49003

ECONOMIC EVALUATION

Introduction to Economics
Macroeconomics

UNIVERSITY OF TECHNOLOGY SYDNEY

 OBJECTIVE OF THIS SUBJECT
Economic evaluation of investment options is an integral part of the
professional role of an engineer–manager. Such evaluation requires:

1) appreciation of the economic and other forces which may influence

investment decision-making
2) knowledge of the concepts and principles of macro- and micro-
economics
3) familiarity with the frameworks and methods for evaluating
investment options, and
4) the ability to apply economic reasoning to evaluate investment
options.

This subject aims to develop knowledge and skills in these areas.

2
 CONTENT
• INTRODUCTION
– Overview of economics
– Evolution of economic ideas
– Classification of economics

• MACROECONOMICS
– National output/income
– Multiplier effect
– International trade
– Macroeconomic policy

• MICROECONOMICS
– The theory of the consumer
– The theory of the producer
– The theory of the market

• PROJECT EVALUATION
– Financial evaluation
– Socioeconomic evaluation
3
– Environmental and Uncertainty/Risk considerations
 OVERVIEW OF ECONOMICS
• ECONOMIC OR ECONOMICS
• WHAT IS ECONOMIC?
– describes something that is related to the economy
– e.g., economic growth, economic phenomena, economic system, economic
idea/doctrine, economic evaluation, …

• WHAT IS ECONOMICS?*
– can it explains everything, as suggested by:
• Tim Harford’s “The Logic of Life – The new economics of everything”
• Robert Frank’s “Why Economics Explains Almost Everything” and “How
economics helps you make sense of your world”
• Levitt & Dubner’s “Freakonomics: exploring the hidden side of everything”
– … these are the study of ‘rational’ human choice (responding to trade-offs
and incentives based on self-interest and utility-maximising behaviour)
– … which is part of the study of the economy
– … that intends to explain various economic phenomena involving diverse
economic agents with differing behaviours 4
* Ha-Joon Chang (2014), Economics: The User’s Guide, A Pelican Introduction, Penguin Press.
• WHAT IS THE ECONOMY?*
– money and finance?
– job?
– tax?
– technology?
– international trade?

• It is not about money or finance (Economics ≠ Finance)

– Finance is related to how money, shares, derivatives, etc. are created, sold
and bought
– Money, shares, derivatives, etc. are symbol of what others in a society owe
you, or your claim on a particular amount of the society’s resources
– Economics is partly about the study of earning, spending, saving, investing,
borrowing, etc. of these so-called symbol

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* Ha-Joon Chang (2014), Economics: The User’s Guide, A Pelican Introduction, Penguin Press.
• It is about jobs, at both micro and macro levels
– Individual workers (jobs) are affected by their skills (i.e., determine salaries),
technological innovation/disruption, international trade
– Jobs (labour markets) are affected by ‘political’ decisions, at national and
international levels

• It is about governments that tax some people to subsidise others

• It is about people using money (earn from jobs and other means)
to consume goods and services, and savings for future needs

• It is about factories, farms, offices and shops that produce and

distribute goods and services to satisfy societal needs

• It is about institutions that govern the interactions of the above

economic agents 6
• The economy is a system of organisations and institutions that
either facilitate or play a role in the production and distribution of
goods and services to satisfy needs in a society

• TYPE OF ECONOMIES (ECONOMIC SYSTEMS)

– Traditional: decisions are dictated by custom, tradition and beliefs
– Command: decisions are made by governments, or centralised power
– Market: decisions are made by the interactions of individuals
– Mixed: has features of both command and market systems

Pure
Pure
planned COMMAND MARKET
Competition
economy

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• Economics is the study of how society (individual, governmental
body, firm and nation) makes decisions to fulfil their needs from its
limited resources – essentially deals with decisions about resources
– Land, Labour, Capital, Materials
– Production, Consumption
– Pricing, Market
– Allocation, Distribution
– Social Needs

• KEY DRIVERS: SCARCITY

• Economics addresses issues that emerge at the interface of other

disciplines, including
– Social Sciences
– Behavioural Sciences
– Political Science
– History
– Philosophy 8
• WHY YOU MAYBE INTERESTED TO LEARN ECONOMICS?

