exceptions to the Law of Diminishing Marginal Utility

There is no real exception to the law of diminishing marginal utility.

1. Hobbies: It is pointed out that in case of certain hobbies like stamp collection or old coins,
every addition unit gives more pleasure. MU goes on increasing with the acquisition of every
unit. However careful analysis shows that the person does not like to spend more money on
same type of coins etc.

2. Drunkards: It is believed that every dose of liquor increases the utility of a drunkard. And
diminishing marginal utility does not apply. However, had the law not applied, the drunkard
would have continued to drink.
3. Miser: In the case of miser, greed increases with the acquisition of every additional unit of
money.

4. Reading: reading of more books gives more knowledge and in turn greater satisfactions.

5. Money: it is said that the law does not apply in the case of money also. But we find that a
rich person has less utility for last one rupee than what the poor person has.

Importance of Law of Diminishing Marginal Utility

The marginal utility analysis has a good number of uses and applications.

1. Explanation of the Determination of Prices: The theory helps in explaining why the
prices of some commodities are high and low of others and thus able to explain the water-
diamond paradox or paradox of value which troubled Adam Smith. According to modern
economists, it is marginal utility and not the total utility which determine the price of
commodity. Water is available in abundant quantities and its relative marginal utility Is very
low and even zero. Therefore, its price is very low or zero. On the other hand, the diamonds
are scarce and therefore their marginal utility and hence their relative price is very high.

2. Explanation of Law of Demand: In order to maximize total utility consumer equates the
marginal utility with its price. Since at larger amount the marginal utility is low. So consumer
would like to pay less price and vice versa.

3. Fiscal Policy: In modern welfare state, in order to increase the social welfare the
government tries to redistribute income of the society from rich to poor. This is based on the
assumption that marginal utility of rich people is less than that of poor people. So government
imposes progressive taxes on rich section of society and spends the tax proceeds on poor
section of society.

The Law of Supply and Demand

What Is the Law of Supply and Demand?

Law of Supply and Demand

Definition

The law of supply and demand states that if a product has a high demand and low supply, the
price will increase. Conversely, if there is low demand and high supply, the price will
decrease. Market equilibrium occurs when demand and supply intersect to create a stable
price.

The law of supply and demand is a fundamental principle of the free market economy. In this
type of economy, consumers purchase goods and services at a price that is acceptable to both
the buyer and seller without interference from the government. The law of supply and
demand indicates that when there is a high demand for a product, there will also be a high
level of need for its supply. High demand for a product with low supply is likely to increase
the price of the product.

Two things determine a product’s price: the available supply of that product and the overall
demand for it. For example, if demand for tennis balls is suddenly high, the supply may
tighten, so the price increases. But when tennis players turn to pickleball, the demand for
tennis balls drops along with the price.

This is basic economics, which factors in the cost to produce, market and sell products at a
price by which both the retailer and manufacturer profit. Since you can buy the same product
from several different companies, there is a natural price ceiling — manufacturers need to be
in line with their competitors to sell cans of balls.

As with anything involving economics, the theory of supply and demand is slightly more
complicated than identifying the point at which the two meet on a graph. Four basic
guidelines define how prices are established:

 If supply increases while demand remains static, the price goes down.
 If supply decreases while demand stays the same, the price goes up.
 If the supply stays the same while demand rises, the price goes up.
 If the supply stays the same while demand drops, the price goes down.

Keep in mind that the market does not exist in a vacuum. There’s constant movement in
supply, demand and price. High prices for everyday commodities result in a drop in demand,
because consumers drive less, buy generic corn flakes, for instance, and grill hot dogs instead
of rib eye steaks.

Incrementally, this decrease in demand leads to lower prices, and the cycle begins again.
When product demand and supply are balanced the market reaches equilibrium, also known
as the market-clearing price.

What Is Elasticity of Demand?

Elasticity of demand refers to the shift in demand for an item or service when a change
occurs in one of the variables that buyers consider as part of their purchase decisions. It’s a
relationship between demand and another variable, such as price, availability of substitutes,
advertising pressure and customer income.

When a change in any one of those variables causes a significant alteration in demand for a
product or service, its elasticity of demand is considered high. Thought of another way,
elasticity shows that a customer’s buying behavior is highly flexible, or stretchy — like an
elastic waistband. The more willing customers are to change purchasing decisions, the more
elastic a product or service is. If a customer is willing to buy a different brand of coffee
simply because it’s on sale that week or completely forgo buying coffee because its price has
gone up, coffee can be said to have elastic demand.
By contrast, products that are inelastic do not experience large shifts in demand due to
changes in their purchase-consideration variables. Customers remain rigid or firm in their
buying choices for certain products and are unwilling or unable to be flexible. Tobacco
products and utilities are classic examples of inelasticity of demand because, most times, a
change in price or increase in advertising won’t significantly influence consumer demand.

