Introduction to Engineering Economics

Introduction to Economics:

The science of economics has assumed greater significance in view of the fact that knowledge of
economics is being used for controlling inflation, reducing unemployment and accelerating growth in
the economies of the world. In developing countries like India, the knowledge of economics is being
used to devise strategies and policies to eradicate poverty and cronic unemployment from the
human race. Besides, the nature of so many other problems such as food shortage, stagnation and
recession, population explosion, adverse balance of payments and so on that confront the
economies of today cannot be understand and solution for them cannot be provided without the
adequate knowledge of the science of economics.

Economics is mainly concerned with the achievement and use of material requirements to satisfy
human want. Human wants are unlimited and productive resources such as land, natural resources,
skilled labour, raw materials, capital equipments with which to produce goods and services to satisfy
these wants are scarce or limited. This give rise to the problem of how to use scarce resources to
attain maximum possible satisfaction to the people.

“Economics is a science which studies human behaviour as a relationship between unlimited wants
and scarce resources which have alternative uses. To use and allocation of scarce resources to
produce goods and services has to be such as would maximize satisfaction.”

From this definition, one can build up the following propositions:

(i) Human wants are unlimited; wants multiply—luxuries become necessities. There is no end of
wants. If food were plentiful, if there were enough capital in business, if there were abundant
money and time—there would not have been any scope for studying economics. Had there been
no wants there would not have been any human activity. Prehistoric people had wants. Modern
people also have wants. Only wants change—and they are limitless.

(ii) The means or the resources to satisfy wants are scarce in relation to their demands. Had
resources been plentiful, there would not have been any economic problems. Thus, scarcity of
resources is the fundamental economic problem to any society. Even an affluent society
experiences resource scarcity. Scarcity of resources gives rise to many ‘choice’ problems.

(iii) Since the prehistoric days one notices constant effort of satisfying human wants through the
scarcest resources which have alternative uses. Land is scarce in relation to demand. However,
this land may be put to different alternative uses.

A particular plot of land can be either used for jute cultivation or steel production. If it is used for
steel production, the country will have to sacrifice the production of jute. So, resources are to be
allocated in such a manner that the immediate wants are fulfilled. Thus, the problem of scarcity of
resources gives rise to the problem of choice.

Society will have to decide which wants are to be satisfied immediately and which wants are to be
postponed for the time being. This is the choice problem of an economy. Scarcity and choice go hand
in hand in each and every economy: “It exists in one-man community of Robinson Crusoe, in the
patriarchal tribe of Central Africa, in medieval and feudalist Europe, in modern capitalist America
and in Communist Russia.”

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The Economic Problem

The Problem of Scarcity:

We live in a world of scarcity. People want and need variety of goods and services. This applies
equally to the poor and the rich people. It implies that human wants are unlimited but the means to
fulfil them are limited. At any one time, only a limited amount of goods and services can be
produced. This is because the existing supplies of resources are extremely inadequate. These
resources are land, labour, capital and entrepreneurship. We explain them below in some detail.

Land: Economists include in the category of land all sorts of naturally occurring resources, such as
water, minerals, climate and forests, as well as the actual physical expanse of land. These resources
are all limited and society has to weigh how best to use them. That’s why, for example, there is a
need to be careful about water consumption, and some businesses assess water risk when they plan
new facilities or relocation projects.

Labour: Labor represents all physical and mental abilities which people can make available for
production of goods and services. An organization may be able to produce more quantities by
employing more workers. However, the workers will have to be paid wages, and the business will
have to decide whether the costs of employing more workers are outweighed by the benefits. If the
business decides the benefits of employing more workers outweigh the costs, it will employ more
workers.

Capital: Capital refers to man-made resources of production. Capital includes equipment, factory-
buildings, all sorts of tools, machines, roads, dams, transport buses, trucks etc. These are often
called capital goods which help in the production of further goods and services.

It is important to note that money, shares and bonds are also often called capital. But they do not
represent physical or real capital which helps in further production of goods and resources. Since
with money or shares and bonds, we can purchase capital goods or other resources, they are called
money capital or financial capital. Thus, real capital is different from money capital.

Entrepreneurship: entrepreneurship represents a special human resource which provides his

entrepreneurial capabilities or what is called enterprise. It is who initiates and organize the
production process by combining other resources such as land, labour and capital. Another
important task of an entrepreneur is to introduce innovations such as the use of new and better
techniques of production, launching of new products.

