notes on engineering economics unit i

UNIT‐1Introduction to Engineering Economics and Managerial Economics (5 Hrs.)

05/02/2023Deepak Srivastava

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UNIT‐1: INTRODUCTION TO ENGINEERING ECONOMICS AND MANAGERIAL ECONOMICS (5 HRS.)

• Concept of Efficiency• Theory of Demand, Elasticity of Demand,• Supply and Law of Supply• Indifference Curves, Budget Line, Welfare Anal

ysis • Scope of Managerial Economics• Techniques and

Applications of Managerial Economics.


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WHAT İS EFFİCİENCY?

•Efficiency is a level of performance that describes a process that uses the lowest amount of inputs to create the greatest amount of inputs.


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EFFICIENCY• In popular discussion, business decision

making, and government policies, three different types of efficiency concepts are encountered. These are engineering, technical, and economic efficiency. Each is a valid concept, and each conveys useful information.


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ENGINEERING EFFICIENCY

• Engineering efficiency refers to the physical amount of some single key input that is used in production. It is measured by the ratio of that input to output.• For example:• The engineering efficiency of an engine refers to the

ratio of the amount of energy in the fuel burned by the engine to the amount of usable energy produced by the engine.


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ENGINEERING EFFICIENCY

• Saying that a steam engine is 40 percent efficient means that 40 percent of the energy in the fuel that is burned in the boiler is converted into work that is done by the engine, while the other 60 percent is lost. • Note that engineering efficiency is expressed in

terms of the use of a single input and does not involve financial considerations—it is purely about physical relationships.


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TECHNICAL EFFICIENCY

•Technical efficiency is related to the physical amount of all factors used in the process of producing some product.• A particular method of producing a given level

of output is technically efficient if there are no other ways of producing the output that use less of at least one input while not using more of any others.


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EXAMPLE…• For example, consider a firm that is currently

using 100 units of labour and 50 units of capital to produce a certain level of output. If the firm could maintain its current output level by using only 90 units of labour without using more capital, then it is being technically inefficient in its current methods because it is “wasting” 10 units of labour.


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ECONOMIC EFFICIENCY

•Economic efficiency is related to the value (rather than the physical amounts) of all inputs used in producing a given output.• The production of a given output is economically efficient if there are no other ways of producing the output that use a smaller total value of inputs.


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EXAMPLE…• For example, a firm may have several alternative

production methods that it could use. One may require a lot of labour but only a little capital whereas another requires a lot of capital and only a little labour. A third production method may require a lot of land but relatively little of both labour and capital. In order to maximize its profits, the firm should choose the production method that costs the least.


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THEORY OF DEMAND…

• Theory of Demand• What is demand ?• “Demand for anything means the quantity of that commodity, which

is desired to be bought, at a given price, per unit of time.”• It is interpreted as your want backed up by your purchasing power.

Demand for a commodity

implies:

Desire to acquire it,

Willingness to pay for it, and

Ability to pay for it.


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TYPES OF DEMAND.Direct and derived demand

Recurring and replacement demand

Complementary and competing demand

Demand for capital goods and consumer goods

Demand for perishable goods and durable goods

Individual and market demand


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DETERMINANTS OF DEMAND

• The demand for a commodity arises from the consumer’s willingness and ability to purchase the commodity. The demand theory says that the quantity demanded of a commodity is a function of or depends on not only the price of a commodity, but also on income of the person, price of related goods – both substitutes and complements – tastes of consumer, price expectation and all other factors. Demand function is a comprehensive formulation which specifies the factors that influence the demand for the product.


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DETERMINANTS OF DEMAND

Dx = Demand for item x

Px = Price of item x

Py = Price of substitutes

Pz = Price of complements

B = Income of consumer

E = Price expectation of the user

A = Advertisement Expenditure

T = Taste or preference of user Notes

U = All other factors


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THE DEMAND FUNCTION

Dx = f(Px, Py, Pz, B, A, E, T, U)


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THE RELATIONSHIP…


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DEMAND SCHEDULE AND DEMAND CURVE

• A demand curve considers only the price-demand relation, other factors remaining the same. The inverse relationship between the price and the quantity demanded for the commodity per time period is the demand schedule for the commodity and the plot of the data (with price on the vertical axis and quantity on the horizontal axis) gives the demand curve of the individual.


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Demand for X

0

0.5

1

1.5

2

2.5

Demand CurvePr

ice

of X


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2.3 ELASTICITY OF DEMAND

• 2.3 Elasticity of Demand and its measurement. • Price Elasticity.• Income Elasticity. • Cross Elasticity and • Advertising Elasticity.


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ELASTICITY OF DEMANDIntroduction Elasticity is the measure of responsiveness.