Key Takeaways

 Elasticity of demand describes the potential for variation in demand for a product or
service arising from changes in price, customer income, advertising and other related
factors.
 Many factors influence elasticity, such as price, availability of substitutes, necessity,
brand loyalty and urgency.
 Understanding elasticity of demand can help guide a business’s marketing and selling
strategies to maximize profitability.
 Executing tactics to influence demand requires keen market insight and robust data
for analysis.

Elasticity of Demand Explained

Elastic demand equates to flexibility in purchasing decisions — whether in quantities

purchased, the chosen brand or product substitution. Inelastic demand is unwavering, up to a
point. For this reason, reducing elasticity is often considered to be a marketer’s primary goal:
to position a product as so essential that customers will continue to buy in most
circumstances. Imagine a business that can increase its product price without a significant
falloff in demand. Or one with customers so loyal they continue to purchase in the same
quantity even when their own income drops. Understanding elasticity helps move the needle
toward inelasticity.

Certain industries are said to be recession-resistant, largely because their products are
inelastic: Demand for those products remains constant despite any economic downturn.
Health care, utilities and certain ―vices‖ like alcohol and tobacco are items that tend to have
consistent demand, regardless of price or the customer’s income. They also tend to generate
high brand loyalty or barriers to switching, adding to customers’ unwillingness (or inability)
to swap brands, as with doctors and utilities.

Four Types of Elasticity

1. Price Elasticity of Demand (PED):

When customers are highly sensitive to changes in price, there is a high PED. This means, for
example, that if inflation causes prices to increase, customers will reduce the quantity they
purchase by switching, substituting or skipping. It can also indicate, conversely, that price
reductions may spur additional sales. The formula for PED is:
 PED = % change in quantity / % change in price

Or

PED = [(Q2–Q1)/Q1] / [(P2–P1)/P1]

Q1 = initial quantity of demand

Q2 = new quantity of demand

P1 = initial price

P2 = new price

2. Cross Elasticity of Demand (XED):

Cross elasticity happens when changes in the price of one product prompt changes in demand
for another. The two products must be related, either as complements or substitutes for each
other. When products are substitutes for each other, a rise in the price of one will usually
cause a rise in demand for the other. For example, if coffee prices rise, then demand for
breakfast tea is likely to increase as customers substitute tea for coffee. When two products
are complementary, a rise in the price of one will usually cause a decrease in the demand for
the other. For example, if coffee prices rise, demand for coffee creamer will likely decline as
people drink less coffee. XED does not apply to unrelated products, such as airline tickets
and oranges. The formula for XED is:

XED = % change in quantity for product A / % change in price for product B

Or

XED = [(Q2a – Q1a) / (Q2a + Q1a)] / [(P2b – P1b) / (P2b + P1b)]

Q1a = initial quantity of demand of product A

Q2a = new quantity of demand of product A

P1b = initial price of product B

P2b = new price of product B

3. Income Elasticity of Demand (YED):

YED — with a ―Y‖ because that’s the notation economists use for income — is the
relationship between demand and a customer’s income. As income decreases, quantity of
demand tends to decline, even if all other factors remain the same, including price. YED
tends to differ according to the priority of a product, meaning that what economists refer to as
―normal goods,‖ like food, clothes and other necessities, are likely to be prioritized over
luxury goods when customers’ income declines. Further, spending on normal goods is more
likely to increase first when income increases, and increase of luxury goods happens on a lag.
The formula for YED is:
 YED = % change in quantity / % change in income

Or

YED = [(Q2–Q1)/Q1] / [(Y2–Y1)/Y1]

Q1 = initial quantity of demand

Q2 = new quantity of demand

Y1 = initial income

Y2 = new income

4. Advertising Elasticity of Demand (AED):

This type of elasticity focuses on the relationship between customer demand and a seller’s
advertising. It’s a measure of advertising effectiveness that assesses whether increases in
advertising elevate customers’ impressions to the point where they respond by buying more.
The formula for AED is:

AED = % change in quantity / % change in advertising

Or

AED = [(Q2–Q1)/Q1] / [(A2–A1)/A1]

Q1 = initial quantity of demand

Q2 = new quantity of demand

A1 = initial advertising expenditure

A2 = new advertising expenditure

Five Categories of Elasticity of Demand

Economists describe elasticity as a spectrum of customer sensitivity, calibrated into five
categories using ―relative‖ and ―perfect‖ to describe the level of elasticity. Any product’s or
service’s elasticity lands in one of the five categories, based on the values produced by the
formulas above and by its demand curve. Because the formulas are independent of each
other, even when applied to the same product, the different types of elasticity — price, cross,
income and advertising — may end up in different categories for the same product or service.
Elastic Demand vs. Inelastic Demand vs. Unitary Elasticity

The elasticity of demand spectrum starts at the left with perfectly inelastic demand, ends at
the right with perfectly elastic demand and has unitary elasticity at its theoretical center. I’ve
used the price elasticity formula — PED — to illustrate the values for each category, because
price elasticity is the most widely used type of elasticity in business and because the other
types can become far more complex to interpret. For example, income elasticity requires
additional dimensions to visualize because different curves apply to people at different
income levels.