These factors of production or inputs are used in producing goods and services that are called
economic goods which have a piece. There are mainly four types of economic goods or output:

1. Consumer goods: The consumer goods are tangible commodities such as food grains, cloth, cars,
shoes, which are produced with resources. There are single-use consumer goods such as food,
milk etc. which are used up in a single act of consumption. There are durable-use consumer
goods such as a car, a house, computer which are used over and over again for a long period of
time.

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2. Services: The second type of output is services which are intangible such as education provided
by a teacher, health services given by a doctor, Telecommunication services etc. They also
provide direct satisfaction to the people.

3. Capital goods: Capital goods are not used for direct satisfaction of wants of the people but, they
are used for producing other goods.

4. Raw materials and intermediate goods: These are also not used for direct satisfaction of wants
of the people but, they are used for production of either consumer goods and services or capital
goods.

These facts explain scarcity as the principal problem of every society and suggest the Law of Scarcity,
The law states that human wants are virtually unlimited and the resources available to satisfy these
wants are limited.

The Problem of Choice:

Since are live in a world of scarcity, a society can produce only a small portion of goods and services
that its people want. Therefore, scarcity of resources gives rise to the fundamental economic
problem of choice. As a society cannot produce enough goods and services to satisfy all the wants of
its people, it has to make choices.

A decision to produce one good requires a decision to produce less of some other good. So choice
involves sacrifice. Thus every society is faced with the basic problem of deciding what it is willing to
sacrifice to produce the goods it wants the most.

For instance, the more roads a country decided to construct the fever resources will there be for
building schools. So the problem of choice arises when there are alternative ways of producing other
goods. The sacrifice of the alternative (school buildings) in the production of a good (roads) is called
the opportunity cost.

There are fee main categories of choices that a society must make:

1. What to goods and services produce and in what quantities?

2. How to produce these goods and services?

3. For whom to product them?

4. How efficiently are the resources being utilized?

5. Is the economy growing?

Why do engineers need to learn about economics?

Ages ago, the most significant barriers to engineers were technological. The things that engineers
wanted to do, they simply did not yet know how to do, or hadn't yet developed the tools to do.
There are certainly many more challenges like this which face present-day engineers. However, we
have reached the point in engineering where it is no longer possible, in most cases, simply to design

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 and build things for the sake simply of designing and building them. Natural resources (from which
we must build things) are becoming more scarce and more expensive. We are much more aware of
negative side-effects of engineering innovations (such as air pollution from automobiles) than ever
before.

For these reasons, engineers are tasked more and more to place their project ideas within the larger
framework of the environment within a specific planet, country, or region. Engineers must ask
themselves if a particular project will offer some net benefit to the people who will be affected by
the project, after considering its inherent benefits, plus any negative side-effects (externalities), plus
the cost of consuming natural resources, both in the price that must be paid for them and the
realization that once they are used for that project, they will no longer be available for any other
project(s).

Simply put, engineers must decide if the benefits of a project exceed its costs, and must make this
comparison in a unified framework. The framework within which to make this comparison is the
field of engineering economics, which strives to answer exactly these questions, and perhaps more.
The Accreditation Board for Engineering and Technology (ABET) states that engineering "is the
profession in which a knowledge of the mathematical and natural sciences gained by study,
experience, and practice is applied with judgment to develop ways to utilize, economically, the
materials and forces of nature for the benefit of mankind".1

It should be clear from this discussion that consideration of economic factors is as important as
regard for the physical laws and science that determine what can be accomplished with engineering.

1. Physical Environment : Engineers produce products and services depending on physical laws (e.g.
Ohm's law; Newton's law).

Physical efficiency takes the form:

system output(s)

Physical (efficiency ) = -------------------

system input(s)

2. Economic Environment : Much less of a quantitative nature is known about economic environments
-- this is due to economics being involved with the actions of people, and the structure of
organizations.

Satisfaction of the physical and economic environments is linked through production and
construction processes. Engineers need to manipulate systems to achieve a balance in attributes in
both the physical and economic environments, and within the bounds of limited resources.
Following are some examples where engineering economy plays a crucial role:

1. Choosing the best design for a high-efficiency gas furnace

2. Selecting the most suitable robot for a welding operation on an automotive assembly line

3. Making a recommendation about whether jet airplanes for an overnight delivery service should be
purchased or leased

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4. Considering the choice between reusable and disposable bottles for high-demand beverages

With items 1 and 2 in particular, note that coursework in engineering should provide sufficient
means to determine a good design for a furnace, or a suitable robot for an assembly line, but it is the
economic evaluation that allows the further definition of a best design or the most suitable robot.

