ECONOMIC DECISIONS MAKING

1. THE ROLE OF ENGINEERING ECONOMIC ANALYSIS

Engineering economic analysis is most suitable for intermediate problems and the economic
aspects of complex problems. They have these qualities:

1. The problem is important enough to justify our giving it serious thought and effort.
2. The problem can't be worked in one's head-that is, a careful analysis requires that we
organize the problem and all the various consequences, and this is just too much to be
done all at once.
3. The problem has economic aspects important in reaching a decision.
When problems meet these three criteria, engineering economic analysis is an appropriate
technique for seeking a solution. Since vast numbers of problems that one will encounter in the
business world (and in one's personal life) meet these criteria, engineering economic analysis is
often required.

1.1 Examples of Engineering Economic Analysis

Engineering economic analysis focuses on costs, revenues, and benefits that occur at different
times. For example, when a civil engineer designs a road, a dam, or a building, the construction
costs occur in the near future; the benefits to users begin only when construction is finished,
but then the benefits continue for a long time.
In fact nearly everything that engineers design calls for spending money in the design and
building stages and after completion revenues or benefits occur-usually for years.
Thus the economic analysis of costs, benefits, and revenues occurring over time is called
engineering economic analysis.
Engineering economic analysis is used to answer many different questions.

Which engineering projects are worthwhile? Has the mining or petroleum engineer
shown that the mineral or oil deposit is worth developing?
Which engineering projects should have a higher priority? Has the industrial engineer
shown which factory improvement projects should be funded with the available dollars?
How should the engineering project be designed? Has the mechanical or electrical
engineer chosen the most economical motor size? Has the civil or mechanical engineer
 chosen the best thickness for insulation? Has the aeronautical engineer made the best
trade-offs between

1) Lighter materials that are expensive to buy but cheaper to fly and
2) Heavier materials that are cheap to buy and more expensive to fly?

2. THE DECISION-MAKING PROCESS

To have a decision-making situation, there must be at least two alternatives available. If only
one course of action is available, there can be no decision making, for there is nothing to
decide. There is no alternative but to proceed with the single available course of action.
At this point we might conclude that the decision-making process consists of choosing from
among alternative courses of action. But this is an inadequate definition. In Economics we
consider only rational decision making.

2.1 Rational Decision Making

Rational decision making is a complex process that contains nine essential elements, which are
shown sequentially in Figure 1. Although these nine steps are shown sequentially, it is common
for decision making to repeat steps, take them out of order, and do steps simultaneously. For
example, when a new alternative is identified, then more data will be required. Or when the
outcomes are summarized, it may become clear that the problem needs to be redefined or new
goals established.
The value of this sequential diagram is to show all the steps that are usually required, and to
show them in a logical order. Occasionally we will skip a step entirely. For example, a new
alternative may be so clearly superior that it is immediately adopted at Step 4 without further
analysis.
The figure is given as follows. The section that follows the figure describes the elements listed
in the figure.
 Figure 1. One possible flowchart of the decision process.

1. RECOGNIZE THE PROBLEM

2. DEFINE THE GOAL OR OBJECTIVE

3. ASSEMBLE RELEVANT DATA

4. IDENTIFY FEASIBLE ALTERNATIVES

5. SELECT THE CRITERION TO

DETERMINE THE BEST ALTERNATIVE

6. CONSTRUCT A MODEL

7. PREDICT EACH ALTERNATIVE'S

OUTCOMES OR CONSEQUENCES

8. CHOOSE THE BEST ALTERNATIVE

9. AUDIT THE RESULT

1. Recognize the Problem

The starting point in rational decision making is recognizing that a problem exists.
Once we are aware of the problem, we can solve it as best we can. Many firms establish
programs for total quality management (TQM) or continuous improvement (CI) that are
designed to identify problems, so that they can be solved.
2. Define the Goal or Objective
The goal or objective can be a grand, overall goal of a person or a firm. For example, a personal
goal could be to lead a pleasant and meaningful life, and a firm's goal is usually to operate
profitably. The presence of multiple, conflicting goals is often the foundation of complex
problems.
But an objective need not be a grand, overall goal of a business or an individual. It may be quite
narrow and specific: plant must produce 300 golf carts in the next 2 weeks," are more limited
objectives. Thus, defining the objective is the act of exactly describing the task or goal.

3. Assemble Relevant Data

To make a good decision, one must first assemble good information. In addition to all the
published information, there is a vast quantity of information that is not written down
anywhere but is stored as individuals' knowledge and experience. There is also information that
remains ungathered. Market research or other data gathering would be required to obtain the
desired information.
Deciding which data are important and which are not maybe a complex task. The availability of
data further complicates this task. Some data are available immediately at little or no cost in
published form; other data are available by consulting with specific knowledgeable people; still
other data require surveys or research to assemble the information. Some data will be of high
quality-that is, precise and accurate, while other data may rely on individual judgment for an
estimate. Some instances about the complexity of data assembling may be worth mentioning.

