Unit – 1 ECONOMICS

Fundamentals of Economic Analysis

Basis of economics
• The scarcity of resources in a country and unlimited wants of the
people, form the basis of economics.
• If the resources were unlimited, we can go on producing goods to
satisfy our unlimited wants. But the resources are limited, i.e., scarce.
• Therefore, we have to make some decisions in utilizing the limited
resources efficiently and maximizing the satisfaction.
Decision making
• Selecting one action from two or more alternative courses of action.
• Selecting one from various alternatives.
• Choice is due to scarcity of resources.

Forward planning
• It means establishing plans for the future.

Problems in decision making and forward planning

• Uncertainty about the future.
• In business land, labour, capital and management is limited.
Therefore, these resources should be used optimally to maximize
profits.
Decisions in business
• Product (what to produce? design to be developed?)
• Capital (from where to get? and at what rate of interest?)
• Number and type of labourers to be used in production
• Number of machines to be used (new machines to be employed, size
of machines)
Central Problems of an Economy
• Allocation of resources
• What to produce?
• How to produce?
• For whom to produce?
• There must be efficient utilisation of resources.
Nature of Economics
(Definitions of Economics)
(1) Wealth Definition
• Adam Smith (1723-1790), in his book, “An inquiry into the Nature and
Causes of the Wealth of Nations” defined economics as, “a science
which studies the nature and causes of wealth of nations”.
• According to the definition, the scope of Economics is limited to
earning and spending of wealth.

(2) Scarcity Definition

• Lionel Robbins defined Economics as follows: “Economics is a
science which studies human behaviour as a relationship between
ends and scarce means which have alternative uses”.
Engineering economics
• Engineering Economics is a branch of engineering that applies
economic principles and methodologies to evaluate and make
decisions about engineering projects and investments.