In item 1 of the list above, what is meant by " high-efficiency"? There are two kinds of efficiency that
engineers must be concerned with. The first is physical efficiency, which takes the form:

System output(s)

Economic (efficiency ) = -----------------

System input(s)

For the furnace, the system outputs might be measured in units of heat energy, and the inputs in
units of electrical energy, and if these units are consistent, then physical efficiency is measured as a
ratio between zero and one. Certain laws of physics (e.g., conservation of energy) dictate that the
output from a system can never exceed the input to a system, if these are measured in consistent
units. All a particular system can do is change from one form of energy (e.g. electrical) to another
(e.g., heat). There are losses incurred along the way, due to electrical resistance, friction, etc., which
always yield efficiencies less than one. In an automobile, for example, 10-15% of the energy supplied
by the fuel might be consumed simply overcoming the internal friction of the engine. A perfectly
efficient system would be the theoretically impossible Perpetual Motion Machine!

The other form of efficiency of interest to engineers is economic efficiency, which takes the form:

system worth

Economic (efficiency ) = -----------------

system cost

You might have heard economic efficiency referred to as "benefit-cost ratio". Both terms of this ratio
are assumed to be of monetary units, such as dollars. In contrast to physical efficiency, economic
efficiency can exceed unity, and in fact should, if a project is to be deemed economically feasible.
The most difficult part of determining economic efficiency is accounting for all the factors which
might be considered benefits or costs of a particular project, and converting these benefits or costs
into a monetary equivalent. Consider for example a transportation construction project which
promises to reduce everyone's travel time to work. How do we place a value on that travel time
savings? This is one of the fundamental questions of engineering economics.

In the final evaluation of most ventures, economic efficiency takes precedence over physical
efficiency because projects cannot be approved, regardless of their physical efficiency, if there is no
conceived demand for them amongst the public, if they are economically infeasible, or if they do not
constitute the "wisest" use of those resources which they require.

There are numerous examples of engineering systems that have physical design but little economic
worth (i.e it may simply be too expensive !!). Consider a proposal to purify all of the water used by a
large city by boiling it and collecting it again through condensation. This type of experiment is done
in junior physical science labs every day, but at the scale required by a large city, is simply too costly.

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Scope of Economics

It is a science or an art and a positive science or a normative science. It also covers the subject
matter Scope means province or field of study. In discussing the scope of economics, we have to
indicate whether of economics.

i) Economics - A Science and an Art

a) Economics is a science: Science is a systematized body of knowledge that traces the

relationship between cause and effect. Another attribute of science is that its phenomena
should be amenable to measurement. Applying these characteristics, we find that economics
is a branch of knowledge where the various facts relevant to it have been systematically
collected, classified and analyzed. Economics investigates the possibility of deducing
generalizations as regards the economic motives of human beings. The motives of individuals
and business firms can be very easily measured in terms of money. Thus, economics is a
science. Economics - A Social Science: In order to understand the social aspect of economics,
we should bear in mind that labourers are working on materials drawn from all over the world
and producing commodities to be sold all over the world in order to exchange goods from all
parts of the world to satisfy their wants. There is, thus, a close inter-dependence of millions of
people living in distant lands unknown to one another. In this way, the process of satisfying
wants is not only an individual process, but also a social process. In economics, one has, thus,
to study social behaviour i.e., behaviour of men in-groups.

b) Economics is also an art. An art is a system of rules for the attainment of a given end. A science
teaches us to know; an art teaches us to do. Applying this definition, we find that economics
offers us practical guidance in the solution of economic problems. Science and art are
complementary to each other and economics is both a science and an art.

ii) Positive and Normative Economics is both positive and normative science.

a) Positive science: It only describes what it is and normative science prescribes what it ought to
be. Positive science does not indicate what is good or what is bad to the society. It will simply
provide results of economic analysis of a problem.

b) Normative science: It makes distinction between good and bad. It prescribes what should be
done to promote human welfare. A positive statement is based on facts. A normative
statement involves ethical values. For example, “12 per cent of the labour force in India was
unemployed last year” is a positive statement, which could is verified by scientific
measurement. “Twelve per cent unemployment is too high” is normative statement
comparing the fact of 12 per cent unemployment with a standard of what is unreasonable. It
also suggests how it can be rectified. Therefore, economics is a positive as well as normative
science.