It is the ratio of the percent change in one variable to the percent change in another variable.

The key thing to understand is that we use elasticity when we want to see how one thing changes when we change something else.

How does demand for a good change when we change its price?

How does the demand for a good change when the price of a substitute good changes?


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CONCEPT OF ELASTICITY

The law of demand tells us that consumers will respond to a price decline by buying more of a product. It does not, however, tell us anything about the degree of responsiveness of consumers to a price change. The contribution of the concept of elasticity lies in the fact that it not only tells us that consumer's demand responds to price changes but also the degree of responsiveness of consumers to a price change. The figure shows two demand curves. Let Da be the demand for cheese in Switzerland and Db be the demand for cheese in England.


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CLASSIFICATION OF DEMAND CURVES ACCORDING TO

THEIR ELASTICITIESDepending on how the total revenue changes, when price changes we can classify all demand curves in the following five categories:1. Perfectly inelastic demand curve

2. Inelastic demand curve

3. Unitary elastic demand curve

4. Elastic demand curve

5. Perfectly elastic demand curve


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Perfectly Inelastic Demand : These are certain goods like salt, match box etc. whose demand neither increase nor decrease with a change in price.

A perfectly inelastic demand curve is a vertical straight line parallel to Y –axis which shows that whatever may be the change in price the demand will remain constant at OQ.


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Perfectly Elastic Demand : That is [ed = ∞]. When the quantity demanded of a commodity changes infinitely due to a slight or no decrease in price, such goods are said to have perfectly elastic demand.

A perfectly Elastic Demand Curve is a straight line parallel to X –axis.


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Relatively Inelastic Demand (ed < 1)In this type of goods and services the proportionate change in quantity demand is less than the change in price. These are mostly essential goods of daily use like rice, wheat etc.

In the diagram change in quantity QQ1 is less than proportionate to the change in price PP1.


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Relatively Elastic Demand : In such type of goods the percentage change in quantity demanded of a commodity is more than proportionate to the percentage change in price, eg. luxury car.

In the diagram we see that change in quantity demanded QQ1 is more than proportionate to the change in price PP1.


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Unit Elastic Demand (ed = 1)Here the rate of change in demand is exactly equal to the rate of change in price. Therefore the products or service with unit elasticity are neither elastic nor inelastic.

A Unit elastic Demand curve is a rectangular - hyperbola as shown above


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NUMERICAL MEASUREMENT OF ELASTICITY

• What does it mean when we say that the elasticity of demand is 0.5? 0.4? 2.3? To answer this question we have to examine the following definition for elasticity coefficient, Ed.


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SUPPLY AND LAW OF SUPPLY

• Supply• Supply is the specific quantity of output that the producers are willing and

able to make available to consumers at a particular price over a given period of time. In one sense, supply is the mirror image of demand. Individuals’ supply of the factors of production or inputs to market mirrors other individuals’ demand for these factors. For example, if we want to rest instead of weeding the garden, we hire someone: we demand labour. For a large number of goods, however, the supply process is more complicated than demand.

• The supply of produced goods (tangibles) is usually indirect and the supply of non-produced goods (intangibles) is more direct. Individuals supply their labour in the form of services directly to the goods market. For example, an independent contractor may repair a washing machine. The contractor supplies his labour directly.


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LAW OF SUPPLY• According to the Law of Supply, other things remaining constant,

higher the price of a commodity, higher will be the quantity supplied and vice versa. There is a positive relationship between supply and price of a commodity.


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MARKET EQUILIBRIUMPRICE IS DETERMINED BY THE TWO FORCES OF DEMAND AND SUPPLY, IN A FREE MARKET. A POINT OF BALANCE, WHERE DEMAND EQUALS SUPPLY IS KNOWN AS MARKET EQUILIBRIUM.


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INDIFFERENCE CURVES• An indifference curve may be defined as the locus of points.

Each point represents a different combination of two substitute goods, which yields the same utility or level of satisfaction to the consumer. Therefore, he/she is indifferent between any two combinations of goods when it comes to making a choice between them. Such a situation arises because he/she consumes a large number of goods and services and often finds that one commodity can be substituted for another. This gives him/her an opportunity to substitute one commodity for another, if need arises and to make various combinations of two substitutable goods which give him/her the same level of satisfaction. If a consumer faced with such combinations, he/she would be indifferent between the combinations.


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FIGURE BELOW SHOWS THE INDIFFERENCE CURVE DRAWN ON THE BASIS OF THE FIGURE GIVE IN TABLE. IT DEPICTS, IN GENERAL, ALL COMBINATIONS OF TWO GOODS WHICH YIELD THE SAME LEVEL OF SATISFACTION TO THE CONSUMER. THE CONSUMER IS INDIFFERENT ABOUT ANY TWO POINTS LYING ON THIS CURVE.