Engineering economic problems

• When an electric utility is considering updating its computer

networking capability and has to decide between upgrading its
 existing computer servers and scrapping them for new computer
systems. If it opts for the latter, then should it buy or lease?
Approaches to Economic Analysis
• Classical economists analysed economic problems through
consumption, production, exchange, distribution and public finance.
• Modern economists analysed economics through Micro and Macro
analysis.
• Prof. Ragnar Frisch in 1933, introduced Micro and Macro analysis.
Microeconomics
• According to Prof. Boulding, Microeconomics is, “the study of
particular firms, particular households, individual prices, wages,
incomes, individual industries, particular commodities”.
• The fields covered by micro economics are:
• Theory of product pricing
• Theory of factor pricing
• Therefore, micro economics is also known as ‘Price theory’.
Macro Economics
• According to Prof. Boulding, “Macro economics deals not with
individual quantities as such, but with the aggregates of these
quantities, not with individual incomes, but with national income; not
with individual prices but with the price level; not with individual
outputs but with the national output”.
• The areas covered by macro economics are Theory of employment
and income, Theory of general price level, Theory of economic growth
(GDP).
Scope of engineering economics
1. Circular flow in an economy
• The circular flow model demonstrates how money moves through
society.
 • It shows how money moves from producers to households and back
again in an endless loop.
• In an economy, money moves from producers to workers as wages
and then back from workers to producers as workers spend money on
products and services.
2. Demand and supply
• Demand
• Demand is defined as, “a desire for a commodity backed by willingness
and ability to pay the price”.
• Law of demand - It shows the relation between price and the quantity
demanded.
• Demand forecasting – Estimating future demand
• Supply
• Supply means the commodity offered for sale at a price (by retailers
and wholesalers) during some given period.
• Law of supply – It shows the relation between price and quantity
supplied.
3. Cost
• Total amount of money spent on the production of a commodity.
Topics to be covered:
• Types of cost
• Cost-output relationship – Short-run & Long-run
• Make/Buy decision
• In a business organization, a component or product can be
made within the organization or bought from a subcontractor
(each decision involves cost).
• Evaluate each of the alternatives and select an alternative which
results in lowest cost.
4. Inventory control
• Inventory can be classified into raw materials, in-process, & finished
goods inventory.
• Two basic inventory decisions are:
• When should the inventory of an item be replaced?
• How much of an item is to be ordered when the inventory of that
item has to be replenished?
5. Depreciation
• Any equipment which is purchased today will not work for ever due to
wear and tear of the equipment or obsolescence of technology.
• Hence, it has to be replaced at proper time & it involves money.
• The recovery of money from the earnings of an equipment for its
replacement purpose is called depreciation fund.
• Depreciation means decrease in the value of any physical asset with
the passage of time.
• Methods of depreciation
• Straight line method of depreciation
• Diminishing/declining balance method of depreciation
6. Pricing
• Pricing is a process of fixing the value that a manufacturer will receive
in the exchange of goods and services.
• Topics to be covered:
• Pricing practices and strategies
7. Revenue
• The income that a firm receives from the sale of a good or service to
its customers.
• Topics to be covered:
• Concepts of revenue
8. Cost-Volume-Profit (CVP) analysis
• It is a method of evaluating how changes in costs and volume will
impact profits.
• CVP analysis is a comprehensive analysis that examines the
relationship between sales volume, costs, and profit to determine
breakeven points and profit targets.
• Break-even analysis only identifies the sales volume required to break
even (no-profit no-loss).
9. Value analysis/Value engineering
• Value analysis is the application of a set of techniques to an existing
product with a view to improve its value. It is thus a remedial process.
• Value engineering is the application of exactly the same set of
techniques to a new product at the design stage, when no hardware
exists to ensure that unnecessary features are not added. Value
engineering, therefore, is a preventive process.
10. Capital budgeting
• Capital budgeting is the process by which investors determine the
value of a potential investment project.
• It involves choosing projects that add value to a company.
• It includes acquiring land or purchasing fixed assets like an equipment
or machinery.
• Project appraisal techniques
• Pay-back period
• Internal Rate of Return (IRR)
• Net Present Value (NPV)
11. Project management
• A project involves completing tasks to achieve an objective with a
limited set of resources and a finite timeline.
 • Project management is a process that allows project managers to
plan, execute, track and complete projects with the help of a project
team.
• Project management techniques
• Program Evaluation Review Technique (PERT)
• Critical Path Method (CPM)
12. Economic growth and development
• National income
• Inflation – Control measures: Monetary & Fiscal Policy
• Banking – Technological innovation
• Sustainable Development Goals (SDGs)
• Circular economy
Circular flow in an economy
• The circular flow model is an economic model that presents how
money, resources, goods, and services move between sectors in an
economic system.
• It highlights the interactions between the households, firms,
government, foreign sector, and the financial sector.
Institutions / Decision-making Agents of an economy
• Households
• Households are consumers. They may be single individuals or
group of consumers (families make joint decision regarding
consumption).
• They are owners of factors of production – land, labour, capital
and entrepreneurial ability.
• They sell the services of these factors and receive income in the
form of rent, wages, interest and profit respectively.
• Firms
• The decision to produce goods and services is taken by a firm.
 • For this purpose, it employs factors of production and makes
payments to their owners.
• Firms produce goods & services to make profit.
• Government
• In a mixed economy, the government strengthens the market
system.
• It regulates the activities of the private sector.
• The government also uses resources to produce goods and
services itself which are sold to households and firms.
• Foreign sector
• The overseas sector turns a closed economy into an open
economy.
• When local firms export goods and services to the foreign
markets, injections are made to the circular flow model.
• Injections increase the money in the circular flow because firms
receive foreign exchange for goods sold to other countries.
• Financial sector
• It includes banks and other institutions that provide borrowing
and lending services to the other sectors.
• Financial sector act as intermediaries.
• It provides the facility for the households/business to save their
share of income and for business/households to borrow some
amount of money.
Circular flow in a two-sector economy
• It is the most basic model containing only two sectors: consumers or
households and business firms.
• In the two-sector model, it is assumed that households spend all their
income as consumer expenditures and purchase the goods and
services produced by businesses.
 • Thus, there are no taxes, savings, or investments that are associated
with other sectors.

Circular flow in a three-sector economy

• The circular flow of income in a three-sector economy includes
households, firms, and the government sector.
• In this model, money flows from households and businesses to the
government in the form of taxes (outflows or leakages from circular
flow).
• The government pays back in the form of government expenditures
through subsidies, benefit programs, public services, purchases etc
(inflows or injection into the circular flow).
• Taxes reduce consumption and saving of the household sector. This in
turn, reduces the sales and incomes of the firms.
• Taxes on business firms reduce their investment and production.
• Injections – Investment, Government spending, Exports.
 • Leakages – Savings, Taxes, Imports.
• To offset these leakages the government purchases goods & services
from the business sector and buys services of the household sector.
These are injection in the circular flow.