Subject Matter of Economics can be studied through a) traditional approach and (b) modern
approach.

a) Traditional Approach: Economics is studied under five major divisions namely consumption,
production, exchange, distribution and public finance.

1. Consumption: The satisfaction of human wants through the use of goods and services is
called consumption.

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 2. Production: Goods that satisfy human wants are viewed as “bundles of utility”. Hence
production would mean creation of utility or producing (or creating) things for satisfying
human wants. For production, the resources like land, labour, capital and organization are
needed.

3. Exchange: Goods are produced not only for self-consumption, but also for sales. They are
sold to buyers in markets. The process of buying and selling constitutes exchange.

4. Distribution: The production of any agricultural commodity requires four factors, viz., land,
labour, capital and organization. These four factors of production are to be rewarded for
their services rendered in the process of production. The land owner gets rent, the
labourer earns wage, the capitalist is given with interest and the entrepreneur is rewarded
with profit. The process of determining rent, wage, interest and profit is called
distribution. 5. Public finance: It studies how the government gets money and how it
spends it. Thus, in public finance, we study about public revenue and public expenditure.

b) Modern Approach The study of economics is divided into: i) Microeconomics and ii)
Macroeconomics.

1. Microeconomics analyses the economic behaviour of any particular decision making unit
such as a household or a firm. Microeconomics studies the flow of economic resources or
factors of production from the households or resource owners to business firms and flow
of goods and services from business firms to households. It studies the behaviour of
individual decision making unit with regard to fixation of price and output and its reactions
to the changes in demand and supply conditions. Hence, microeconomics is also called
price theory.

According to K.E. Boulding, "Micro economics is the study of a particular firm, household,
individual price, wages, income, individual industry and particular commodity".

The four basic economic questions namely, (1) what goods shall be produced and in what
quantities, (2) how they shall be produced, (3) how the goods and services produced shall
be distributed among the people, (4) whether the production of goods and their
distribution for consumption is efficient fall within the domain of microeconomics. The
whole content of microeconomic theory is presented in the following chart:

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 Microeconomic
Theory

Factor
Theory of
Product Pricing Pricing(Theory of Welfare Economics
International Trade
Distribution)

Theory of Demand
Theory of Wages
Rent Interest Profits
Production & Cost

Importance of Microeconomics

1. Evaluation of economic policies : Importance Of Microeconomics is huge because

Microeconomics is the best means for evaluating the economic policies of the
government,

2. Efficient employment of resources: The main problem faced by the modern

governments is related to the efficient utilization of resources. Economic development
of a country depends to a great extent on the efficient employment of resources.
Micro Economics emphasizes the need for the efficient employment of the scarce but
valuable resources.

3. Growth with stability : Microeconomics helps to achieve the target of growth with
stability. While the developed economies are facing the problems of maintaining
growth rates with stability, the developing economies are making efforts for achieving
growth. Micro Economics is useful in this regard.

4. A boon to business executive : Micro Economics is considered as a boon to the

business executive. Every business executive wants to increase the level of output as
maximum as possible. For this purpose he makes estimation of the total quantity of
goods and services and the total costs involved for their manufacture.

5. Taxation : Microeconomics helps us to understand the complex problems of taxation.

It explains the welfare implications of a tax. It also explains which one of the taxes
decreases the welfare of the society.

6. International trade : Matters relating to international trade, balance of payments,

determination of the exchange value of the domestic currency etc. can be easily
understood with the help of micro economic analysis.

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 7. Prediction : Micro Economics helps us to predict the impact of economic policies of
the government. Because Microeconomics studies closely the minute matters relating
to the nature, causes and consequences of price determination by the government.

8. Construction and use of models: This approach helps us to construct and use different
models for understanding the actual phenomenon.

9. Conditions of economic welfare: Microeconomics involves the study of welfare

economics. It is considered as a basis for examining the conditions of economic
welfare. It suggests various alternatives for eliminating wastage with a view to
achieve maximum social welfare.