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ASSUMPTIONS• The following assumptions about the consumer psychology are implicit

in indifference curve analysis:• Transitivity: If a consumer is indifferent to two combinations of two

goods, then he is unaware of the third combination also.• Diminishing marginal rate of substitution: The rarer the availability of

a good, the greater is its substitution value. For example, water has a high substitution value as it is a scarce resource.

• Rationality: The consumer aims to maximise his total satisfaction and has got complete market information.

• Ordinal utility: Utility in this approach is not measurable. A consumer can only specify his preference for a particular combination of two goods, he cannot specify how much.


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PROPERTIES OF INDIFFERENCE CURVE

• Indifference curves have the four basic characteristics:• 1. Indifference curves have a negative slope• 2. Indifference curves are convex to the origin• 3. Indifference curves do not intersect nor are they tangent to one

another• 4. Upper indifference curves indicate a higher level of satisfaction.

• These characteristics or properties of indifference curves, in fact, reveal the consumer’s behaviour, his choices and preferences. They are, therefore, very important in the modern theory of consumer behaviour. Now, we will observe their implications.


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BUDGET LINE• THE BUDGET CONSTRAINT Having described preferences,

next we determine the consumer’s alternatives. The amount of goods he can purchase depends on his available income and the goods’ prices. Suppose the consumer sets aside Rs. 200 each week to spend on the two goods. The price of good X is Rs. 40 per unit, and the price of Y is Rs. 20 per unit. Then he is able to buy any quantities of the goods (call these quantities X and Y) as long as he does not exceed his income. If he spends the entire Rs. 200, his purchases must satisfy:

40X + 20Y = 200


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CONSUMER EQUILIBRIUM

• If we superimpose the indifference map and budget line as in Figure shown above, we find that a consumer has to decide to purchase a particular combination (C) as it falls on his budget line, though a different combination (D) would be more desirable as it will give a higher level of satisfaction. At his point of equilibrium C, the price line is touching the indifference line tangentially meaning that the slopes are equal. The slope of indifference curve indicates the marginal rate of substitution between X and Y, and the slope of budget line indicates the ratio of price of X to that of Y. Thus the principle of consumer's equilibrium works out; the marginal rate of substitution between X and Y must be proportional to the ratio of price of X to that of Y.


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SCOPE OF MANAGERIAL ECONOMICS

• Study of managerial economics essentially involves the analysis of certain major subjects like:• Demand analysis and methods of forecasting• Cost analysis• Pricing theory and policies• Profit analysis with special reference to break-even point• Capital budgeting for investment decisions• The business firm and objectives• Competition.


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There are four groups of problem in both decision making and forward

planning.

Resource allocation

Inventory and

queuing problem

Pricing problems

Investment problems


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• A firm applies principles of economics to answer these questions. The first question relates to what goods and services should be produced and in what quantities. Demand theory guides the manager in the selection of goods and services for production. It analyses consumer behavior with regard to:• Type of goods and services they are likely to purchase in the

current period and in the future, Goods and services which they may stop consuming,

• Factors influencing the consumption of a particular good or service, and

• The effect of a change in these factors on the demand of that particular good or service.


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SCOPE OF ECONOMICS • Microeconomics• Macroeconomics• International economics• Public finance• Development economics• Health economics• Environmental economics• Urban and rural economics


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MICRO & MACROECONOMICS

• Subject- matter of economics can be sub- divided in to Microeconomics and Macroeconomics.

• These terms were first coined and used by Ragnar Frisch.• Acc. To K E Boulding:

• “Microeconomics is the study of particular firms, particular households, individual prices, wages, incomes, individual industries, particular commodities.”

• “Macroeconomics deals not with individual quantities as such but with aggregates of these quantities, not with individual incomes but with national income; not with individual prices but with general price level; not with individual output but with national output.”


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MANAGERIAL ECONOMICS AND ITS RELEVANCE IN BUSINESS

DECISIONS.• To quote Mansfield, "Managerial Economics is concerned with the application of

economic concepts and economic analysis to the problems of formulating rational managerial decisions."

• According to McNair and Meriam, "Managerial economics is the use of economic modes of thought to analyse business situations."

• "Managerial Economics is concerned with the application of economic principles and methodologies to the decision making process within the firm or organisation under the conditions of uncertainty," says Prof. Evan J Douglas.

• Spencer and Siegelman define it as "The integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management."

• According to Hailstones and Rothwel, "Managerial economics is the application of economic theory and analysis to practice of business firms and other institutions."


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MANAGERIAL ECONOMICS

• Coordination• An activity or an ongoing

process• A purposive process• An art of getting things

done by other people.

