Engineering Economics and Finance

(Units 4 - 10)

Unit 4
Introduction to Economics
 Course Objective (Units 4 - 10)

To introduce basic concepts of economics with

emphasis on using tools to perform economic
evaluation
 Topics to be Covered
Unit No. Topics to be Covered
4 Introduction to Economics

5 Economic Growth and Development

6 Inflation and Recession

7 Taxation

8 Consumer Behaviour Analysis

9 Supply and Demand Analysis

Decision Making under Risk and Uncertainty
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 Recommended Reading Material
• Principles of Macroeconomics - N. Gregory Mankiw
• Microeconomics (8th Edition) - Robert S. Pindyck and
Daniel L. Rubinfeld, Pearson
• Economics for Dummies- Peter Antonioni and Sean Masaki
Flynn, Wiley
INTRODUCTION TO ECONOMICS
• You have Rs. 1000 with you. You want to
purchase shoes and a shirt. Shoes cost Rs. 700
and shirt costs Rs. 800.
• Assume: cannot borrow money or purchase on
credit, no cheaper alternatives available
Can you purchase both the items?
 What is Economics?
• Scarce resources in households and economies
• Economics is the science of scarcity

• Scarcity forces households and economies to

make choices
• Economics is the study of choices
Economics is a science which studies human
behavior as a relationship between ends and
scarce means which have alternative uses
- Lionel Robbins (1932)
• You have Rs. 1000 with you. You want to
purchase shoes and a shirt. Shoes cost Rs. 700
and shirt costs Rs. 800.
• Assume: cannot borrow money or purchase on
credit, no cheaper alternatives available
What are ends?
What are scarce means?
What are alternative uses?
Where does human behavior figure in?
• You can either pursue full-time work and earn
Rs. X or you can continue with your full-time
B.Tech degree and complete your college
education.
What are ends? Scarce means? Alternative uses?
Which of the two would you choose?
If cost of B.Tech is increased from Y to Z, would
that affect your pervious answer?
• There is 200X litres of oil reserves available on earth.
Current demand of oil is 100X litres.

Are the reserves sufficient to meet current demand? Is there

scarcity?

• Oil reserves increase at rate of X% and oil demand

increases at rate of Y% every 10 years (Y > X)

Is oil a scarce resource now? Alternative use?

Are reserves still sufficient to meet demand?
Does the new information affect decision about current use
of oil reserves?
 Key Features of Economics
• It is a science
o Science: systematic acquisition of knowledge, explains a phenomenon
in terms of general framework of laws and by a process of logical
reasoning, end result is a ‘fact’

• Economics is a social science

o Deals with human beings who are complex and possess ‘free’ will
o Humans show stable response to stimulus as a group
o Predictions about humans possible due to statistical law of large
numbers

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13
• Difference between Economics and Finance?
• Economics: Big picture of human behaviour
around allocation of real resources
• Finance: techniques and tools for managing
money
 Key Areas of Study in Economics
• How people make decisions
• How people interact
• How economy as a whole works

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MICROECONOMICS VS MACROECONOMICS
• Microeconomics: studies how one agent or a small group of
agents decide to allocate resources

• Macroeconomics: studies economy as a whole; looks at

aggregate outcomes of all decisions that consumers, firms and
government make in an economy
Example:
• Topics studied under microeconomics:
o What to produce
o How much to produce
o What price to set
o How much to purchase

• Topics studied under macroeconomics:

o Rate of inflation
o Quantity of output
o Quantum of wages
o Rate of unemployment
• Micro and macro-economics do not exit is isolation
o Decisions of individual firms influenced by larger economic
environment;
o Larger economic environment formed by decisions of all
economic agents

• Micro-economics:
o Takes a bottom-up approach
o Used by individual agents in taking decisions

• Macro-economics
o Takes a top-down approach
o Used as analytical tool to craft economic and fiscal policy
ECONOMIC SYSTEMS
• Economic System: System of production and distribution of
goods and services in a society

• Key Questions for an Economy

o What goods and services to produce?
o How should the goods and services be produced?
o For whom to produce goods and services?
 Types of Economic Systems
• Market Economy
– Also: Free Enterprise Economy/Capitalist Economy