Circular flow in a four-sector economy

• The four-sector model contains the foreign sector (overseas/external
sector).
• Injection (Exports) - When firms sell goods and services to foreign
countries, they earn foreign currency. It is spent on domestic goods
and services.
• Leakages (Imports) - When goods and services are purchased from
foreign countries, it reduces the amount of money available for
spending on domestic goods and services.
 • The circular flow of income for a nation is said to be balanced when
leakage equal injections.
• For a healthy and stable economy, it's desirable to have leakages and
injections roughly balanced.
• If leakages are too high, the economy might stagnate. Conversely, if
injections are too high, it could lead to inflation.
Demand
• Demand is defined as, “a desire for a commodity backed by
willingness and ability to pay the price”.
Law of demand
• It shows the relation between price and the quantity demanded.
• There is inverse relationship between price and quantity demanded.
 • Law of demand according to Marshall is, “the amount demanded
increases with a fall in price and diminishes with a rise in price”.
• Demand curve is downward sloping from left to right.

Demand Schedule

Quantity demanded
Price per (Units)
unit (Rs)
10 50
8 60
6 70
4 80
2 90
 • Law of demand is based on Ceteris Paribus assumption.
• Only one factor changes, other factors being constant is Ceteris
Paribus assumption (Price alone changes and other factors are
constant).
• Only with Ceteris Paribus assumption the law will operate.
Factors influencing demand/Demand determinants
1. Level of income
2. Tastes and preferences of consumers
3. Existence of substitutes
4. Expectation about future
5. Type of commodity
6. Changes in weather
• All these factors are assumed to be constant. Price alone changes.
Types of demand
1. Price Demand
• Q = f (P, Y, PR, W)
• Price (P) alone changes, all other factors are constant.

2. Income Demand
• Q = f (P, Y, PR, W)
• Income (Y) alone changes, all other factors are constant.
3. Cross Demand
• Q = f (P, Y, PR, W)
• Price of related goods (PR) alone changes, all other factors are
constant.
Complementary goods

Substitutes

Elasticity of Demand
• Marshall introduced the concept of elasticity of demand.
• It shows the extent of change in quantity demanded to a change in
price.
• In the words of Marshall, “The elasticity of demand in a market is
great or small according as the amount demanded increases much
or little for a given fall in the price and diminishes much or little for a
given rise in price”.
Elastic demand
• A change in price may lead to a great change in quantity demanded.
Inelastic demand
• A change in price is followed by a small change in demand.
I. Price elasticity of demand
• Price elasticity of demand is the extent of change in quantity
demanded to a change in price.
ep= Proportionate change in quantity demanded
Proportionate change in price

• Price elasticity of demand is negative.

Demand forecasting
• Demand forecasting is estimating future demand for the product.
• Forecasting for a new product.

Methods of demand forecasting

❖ Opinion polling / Survey method
• It is one of the most common and direct methods of forecasting
demand in the short term.
• In this method, an organization conducts surveys with
consumers/dealers to determine the future demand for their
products.
1. Opinion survey method
• It is known as sales-force-composite method or collective opinion
method.
• Forecasting is done by getting the opinion of salesmen.
Advantages
• It is simple.
• It requires minimum statistical work.
• It is economical (less costly).
Disadvantages
• Highly subjective (more personal opinion)
2. Expert opinion
• Opinion from dealers or distributors
• E.g. Automobile companies
Advantages
• Quick and cheap forecasts
• Useful for new products
Disadvantage
• Subjective

3. Consumers’ interview method

• Direct interview with the consumers (about their preferences)
Advantage
• First-hand information
Disadvantage
• Costly and difficult

Consumers interview is done in 3 ways:

i. Complete enumeration method
• All the consumers are interviewed.
• Advantage - First-hand information
 • Disadvantage - Costly and difficult
ii. Sample survey method
• A sample of consumers are selected for the interview
• It is easy, less costly and highly useful.
iii. End-use method
• Demand for textile machinery = f(expansion of textile industry)

❖ Statistical methods
• It is used for long-run forecasting.
• Statistical and mathematical techniques are used to forecast
demand.
• This method relies on past data. Sales (in
1. Trend projection method Year 000s)