– gain more understanding of issues (e.g., free trade agreement, inequality,

future of works, taxation, perverse incentives on housing property, etc.) that
may affect your life and work, either in positive or negative ways, and make
the best decision for yourself

– capable to express informed opinions (on above noted issues) that matter to
your society (because economics involves value-judgements and hence there
is no expert that can provide one right answer)

– perhaps to get a good grade, or pass this subject and get a degree, or maybe
to help you progressing in career and earn more income

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EVOLUTION OF ECONOMIC IDEAS (DOCTRINES)

PHILOSOPHERS MERCANTILISTS INSTITUTIONALISM …

Plato Aristotle
PHYSIOCRATS
428-348BC 384-322BC CLASSICAL
Al-Ghazali NEO-CLASSICAL NEO-CLASSICAL
Buddha
1058-1111
480-400BC
KEYNESIAN KEYNESIAN
Confucius MARXISM
551-479BC COMMUNISM
Mahavira Chanakya SOCIALISM
599-527BC 371-283BC

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 SALIENT POINTS ON ECONOMIC DOCTRINES

• PHILOSOPHERS (Before the Common Era)

– Society over Individual: individual is ephemeral while society persists
– Social dimensions of business/economics
– Western philosophers: Plato, Aristotle, several in the Middle Ages
– Eastern philosophers: Mahavira/Chanakya, Confucius, Buddha, Al-Ghazali, …

• MERCANTILISTS (16th - 18th century)

– Main source of wealth: Trade/Commerce
– State/Government intervention necessary – protection of domestic markets
(tariffs) and expansion of supply sources (colonialism)
– Main contributor: Tudors and Stuarts (1600s-1750s)

• PHYSIOCRATS (18th century)

– Main source of wealth: Land
– Laissez-faire
– Main contributor: Quesnay (1694-1774) 11
• CLASSICISTS (18th - 19th century)
– Main source of wealth: Labour
– Individual: Best judge
– Market: Decisions about production, consumption, distribution (invisible hand)
– Government: No role
– Main contributor: A Smith, JS mills, D Ricardo, JB Say

• MARXISTS/SOCIALISTS (1850s →)
– Society develop due to socio-economic competition (i.e., power relationships)
between classes
– Capitalism is self-destructive, leading to class antagonism
– Socialism: means of production, distribution, and exchange owned or
regulated by the community
– Main contributor: K Marx, F Engels, V Lenin, Mao

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• NEO-CLASSICISTS (1860s →)
– Technical analysis of production and consumption
– Price theory
– Market allocation and distribution: Profit/Utility maximisation
– Market imperfections
– Government: Limited role, correction of market when it fails
– Main contributor: WS Jevons, L Walras, A Marshall, F Hayek, M Friedman, …

• KEYNESIANS (1930s →)
– Market imperfections
– Cyclical unemployment
– Government: Key role
– Main contributor: JM Keynes

• INSTITUTIONALIST (1910s – 1960s; 1980s →)

– Role of society/institutions in shaping individual’s motivation and behaviour
– Emphases the significance of transaction cost in ‘running’ the economic
systems
– Main contributor: T Veblen, D North, O Williamson, … 13
 CLASSIFICATION OF ECONOMICS
ECONOMICS

MACRO-ECONOMICS
• analyses behavior of
economy as a whole
• focuses on economic
aggregates
• countries and governments
MICRO-ECONOMICS
• analyses behavior of
individuals: households, firms
• focuses on supply, demand and
their interactions in markets
• human choices and resource
allocation

- DEVELOPMENT ECONOMICS
- RESOURCE ECONOMICS
- ENVIRONMENTAL ECONOMICS
- ENERGY ECONOMICS
- PROJECT ECONOMICS
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 MACROECONOMICS
• MACROECONOMICS IS CONCERNED WITH THE OPERATION OF THE
ECONOMY AS A WHOLE; IT IS THE STUDY OF BROAD ECONOMIC
AGGREGATES
– National Output (National Income)
– Employment
– Inflation
– Foreign Trade

• PERFORMANCE OF A COUNTRY MEASURED IN TERMS OF THESE

BROAD AGGREGATES IS A REFLECTION OF THE STATE OF ECONOMIC
HEALTH OF THE COUNTRY

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 MACROECONOMICS: KEY TOPICS

• NATIONAL OUTPUT/INCOME

• MULTIPLIER EFFECT

• MACROECONOMIC POLICY INSTRUMENTS

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 NATIONAL OUTPUT

• NATIONAL OUTPUT – MOST IMPORTANT ENTITY

DISCUSSED IN MACROECONOMICS

• OTHER EQUIVALENTS OF NATIONAL OUTPUT

- National Income, National Expenditure
- Gross/Net Domestic Product (GDP/NDP)
- Gross/Net National Product (GNP/NNP)

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 National Output (Contd.)

