ENGINEERING ECONOMICS
ECONOMICS
Economics is the science that deals with the production and
consumption of goods and services and the distribution and rendering
of these for human welfare
The following are the economic goals.
•A high level of employment
• Price stability
•Efficiency
•An equitable distribution of income
• Growth
Some of the goals mentioned are interdependent. The economic goals are not
always complementary; in many cases they are in conflict. For example, any
move to have a significant reduction in unemployment will lead to an increase
in inflation.
Flow in an Economy
The flow of goods, services, resources and money payments in a simple
economy are shown below.
TYPES OF MARKET SITUATION
LAW OF SUPPLY AND DEMAND
The theory of demand and supply is a theory of price and output
determination. In a market economy, individual consumers make plans of
consumption and individual firms make plans of production based on the
changes in market prices.
Analysis of the determination of prices of goods and services in the market is
an indispensable part of the subject matter of economic theory. When an
economy is guided by market mechanism, prices are determined by
interaction between demand and supply forces, that is, they are the result of
decisions taken by buyers and sellers in market place to buy and sell.
TERMS TO UNDERSTAND
Commodity
In economics, a commodity is defined as a tangible good that can be bought
and sold or exchanged for products of similar value.
Demand
In economics, demand is the quantity of a good that consumers are willing and
able to purchase at various prices during a given time
Supply
Supply is a fundamental economic concept that describes the total amount of a
specific good or service that is available to consumers.
Necessities
In economics, a necessity good or a necessary good is a type of normal good.
Necessity goods are product and services that consumers will buy regardless
of the changes in their income levels, therefore making these products less
sensitive to income change.
Luxury
In economics, a luxury good is a good for which demand increases more than
what is proportional as income rises, so that expenditures on the good become
a greater proportion of overall spending. Luxury goods are in contrast to
necessity goods, where demand increases proportionally less than income.
Scarcity
Scarcity is one of the key concepts of economics. It means that the demand for
a good or service is greater than the availability of the good or service.
Therefore, scarcity can limit the choices available to the consumers who
ultimately make up the economy
Utility
It is a measure of satisfaction an individual gets from the consumption of the
commodities. In other words, it is a measurement of usefulness that a
consumer obtains from any good. Utility is a subjective thing. It depends upon
the mental assessment of the consumer and is determined by several factors
which influence the consumer's judgment. These factors include, for example,
the intensity of the want(s) to be satisfied. Utility of a good varies with the
intensity of the want to be satisfied by its consumption. This fact leads to a few
important inferences.
● Utility of a good differs from consumer to consumer. This is because a
given want can be felt in different intensities by different consumers.
● The utility of a good keeps changing even for the same consumer on
account of changes in the intensity of the want(s) to be satisfied by its
use. This change may be the result of a shift in the circumstances faced
by the consumer, or it may take place in the process of the satisfaction of
the want itself.
● The utility of a good is not to be equated with its usefulness. Satisfaction
of a want need not add to the welfare of the consumer.
In economics, we are not concerned with the 'normative' aspect of utility. It
does not matter whether its consumption adds to their well-being or not. So
long as the consumers expect to derive some 'satisfaction' from a good (that is,
so long the good has a 'utility' for them), they will be ready to buy it at some
price and create a demand for it in the market.
MEANING OF DEMAND
The quantity demanded is the amount of a product people are willing to buy
at a certain price. Demand for a good by a consumer is not the same thing as
his desire to buy it. A desire becomes a demand only when it is 'effective'
which means that, given the price of the good, the consumer should be both
willing and able to pay for the quantity which he wants to buy.
Thus three things are essential for a desire for a commodity to become
effective demand.
➔ desire for a commodity
➔ willingness to pay
➔ ability to pay for the commodity
LAW OF DEMAND
The consumer's decisions are guided by several elements, such as price,
income, tastes and preferences etc. Among the many causal factors affecting
demand, price is the most significant and the price-quantity relationship
called as the Law of Demand is stated as follows in the graph.
Ceteris Paribus'; “all other things being equal”
• With a change in the price of the good, the consumer changes the quantity
purchased by him.
• The quantity demanded must be related to the time interval over which it is
purchased.
EXEMPTIONS TO THE LAW OF DEMAND P↑D↓: P↓D↑
• Expected Change in the Price of a Good
• The consumer may not consider a good as 'normal' or 'superior'.
➢ Normal Goods (Income↑, Demand↑)
➢ Inferior Goods (Income↑, Demand↓)
➢ Giffen Goods (no substitute)
➢ Ignorance (it is efficient when the Price↑, thus follows the Demand↑)
➢ Conspicuous Consumption/ Veblen (social status)
• Change in Fashion
• Complementary Goods (pair of products, ex.
Customer (goods)
Client (services)
Factors influencing demand
The shape of the demand curve is influenced by the following factors:
• Price of the Commodity
• Prices of Related Commodities
■ Substitute goods
■ Complement goods
•Levels of Income
•Expected Change in Price
• Other factors:
■ Size of population
■ the marketing and sale campaigns by the suppliers
■ the tastes and preferences of the buyers
■ and distribution of income and wealth
MEANING OF SUPPLY
Supply represents how much the market can
offer. The quantity supplied refers to the amount
of a good producers are willing to supply when
receiving a certain price. The supply of a good or
service refers to the quantities of that good or
service that producers are prepared to offer for
sale at a set of prices over a period of time.