• Centrally Planned Economy

– Also: Controlled Economy

• Mixed Economy
 Brief History of Socialism and Communism

• Origins in collectivism
o Primacy of collective goals over individual goals
o Individuals barred from doing things counter to ‘the common good’
o Traced to Plato (427 – 347 BC)

• Renamed to socialism in modern time

o Traced to Karl Marx (1818 – 1883)
o Suitable compensation to labour through state ownership of means of
production, distribution and exchange

• Split of socialist ideology in early twentieth century

o Communists: advocates from revolution
o Social democrats: followers of democratic process
 Planned Economy
• Production and distribution of goods and services determined by
government

• Key characteristics:
a) Means of production (land and capital) owned by government
b) Most people employed by government
c) Production based on consumers’ need assessment made by
government planner (the what)
d) Production processes based on input-output analysis by govt.
planners (the how)
e) Distribution through state outlets at fixed prices (the for whom)
 Shift towards Individualism
• Individual should have freedom in economic and political
pursuits

• Welfare of society best served when people pursue economic

self-interest

• Renamed to capitalism
 Free Market Economy
• Production and consumption determined by individuals and
private firms

• Key characteristics:
a) Production of products that yield the highest profits (the what)
b) Production through least costly techniques of production (the how)
c) Consumption depending upon people’s desires and incomes (the
for whom)

• Role of government:
– Minimal
– Protects property rights to ensure free competition
 Market Failure and Role of Government
• Market failure: inefficient distribution of goods and
services
– individual incentives for rational behavior do not lead to rational
outcomes for the group

• Example of market failure: Public good

• Public goods
– Def: non-excludable and non-rivalrous goods
– Ex: national security, street lighting
– Problem: ‘free-rider problem’
• People enjoy benefits but shirk public responsibility to pay
– Result: may be under-produced, overused or degraded
 Comparing Market and Planned Economy
Market Economy Planned Economy
Ownership of means With private firms and With government
of production individuals
 Comparing Market and Planned Economy
Market Economy Planned Economy
Ownership of means With private firms and With government
of production individuals
Decisions about - By businesses - By government planners
production - Based on demand analysis - Based on planners’ assumption
- Based on cost-benefit about consumer needs
analysis - Based on input-output analysis
 Comparing Market and Planned Economy
Market Economy Planned Economy
Ownership of means With private firms and With government
of production individuals
Decisions about - By businesses - By government planners
production - Based on demand analysis - Based on planners’ assumption
- Based on cost-benefit about consumer needs
analysis - Based on input-output analysis
Flexibility to set With businesses With state outlets
prices
 Comparing Market and Planned Economy
Market Economy Planned Economy
Ownership of means With private firms and With government
of production individuals
Decisions about - By businesses - By government planners
production - Based on demand analysis - Based on planners’ assumption
- Based on cost-benefit about consumer needs
analysis - Based on input-output analysis
Flexibility to set With businesses With state outlets
prices
Role of government - To protect businesses and - To take economic decisions
consumers - To co-ordinate production and
- To issue money distribution of goods
 Comparing Market and Planned Economy
Market Economy Planned Economy
Ownership of means With private firms and With government
of production individuals
Decisions about - By businesses - By government planners
production - Based on demand analysis - Based on planners’ assumption
- Based on cost-benefit about consumer needs
analysis - Based on input-output analysis
Flexibility to set With businesses With state outlets
prices
Role of government - To protect businesses and - To take economic decisions
consumers - To co-ordinate production and
- To issue money distribution of goods

Prominent examples USA. Japan Cuba, Former Soviet Union,

China
Comparing Market and Planned Economy (Contd..)

Market Economy Planned Economy

Advantages - Market responds quickly - More equal distribution of
to consumer needs wealth
- Freedom to take economic - Production of goods according
decisions to needs of people
- Greater efficiency due to - Possible to make long-term
competition among plans for economy
producers
Comparing Market and Planned Economy (Contd..)