(Gross Domestic Product: GDP)

THE CIRCULAR FLOW OF MACROECONOMICS
(TWO SECTOR MODEL)

SPENDING REVENUE
MARKETS FOR
GOODS &
SERVICES
PRODUCTS BOUGHT PRODUCTS SOLD
FLOW OF PRODUCTS
– outputs
– inputs
PUBLIC BUSINESS FLOW OF EARNINGS
– expenditure
CAPITAL, LABOUR,
– income
LAND, INPUTS FOR
ENTREPRENEURSHIP PRODUCTION
MARKETS FOR
FACTORS OF
INCOME
PRODUCTION INTEREST, WAGES,
RENT, PROFITS 18
 MEASUREMENT OF GDP

• FLOW-OF-PRODUCTS APPROACH

GDP – Total money value of the flow of final

products (goods & services)

• FLOW-OF-EARNINGS APPROACH
(Expenditure Approach)
(Income Approach)

GDP – Total of (primary) Factor Earnings

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 National Output (Contd.)

• DOUBLE COUNTING
- Flow-of-products approach: double counting is avoided by
including in GDP only final goods/services and not
intermediate goods/services that are absorbed in the final
goods

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 National Output (Contd.)

• DOUBLE COUNTING
- Flow-of-earnings approach: double counting is avoided by
using the concept of value added, where only the increase
in the value of goods or services as a result of the
production process is considered

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 VALUE ADDED

FACTORS OF PRODUCTION PRODUCTION

PROCESS OUTPUT
MATERIAL INPUTS FIRM 1
FROM OTHER FIRMS

FACTORS OF
PRODUCTION PRODUCTION
PROCESS OUTPUT
FIRM 2

MATERIAL INPUTS
FROM OTHER FIRMS

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 Value Added (Contd.)

• Value added by a firm is the value of its output minus

the value of intermediate inputs purchased from
other firms

• Value that the firm adds by means of its factor

services

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 GDP (Contd.)

• GDP = C (Flow of Products Approach)

= ƩVA (Earnings Approach)

• FLOW-OF-PRODUCTS APPROACH: OTHER COMPONENTS

GDP = C + I

Gross Investment
Private Consumption

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 GDP (Contd.)

• GDP = C + IGross

• NDP = C + INet

• GDP = NDP + Depreciation

• GDP = C + I + G
Government expenditure (excluding
Transfer Payments)
• GOVERNMENT: SOURCES OF INCOME
- Taxes, Bonds, Borrowings, Printing new money
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 GDP (Contd.)

DIRECT TAXES

TAXES

INDIRECT TAXES

• TREATMENT OF TAXES (IN OUR MODEL)

- Flow-of-Earnings Approach: Income includes direct
taxes that go to the government (the rest is spent on
consumption and savings, which becomes investment)

Disposable income - net income (exclude direct taxes)

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 GDP (Contd.)

• INDIRECT TAXES

Load of bread
Value Added Costs $1
Indirect Taxes $0.20

Price in Upper Loop $1.20

Price in Lower Loop $1.00

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 GDP (Contd.)

• Price in Upper Loop =

Price in Lower Loop + Indirect Taxes

• We must subtract from the market value the amount

of indirect taxes less any subsidies (subsidies are
negative indirect taxes) paid to the consumers

• GDP at market prices

≠
GDP at factor prices (value added)

• GDP at market prices = GDP at factor prices + Indirect

Taxes
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 GDP (Contd.)

THE FOREIGN CONNECTION

• GDP = C + I + G

• OPEN ECONOMIES TRADE WITH EACH OTHER

• Why?