2. Macroeconomics studies the behaviour of the economic system as a whole or all the
decision-making units put together. Macroeconomics deals with the behaviour of
aggregates like total employment, gross national product (GNP), national income, general
price level, etc. So, macroeconomics is also known as income theory. Microeconomics
cannot give an idea of the functioning of the economy as a whole. Similarly,
macroeconomics ignores the individual’s preference and welfare. What is true of a part or
individual may not be true of the whole and what is true of the whole may not apply to the
parts or individual decision making units. By studying about a single small-farmer,
generalization cannot be made about all small farmers, say in Tamil Nadu state. Similarly,
the general nature of all small farmers in the state need not be true in case of a particular
small farmer. Hence, the study of both micro and macroeconomics is essential to
understand the whole system of economic activities.

According to K.E. Boulding, "Macroeconomics is the study of the nature, relationship, and
behavior of aggregate and averages of economic quantities."

The various aspects of macroeconomic theory are shown in following chart:

Macroeconomic
Theory

Theory of General Balance of

Theory of Income The Theory of
Price level and Payments and
and Employment Economic Growth
Inflation Foreign Exchange

Importance of Macroeconomics

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 1. It helps to understand the functioning of a complicated modern economic system. It
describes how the economy as a whole functions and how the level of national income
and employment is determined on the basis of aggregate demand and aggregate
supply.

2. It helps to achieve the goal of economic growth, higher level of GDP and higher level
of employment. It analyses the forces which determine economic growth of a country
and explains how to reach the highest state of economic growth and sustain it.

3. It helps to bring stability in price level and analyses fluctuations in business activities. It
suggests policy measures to control Inflation and deflation.

4. It explains factors which determine balance of payment. At the same time, it identifies
causes of deficit in balance of payment and suggests remedial measures.

5. It helps to solve economic problems like poverty, unemployment, business cycles, etc.,
whose solution is possible at macro level only, i.e., at the level of whole economy.

6. With detailed knowledge of functioning of an economy at macro level, it has been

possible to formulate correct economic policies and also coordinate international
economic policies.

7. Last but not the least, is that macroeconomic theory has saved us from the dangers of
application of microeconomic theory to the problems of the economy as a whole.

Difference between Micro and Macroeconomics

The Major Differences between Micro and Macroeconomics are mentioned below:

1. The word ‘Micro’ means small. It is a study of individuals or groups. According to Shapiro,
“Microeconomics deals with small parts of the economy.” It is a piece meal study. On the other
hand, ‘Macro’ means large. It is a study of economy as a whole.

2. Microeconomics is a study of particular households, particular firms, particular industries,

particular commodities, particular prices etc. On the other hand, Macroeconomics deals with
aggregate of these quantities, not with individual incomes but with the national income, not
with individual prices but with the price level, not with individual output but with the national
output.

3. The objective of microeconomics is to maximise utility or maximisation of profit or minimisation

of cost. But the objectives of macroeconomics are full employment, price stability, economic
growth, favourable balance of payments etc.

4. The basis of microeconomics is the price mechanism which operates with the help of demand
and supply forces. These forces help to determine the equilibrium price in the market.

On the other hand, the bases of macroeconomics are the national income, output, employment
and the general price level which are determined by aggregate demand and aggregate supply.

5. Microeconomics is based on the assumption of ‘ceteris paribus’ (It means other things remaining
constant) to explain the various laws. It means microeconomics uses the technique of partial

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 equilibrium analysis which explains the equilibrium conditions of an individual, a firm or an
industry.

But macroeconomics uses the technique of general equilibrium analysis that studies aggregate
economic variables and their interrelations.

6. Microeconomics is a static analysis while macroeconomics is a dynamic analysis.

Microeconomics does not take into account the time element while macroeconomics is based
on time-lags, the rates of change and past and expected values of the variables.

7. The variables of microeconomics are taken as given (or constant) in macroeconomics and the
variables of macroeconomics are taken as given in microeconomics. Microeconomics assumes
full employment, optimum allocation of total resources and general price level as given. But
macroeconomics assumes a situation of less than full employment. It studies under
employment. It takes general price level as variable and assumes price of a particular product or
factor as given.

8. Microeconomic problems are many. It possesses maximum generality and applicability to a wide
range of situations. But macroeconomics seeks practical understanding of an economy. So
macroeconomic problems are relatively few and so are their specific solutions.

9. Under micro study the main problem is of price determination. But under macro study the main
problem is income determination.

10. Micro study is based on the objective of optimum allocation of resources while macro study is
based on the objective of full employment of total resources.

The difference between micro and macroeconomics is a difference of degree and not of kind.

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