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
10
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?
How would you choose which item to purchase?
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?
• In 2020, 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?
Prominent Areas of Study in Economics
• How people decide on:
– How much to work
– What to buy
– How much to save
– How to invest savings
• More nuanced study:
– impact of information on multiple periods on
decisions
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
• Example:
An improvement in technology enables each worker to
produce 20 pieces of product X instead of 15 products
Micro-economic analysis:
• What will be cost of technology to the firm?
• Would the change lead to productivity gains?
Macro-economic analysis:
• What would the innovation cost if large number of firms
adopt it?
• What impact would it have on demand of labour? And
wages paid to labour? On skilled vs unskilled labour?
• Example:
Study on consumers and their purchase decisions
• Microeconomics:
o Assumption about how much consumer wants to
spend or save
• Macroeconomics:
o Impact of unemployment rate
o Impact of changes in tax regime
• 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 a analytical tool to craft economic and fiscal
policy
ECONOMIC SYSTEMS
Key Questions for an Economy
a) What goods and services to produce
b) How should the goods and services be produced
c) For whom to produce goods and services
Definition: Economic System
• System of production and distribution of
goods and services in a society
Types of Economic Systems
• Market Economy
– Also: Free Enterprise Economy/Capitalist Economy
• Centrally Planned Economy
– Also: Controlled Economy/ communist economy- North
Korea
• Mixed Economy – mixture of market+ controlled
Classification by Involvement of Government
Free market Mixed Planned
economy Economy Economy
Level of involvement of government in economic activities
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
‘Invisible Hand’
• Idea by Adam Smith, An Inquiry into Nature and Cause
of Wealth of Nations, 1776.
• Metaphor for unseen forces that move market economy
• Idea: Self-interested individuals operate through a system
of mutual interdependence, leading to widespread
benefits
• Primary justification for economic system of free market
capitalism
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
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)
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
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 -30
• 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 -30 -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)