LAW OF SUPPLY
The law of supply states that a firm will produce and offer to sell greater
quantity of a product or service as the price of that product or services rises,
other things being equal. There is a direct relationship between price and
quantity supplied.
Ceteris Paribus':
• With an increase in the price of the good, the producer is willing to offer
more of goods in the market for sale.
• The quantity supplied must be related to the specified time interval over
which it is offered.
EXEMPTIONS TO THE LAW OF SUPPLY P↑S↑: P↓S↓
• Expected Change in the Price of a Good (when the price is higher, inc. in
supply)
• Monopoly (controls the supply) ex. Current
• Competition
• Perishable Goods ( frozen products, seasonal fruits) P↓S↑
• Legislation Restricting Quantity
• Agricultural Products
• Artistic and Auction Goods (social status, limited edition)
Factors affecting Supply
• Costs of the Factors of Production
■ Inputs
■ Process
■ Output
• Changes in Technology
• Price of Related Goods (Substitutes)
• Change in the Number of Firms in the Industry (Market) Taxes and
Subsidies
• Goal of a Business Firm
• Natural Factors
■ weather
• Changes in Producer or Seller Expectations
• Government Intervention
DETERMINATION OF EQUILIBRIUM PRICE AND QUANTITY
In economics, equilibrium is a situation in which:
➢ there is no inherent tendency to change
➢ quantity demanded equals quantity supplied
➢ the market clears itself and becomes stable
➢ equilibrium price is the price at which the demand is equal to supply.
DETERMINATION & SUPPLY SCHEDULE FOR COMMODITY OR
GOOD X
Effect of Changes in Demand Effect of Change in Supply
and Supply on Market Price on Market Price
LAWS OF DEMAND & SUPPLY IN A FREE MARKET
➤Excess demand for a commodity will cause a rise in its price.
➤ Excess supply of a commodity will cause a fall in its price.
➤ Price will settle at one point where the quantity demanded equals the
quantity supplied-the equilibrium price.
➤An increase in demand will cause a rise in price and a rise in the quantity
bought and sold.
➤A decrease in demand will cause a fall in price and a fall in the quantity
bought and sold.
➤ An increase in supply will cause a fall in price and a rise in the quantity
bought and sold.
➤ A decrease in supply will cause a rise in price and a fall in the quantity
bought and sold.
ELASTICITY
In economics, elasticity measures the responsiveness of one economic variable
to a change in another.
ELASTICITY OF DEMAND
Elasticity of demand is mainly of three types:
• Price Elasticity of Demand
• Cross Price Elasticity of Demand
• Income Elasticity of Demand
PRICE ELASTICITY OF DEMAND
Price elasticity of demand (PED) is a measure of the responsiveness of the
quantity of a good or service demanded to changes in its price. It is calculated
by taking the percentage change in the quantity demanded and dividing it by
the percentage change in price. Elasticity of demand differs with different
commodities. For the same commodity, elasticity of demand differs from
person to person.
There are five cases of Elasticity of Demand in which it responds:
• Perfectly elastic demand: E=
• Perfectly inelastic demand: E=0
• Relatively elastic demand: E>1
• Relatively inelastic demand: E<1
• Unitary elastic demand: E=1
DETERMINANTS OF PRICE ELASTICITY OF DEMAND
➔ Price Level
➔ Availability of Substitutes
➔ Time Period
➔ Proportion of Total Expenditure Spent on the Product
➔ Habits
➔ Nature of the Commodities
➔ Various Uses
➔ Postponing Consumption
CROSS PRICE ELASTICITY IN DEMAND
The coefficient of cross elasticity of demand measures the percentage change
in the demand of GOOD X which is shift of the demand curve, in response to
a percentage change in the price of GOOD Y GOOD X and Y may be related
in two ways, substitutes and complements.
Coefficient is positive, substitute. EC is negative, complements
INCOME ELASTICITY OF DEMAND
Income elasticity of demand refers to the sensitivity of the quantity demanded
for a certain good to a change in the real income of consumers who buy this
good.
(Change in quantity / Initial quantity of product) / (Change in income / Initial
income) = Elasticity
It is noteworthy that sign of income elasticity of demand is associated with the
nature of the good in question.
Normal Goods: Normal goods have a positive income elasticity of demand so
as consumers' income rises, demand also increases.
➤Normal necessities have an income elasticity of demand between 0 and 1.
➤ Luxuries have an income elasticity of demand, Ed>1 i.e. The demand rises
more than percentage change in income.
Inferior goods: Inferior goods have a negative income elasticity of demand.
Demand falls as income rises.
PRICE ELASTICITY OF SUPPLY
Price elasticity of supply (PES) indicates how quickly producers shift
production levels in response to price changes. Economic theory predicts that
when prices rise, producers will want to increase the quantity supplied to sell
more at higher prices.
To be more precise, the elasticity of supply is defined as a percentage change
in the quantity supplied of a product divided by the percentage change in
price.
There are five cases of elasticity of supply in which it responds:
•Perfectly Elastic Supply: E=
• Perfectly Inelastic Supply: E=0
• Relatively Elastic Supply: E>1
• Relatively Inelastic Supply: E<1
• Unitary Elastic Supply: E=1
DETERMINANTS OF PRICE ELASTICITY OF SUPPLY
➔ Time Period
➔ Ability to Store Output
➔ Factor Mobility
➔ Cost Relationships
➔ Excess Supply
*Elastic- we can store
Inelastic- we cannot store