If there is a published price or a contract, the data may be known exactly. In most cases,
the data is uncertain. What will it cost to build the dam? How many vehicles will use the
bridge next year and in year 20? How fast will a competing firm introduce a competing
product? How will demand depend on growth in the economy? Future costs and
revenues are uncertain, and the range of likely values should be part of assembling
relevant data.
The problem's time horizon is part of the data that must be assembled. How long will
the building or equipment last? How long will it be needed? Will it be scrapped, sold or
shifted to another use? In some cases, such as for a road or a tunnel, the life may be
centuries with regular maintenance and occasional re-building. A shorter time period,
such as 50 years, may be chosen as the problem's time horizon, so that decisions can
be based on more reliable data.
In engineering decision making, an important source of data is a firm's own accounting
system. These data must be examined quite carefully. Accounting data focuses on past
information, and engineering judgment must often be applied to estimate current and
future values. For example, accounting records can show the past cost of buying
 computers, but engineering judgment is required to estimate the future cost of buying
computers.
Financial and cost accounting are designed to show accounting values and the flow of
money-specifically costs and benefits-in a company's operations. Where costs are
directly related to specific operations, there is no difficulty; but there are other costs
that are not related to specific operations. These indirect costs, or overhead, are usually
allocated to a company's operations and products by some arbitrary method. The
results are generally satisfactory for cost-accounting purposes but may be unreliable for
use in economic analysis.

4. Identify Feasible Alternatives

One must keep in mind that unless the best alternative is considered, the result will always be
suboptimal. One should try to be certain that all conventional alternatives have been listed and
then make a serious effort to suggest innovative solutions. Any good listing of alternatives will
produce both practical and impractical alternatives.
It would be of little use, however to seriously consider an alternative that cannot be adopted.
An alternative may be infeasible for a variety of reasons. For example, it might violate
fundamental laws of science, require resources or materials that cannot be obtained, or it
might not be available in time. Only the feasible alternatives are retained for further analysis.

5. Select the Criterion to Determine the Best Alternative

The central task of decision making is choosing from among alternatives. How is the choice
made? Logically, to choose the best alternative, we must define what we mean by best.
There must be a criterion, or set of criteria, to judge which alternative is best. Now, we
recognize that best is a relative adjective on one end of the following relative subjective
judgment:

Worst Bad Fair Good Better Best

Figure2: Relative subjective judgment spectrum

Since we are dealing in relative terms, rather than absolute values, the selection will be the
alternative that is relatively the most desirable. In absolute terms, neither alternative is good.
But on a relative basis, one simply makes the best of a bad situation.
There may be an unlimited number of ways that one might judge the various alternatives.
Several possible criteria are:

Create the least disturbance to the environment

Improve the distribution of wealth among people
Minimize the expenditure of money
Ensure that the benefits to those who gain from the decision are greater than the losses
of those who are harmed by the decision
Minimize the time to accomplish the goal or objective
Minimize unemployment
Maximize profit

Selecting the criterion for choosing the best alternative will not be easy if different groups
support different criteria and desire different alternatives. The criteria may conflict.
For example, minimizing unemployment may require increasing the expenditure of money.
Or minimizing environmental disturbance may conflict with minimizing time to complete the
project. The disagreement between management and labor in collective bargaining (concerning
wages and conditions of employment) reflects a disagreement over the objective and the
criterion for selecting the best alternative.
The last criterion-maximize profit-is the one normally selected in engineering decision making.
When this criterion is used, all problems fall into one of three categories:
Fixed input, fixed output, or neither input nor output fixed.

Fixed Input: The amount of money or other input resources (like labor, materials, or
equipment) are fixed. The objective is to effectively utilize them.
For economic efficiency, the appropriate criterion is to maximize the benefits or other outputs.

Fixed Output: There is a fixed task (or other output objectives or results) to be accomplished.
The economically efficient criterion for a situation of fixed output is to minimize the costs or
other inputs.

Neither Input nor Output Fixed: The third category is the general situation, in which the
amount of money or other inputs is not fixed, nor is the amount of benefits or other outputs.
Obviously, to be as economically efficient as possible, we must maximize the difference
between the return from the investment (benefits) and the cost of the investment. Since the
difference between the benefits and the costs is simply profit, a businessperson would define
this criterion as maximizing profit.
6. Constructing the Model
At some point in the decision-making process, the various elements must be brought together.
The objective, relevant data, feasible alternatives, and selection criterion must be merged.
Constructing the interrelationships between the decision-making elements is frequently called
model building or constructing the model. In economic decision making, the model is usually
mathematical.

7. Predicting the Outcomes for Each Alternative

A model and the data are used to predict the outcomes for each feasible alternative. As was
suggested earlier, each alternative might produce a variety of outcomes. To avoid unnecessary
complications, we assume that decision making is based on a single criterion for measuring the
relative attractiveness of the various alternatives. If necessary, one could devise a single
composite criterion that is the weighted average of several different choice criteria.
To choose the best alternative, the outcomes for each alternative must be stated in a
comparable way. Usually the consequences of each alternative are stated in terms of money,
that is, in the form of costs and benefits. This resolution of consequences is done with all
monetary and nonmonetary consequences. The consequences can also be categorized as
follows:
Market consequences: where there are established market prices available
Extra-market consequences: no direct market prices, so priced indirectly
Intangible consequences: valued by judgment not monetary prices.

8. Choosing the Best Alternative

Earlier we indicated that choosing the best alternative may be simply a matter of determining
which alternative best meets the selection criterion. The alternative to be chosen is the one
that best meets the choice criterion after considering both the numerical consequences and the
consequences not included in the monetary analysis. During the decision-making process
certain feasible alternatives are eliminated because they are dominated by other, better
alternatives. The person, who performs all the steps in decision making, is the decision maker.

9. Audit the Results

An audit of the results is a comparison of what happened against the predictions. Do the results
of a decision analysis reasonably agree with its projections? If so, the economic analysis seems
to be accurate. The audit may help ensure that projected operating advantages are ultimately
obtained. On the other hand, the economic analysis projections may have been unduly
optimistic. We want to know this, too, so that the mistakes that led to the inaccurate projection
are not repeated.