Market Economy Planned Economy

Advantages - Market responds quickly - More equal distribution of
to consumer needs wealth
- Freedom to take economic - Production of goods according
decisions to needs of people
- Greater efficiency due to - Possible to make long-term
competition among plans for economy
producers
Disadvantages - Creates inequal incomes - Vast bureaucracies
- May lead to inefficient use - Poor motivation to work
of resources - Over-dependence on skills of
- May lead to social ills planners
- Poor standard of living of
people
Classification by Involvement of Government

Free market Mixed Planned

economy Economy Economy

Level of involvement of government in economic activities

 Mixed Economy
• Most economic decisions made by markets

• Government plays important role in:

o Overseeing the functioning of the market
o Pass laws that regulate economic life
o Produce educational services, police services etc.
o Control pollution
o Decide on allocation of goods and services to poor

• Degree of government’s involvement decided by

government
o Implications for taxes
MARGINAL ANALYSIS
• Used as a tool for optimal economic decisions

• Main Components:
o Marginal Benefit
o Marginal Cost

• Marginal analysis: Comparing marginal

benefits of a decision with its marginal costs
Individual Level Decisions

Whether to study six hours or seven hours for EEF?

Marginal Benefit of 7th hour: additional 10 marks in exams
Marginal Cost of 7th hour: One less hour for other courses

Whether to ride the big roller coaster again?

Marginal Benefit of second ride: more thrill!
Marginal Cost of second ride: Stand in 4 hour queue again

Whether to bake 21 instead of 20 loaves of bread?

Marginal Benefit of 21st loaf: 15 more rupees
Marginal Cost of 21st loaf: Raw material and labour
Golden rule:
Produce/Consume additional units till:
benefit from additional unit = cost of additional
unit

Optimal level:
Marginal Benefitx = Marginal Costx
• Example:
Revenues and Cost
Number of Units Revenues from Sale Cost of Production
1 15 10
2 35 20
3 50 30
4 60 40
5 65 50
6 60 60
7 55 70
8 50 80
• Example:
Revenues and Cost

Number of Units Revenues from Sale Cost of Production Net Benefits

1 15 10 5
2 35 20 15
3 50 30 20
4 60 40 20
5 65 50 15
6 60 60 0
7 55 70 -15
8 50 80 -50
• Example:
Revenues and Cost
Number Revenues Cost of Net Marginal
of Units from Sale Production Benefits Benefits
1 15 10 5 15
2 35 20 15 20
3 50 30 20 15
4 60 40 20 10
5 65 50 15 5
6 60 60 0 -5
7 55 70 -15 -5
8 50 80 -50 -5
• Example:
Revenues and Cost
Number Revenues Cost of Net Marginal Marginal
of Units from Sale Production Benefits Benefits Cost
1 15 10 5 15 10
2 35 20 15 20 10
3 50 30 20 15 10
4 60 40 20 10 10
5 65 50 15 5 10
6 60 60 0 -5 10
7 55 70 -15 -5 10
8 50 80 -50 -5 10
• Example:
Revenues and Cost
Number Revenues Cost of Net Marginal Marginal Marginal
of Units from Sale Production Benefits Benefits Cost Analysis
1 15 10 5 15 10 5
2 35 20 15 20 10 10
3 50 30 20 15 10 5
4 60 40 20 10 10 0
5 65 50 15 5 10 -5
6 60 60 0 -5 10 -15
7 55 70 -15 -5 10 -15
8 50 80 -50 -5 10 -15
Qs:
Twentyfirst Century Electronics has discovered a theft problem at
its warehouse and has decided to hire security guards. The firm
wants to hire the optimal number of security guards. The
following table shows how the number of security guards affects
the number of radios stolen per week
Number of Security Guards Number of radios stolen per week
0 50
1 30
2 20
3 14
4 8
5 6

If each security guard is paid $200 a week and the cost of a

stolen radio is $25, how many security guards should the firm
hire? And what is the most the firm would be willing to pay to
hire the second security guard?
Solution:
No. of SG Radios stolen Radios saved Marginal benefit Marginal Cost
0 50 0 0 0
1 30 20 20 x 25 = 500 200
2 20 10 10 x 25 = 250 200
3 14 6 6 x 25 = 150 200
4 8 6 6 x 25 = 150 200
5 6 2 2 x 25 = 50 200

MB – MC most optimal at 2 guards

Maximum wages paid to second guard: 250 (MB = MC at this point)