Management

• Human wants are virtually unlimited and insatiable, and

• Economic resources to satisfy these human demands are limited.

Economics• Thus managerial

economics is the study of allocation of resources available to a firm or a unit of management among the activities of that unit.

Managerial Economics


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RELATIONSHIP OF MANAGERIAL ECONOMICS WITH DECISION SCIENCES

• Economics is linked with various other fields of study like:

• Operation Research• Theory of Decision Making• Statistics• Management Theory and Accounting

• Satisficing instead of maximizing• Managerial Accounting

Economics and other Disciplines


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BASIC TOOLS OF MANAGERIAL

ECONOMICS FOR DECISION MAKING

Business decision making is essentially a process of selecting the best out of alternative opportunities

open to the firm.

The steps in next slides put managers’ analytical ability to test and determine the appropriateness

and validity of decisions in the modern business world.

1. Establish objectives

2. Specify the decision problem

3. Identify the alternatives

4. Evaluate alternatives

5. Select the best alternatives

6. Implement the decision

7. Monitor the performance

Modern business conditions are changing so fast and becoming so competitive and complex that personal business sense, intuition and experience alone are not sufficient to make appropriate business decisions. It is in this area of decision making that economic theories and tools of economic analysis contribute a great deal.

Economic theory offers a variety of concepts and analytical tools which can be of considerable assistance to the managers in his decision making practice. These tools are helpful for managers in solving their business related problems. These tools are taken as guide in making decision.

• Opportunity cost

• Incremental principle

• Principle of the time perspective

• Discounting principle

• Equi-marginal principle


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OPPORTUNITY COST• An opportunity cost refers to a benefit that a

person could have received, but gave up, to take another course of action. Stated differently, an opportunity cost represents an alternative given up when a decision is made. This cost is therefore most relevant for two mutually exclusive events, whereby choosing one event, a person cannot choose the other.


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INCREMENTAL PRINCIPLE

• The incremental concept is probably the most important concept in economics and is certainly the most frequently used in Managerial Economics. Incremental concept is closely related to the mar ginal cost and marginal revenues of economic theory.

• The two major concepts in this analysis are incremental cost and incremental revenue. Incremental cost denotes change in total cost, whereas incremental revenue means change in total revenue resulting from a decision of the firm.

• The incremental principle may be stated as follows:• A decision is clearly a profitable one if

• It increases revenue more than costs.• It decreases some cost to a greater extent than it increases others.• It increases some revenues more than it decreases others.• It reduces costs more than revenues


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PRINCIPLE OF THE TIME PERSPECTIVE

• “a decision by the firm should take into account of both short-run and long-run effects on revenues and cost & maintain the right balance between the long run and short run.

• Short-run refers to a time period in which some factors are fixed while others are variable. The production can be increased by increasing the quantity of variable factors. While long-run is a time period in which all factors of production can become variable.

• Entry and exit of seller firms can take place easily. From consumers point of view, short-run refers to a period in which they respond to the changes in price, given the taste and preferences of the consumers, while long-run is a time period in which the consumers have enough time to respond to price changes by varying their tastes and preferences.


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DISCOUNTING PRINCIPLE

• This concept is an extension of the concept of time perspective. Since future is unknown and incalculable, there is lot of risk and uncertainty in future. Everyone knows that a rupee today is worth more than a rupee will be two years from now. This appears similar to the saying that “a bird in hand is more worth than two in the bush.” This judgment is made not on account of the uncertainty surround ing the future or the risk of inflation.

• It is simply that in the intervening period a sum of money can earn a return which is ruled out if the same sum is available only at the end of the period. In technical parlance, it is said that the present value of one rupee available at the end of two years is the present value of one rupee available today. The mathematical technique for adjusting for the time value of money and computing present value is called ‘discounting’.


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EQUI-MARGINAL PRINCIPLE

• An optimum allocation cannot be achieved if the value of the marginal product is greater in one activity than in another. It would be, therefore, profitable to shift labour from low marginal value activity to high marginal value activity, thus increasing the total value of all products taken together.

• If, for example, the value of the marginal product of labour in activity A is Rs. 50 while that in activity В is Rs. 70 then it is possible and profitable to shift labour from activity A to activity B. The optimum is reached when the values of the marginal product is equal to all activities. This can be expressed symbolically as follows:• VMPLA = VMPLB = VMPLC = VMPLD = VMPLE

• Where VMP = Value of Marginal Product.• L = Labour

• ABCDE = Activities i.e., the value of the marginal product of labour employed in A is equal to the value of the marginal product of the labour employed in В and so on. The equimarginal principle is an extremely practical notion.

notes on engineering economics unit i

Economy & Finance