• It is concerned with the movement of variables 2011 53

through time.
2012 49
• It requires long time – series data.
2013 61
2014 42
2015 59

• This method is based on the assumption that the factors liable for the
past trends in the variables shall continue to play their role in future
in the same manner and to the same extent.
2. Barometric technique
• In this method, estimation of time-series is done through certain
indicators to predict the future.
• Eg: Personal income, unemployment rates, automobile registration

Econometric methods of demand forecasting

 • The econometric methods make use of statistical tools and economic
theories in combination to estimate the economic variables.
• The econometric methods are:
i.Regression method
Regression
• Regression analysis is about how one variable affects another.
• It focuses on the relationship between a dependent variable and one or
more independent variables (or 'predictors').
• It is a statistical approach to forecast change in a dependent variable
due to change in one or more independent variables.
• It shows the extent of relationship between variables, i.e., how the value
of the dependent variable changes when one of the independent
variable is varied, while other independent variables are fixed.
• Eg: D=f(P); extent of relation i.e., 98% or 39%
• In the above equation, there is only 1 independent variable ie., P
• If D=f (P,Y,PR, W) – There are several independent variables i.e., P,Y,PR,W
etc.
• Identifying the functional relationship with 1 independent variable is
simple regression; and with several independent variables is known as
multiple regression.

Regression models
• In this method the demand function is estimated with demand as the
dependent variable and its determinants as the independent
variables, using the classical linear equation
Yi = F(Xi) + ui

• Standard regression model is

Yi = β0 + β1Xi + ui
Were,
Yi is dependent variable (demand)
Xi is explanatory variable (Price, income…)
ui is disturbance term or error term (accounts for all omitted
variables)
β0 is intercept or constant
β1 is slope or parameter
• Two regression models used in demand forecasting are:
• Simple linear regression model
Problem - 1
1. The data of price and quantity demanded are given below. Estimate the
demand function for the product Y = β0 + β1 X + u

Forecast the demand when price increases to 8.

n=6
Supply
• Supply means the commodity offered for sale at a price (by retailers
and wholesalers) during some given period; say a month or week or 3
months or 6 months, etc.
• ↑Price ↑Supply (Direct relation)

Factors determining supply

1. State of technology
2. Cost of production
3. Natural factors
4. Labour trouble
5. Change in government policy

Law of supply
▪ The law of supply states that, “Other things being constant, the price of a
commodity has a direct influence on the quantity supplied. As the price of a
commodity rises, its supply is extended; as the price falls, its supply is
contracted”.

Supply=f(Price); ↑Price ↑ Supply; ↓ Price ↓ Supply

▪ There is a direct relation between price and supply.
▪ Other factors are assumed to be constant.
Supply schedule

Market price determination

• Market price is determined at a point where demand and supply are
equal.
• Market price is determined by the aggregate demand and aggregate
supply.
• The equilibrium price is determined where D=S.

Market price determination

At equilibrium price, both the buyers and sellers are satisfied (because D=S).
o If price is higher than the equilibrium price; S>D (↑P; sellers bring
down the prices to dispose the excess stock. Ultimately, the price
reaches the equilibrium).
o If price is less than the equilibrium price; D>S (↓P; buyers bid up the
prices to get the product. When buyers bid up the price, the price
reaches the equilibrium).
Types of efficiency
▪ Efficiency of a system is defined as the ratio of its output to input.
▪ Efficiency can be classified as:
1. Technical efficiency
2. Economic efficiency

(i) Technical efficiency

▪ Technical efficiency is the effectiveness with which a given set of inputs is
used to produce an output. It occurs when a firm produces a given level of
output by using the least amount inputs.
▪ A firm is said to be technically efficient if a firm is producing the maximum
output from the minimum quantity of inputs, such as labour, capital, and
technology.
▪ Technical Efficiency = (Actual Output from given inputs/Maximum
potential output from given inputs) x 100

(ii) Economic efficiency

▪ Economic efficiency occurs when the firm produces a given level of output
at the least cost.
▪ It means using the method that produces a given level of output at the
lowest possible cost.

Difference between technical & economic efficiency

• Technical efficiency
Technical efficiency means the quantity of inputs used in production for a
given level of output.
• Economic efficiency
Economic efficiency refers to the cost of the inputs used