Fig. Elasticity as a spectrum, showing change in demand from low sensitivity at left to high sensitivity
at right.

1. Perfectly inelastic demand is when demand does not change, regardless of changes in other
factors. Products that are considered a necessity, with no substitutes, are in this zone, such as
essential foods and lifesaving drugs. Perfectly inelastic demand has a PED of zero.

Fig: Perfectly inelastic demand.

2. Relatively inelastic demand means that it takes large changes in a factor, such as price, to
cause a small change in demand. Gasoline and salt are common examples of relatively
inelastic products. Relatively inelastic demand has a PED of less than one.

Fig: Relatively inelastic demand.

3. Unitary elastic demand is a special case that arises when the impact on demand is an
equal, one-for-one change compared with another factor. For example, a 10% increase in
price causes a 10% decrease in demand quantity. Unitary elastic demand is mostly a
hypothetical concept, as it is unusual to find a product with such perfect correlation. Unitary
elastic demand has a PED of exactly one.

Fig: Unitary elastic demand.

4. Relatively elastic demand means a small change in one factor creates a disproportionately
larger change in demand. For example, if a 5% increase in the price of a streaming service
caused a 10% decrease in subscribers, it would be considered relatively elastic. Most
products and services fall into this zone. Relatively inelastic demand has a PED greater than
one. Higher values indicate greater elasticity.

Fig: Relatively elastic demand.

5. Perfectly elastic demand is the extreme scenario where demand drops 100% due to
changes in one of the factors. This is relatively rare, since characteristics like accessibility,
brand loyalty and quality will often cause some customers to continue to purchase a product.
As an example, if the price of organic bananas goes up at Fred’s Supermarket but not at
Barney’s Grocery, under perfect elasticity of demand no shoppers would purchase the
bananas at Fred’s. However, some customers might decide to pay the higher price to save
time and effort, especially if they believe Fred’s produce is fresher. The result of the PED
calculation for perfect elasticity is infinity — representing the all-or-nothing buying decision.

Fig: Perfectly elastic demand.

Applications Elasticity of demand

Elasticity of demand is influenced by several factors to which customers respond with

differing levels of intensity.

1. Availability of substitutes. When customers perceive that a product lacks significant

differentiation or is easily substituted, the product tends to have a higher elasticity of
demand. This means customers will easily swap one brand for another or one product
for another. A good example is the plethora of breakfast cereal substitutes, from
swapping flakes for O’s to switching to granola bars. The opposite also holds true:
Products that have no substitute, such as gasoline, are highly inelastic.
2. Urgency of purchase. When customers are not in a rush to make a purchase, they can
put it off if prices are increasing. This means there is a higher elasticity of demand for
optional or discretionary purchases. Conversely, when a purchase is urgent, such as
plumbing services for a leaky pipe, customers are more willing to pay a higher price
in return for quicker service. Their viewpoint is inelastic.
3. Duration of price change. Customers react differently to price changes that are
expected to last a short period of time versus a long-term shift. Flash sales that are
perceived to be short-term can cause greater increases in demand than discounts that
are expected to be around longer. Consider the changes in demand around Black
Friday and Cyber Monday.
4. Percentage of income. Purchases that represent a higher percentage of a household
budget tend to be more elastic than those that are smaller. For example, customers
demonstrate a higher level of price elasticity when buying clothing than when
purchasing computer paper. The same percentage of change in price would cause a
greater change in demand for sweaters than for paper because sweaters are a bigger-
ticket item relative to the customer’s income.
5. Necessity. The essential/inessential nature of goods is a primary driver of elasticity.
Customers tend to have unchanging levels of demand for products they consider
essential. Customers will be rigid when purchasing products considered indispensable
for survival or quality of life. Conversely, buying habits tend to be more elastic for
luxury goods. This dynamic occurs, in part, because purchasing necessities cannot be
postponed. Addictive products, such as alcohol, tobacco and drugs, are an extreme
variation of inelasticity caused by necessity.
6. Brand loyalty. When customers have a high level of brand loyalty, they are less
likely to swap brands, resulting in a higher level of inelasticity of demand. This
typically happens when substitutes are perceived to be of inferior quality or a poor
match, so customers are willing to pay a little more rather than reduce their demand.
Marketers focus on these characteristics when positioning their products. Items seen
as commodities, where one brand is the same as the next, have a higher level of
elasticity of demand, and therefore their sales fluctuate more significantly with price.
7. Buyer. The ―other people’s money‖ concept shows that the same product may be
susceptible to different levels of price elasticity depending on who pays for the goods.
Customers tend to be more willing to pay higher prices when they aren’t the one
actually paying for the product, such as for company-reimbursed travel and
entertainment.