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 TRADE
• International trade is the exchange of capital, good
and services between countries

• PRINCIPLES
Absolute Advantage: ability to produce more of a
given product or service using less of a given resource
(Adam Smith)

Comparative (Relative) Advantage: ability to produce

a particular product or service at a lower opportunity
cost over another (David Ricardo)
• BASIS OF TRADE – COMPARATIVE ADVANTAGE
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 Trade (Contd.)

• Example*: Australia vs Japan (food/car)

Australia Japan

1 unit of food 1.25 hrs 1 hr

1 unit car 100 hrs 50 hrs

Absolute advantage in:

– food Japan
– car Japan
* Ref: Samuelson et.al (1992)
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 Trade (Contd.)

Cost per hr. Australia Japan

Car 1/1.25 UF 1 UF
Food 1/100 UC 1/50 UC

Price of a unit of car 80 UF 50 UF

Price of a unit of food 0.0125 UC 0.020 UC

Comparative advantage in:

– food Australia
– car Japan
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 Trade (Contd.)

TRADE vs NO TRADE

Assumption: 2000 hours of labour available

Australia Japan Total

Car Food Car Food Car Food
No trade 10 800 20 1000 30 1800

With trade 0 1600 36 200 36 1800

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 Trade (Contd.)

TRADE IN REALITY!

• most nations will keep some level of production of all goods and
services regardless of comparative advantage – trying to be
partially self-sufficient (e.g., food security)
• markets are not perfectly competitive
• things are more complex than the simplistic two-product/two-
country model that comparative advantage relies on
• countries export surpluses whenever they can
• changes in relative prices and exchange rates affect trade
• extreme specialisation could result in structural unemployment
• comparative advantage is not static
• …

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 GDP (Contd.)

GDP = C + I + G + (X - M)

Net Exports
GNE
(Gross National Expenditure)

GDP is the dollar value of a nation’s production.

It comprises the dollar value of consumption (C), gross
domestic investment (I), government purchases of
goods & services (G), and net exports (X - M).

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 GDP (Contd.)

POTENTIAL USES OF GDP

• Size of the economy (international comparisons)

• Growth of the economy (expansions, contractions)

• Relative contribution & significance of various

components (C, I, G, X - M)

• Analysis of changes in national output (GDP) in

response to policy changes

36
 GDP (Contd.)
SIZE OF THE ECONOMY
• International comparisons: GDP or Per-capita GDP

37
Source: World Bank’s World Development Indicators
 GDP (Contd.)
SIZE OF THE ECONOMY
• International comparisons: Exchange rate or Purchasing
Power Parity (PPP)

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Source: World Bank’s World Development Indicators
 GDP (Contd.)

ECONOMIC GROWTH
• Time series comparisons

• Nominal (Current) vs Real (Constant) GDP

• Nominal GDPs cannot be directly compared

• Price Indices
- Consumer Price Index (CPI)
- Wholesale price Index (WPI)
- Retail Price Index (RPI)
𝐍𝐨𝐦𝐢𝐧𝐚𝐥 𝐆𝐃𝐏
- GDP Deflator = × 𝟏𝟎𝟎
𝐑𝐞𝐚𝐥 𝐆𝐃𝐏

39
 GDP (Contd.)
Comparison of Australia’s GDP in Nominal and Real Terms

Nominal/Current

Real/Constant

40
Source: Australian Bureau of Statistics (www.abs.gov.au)
 GDP (Contd.)
Example
Agriculture Industry Services Nominal Real GDP
GDP GDP deflator
PA QA PI QI PS QS
($/unit) (unit) ($/unit) (unit) ($/unit) (unit) ($) ($, 2000 (index)
prices)

2000 2 100 10 50 15 20 1000 1000 100

2015 3 118 15 70 25 35 2279 1461 156

Base year = 2000

Increase in GDP over the period 2000 – 2015

1) 1000 → 2279 … 128%
2) 1000 → 1461 … 46% ?
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 GDP (Contd.)
COMPONENTS OF GDP
Australia’s GDP account for 2017-2018
Current Prices $bn (2017-2018)

Flow of Products Approach Flow of Earning Approach

Consumption, C 1044 Wages 0871
Investment, I 0447 Interest, Profit, Rent 0791
Government, G 0346 GDP (factor prices) 1662
Change in Inventories 0003
GNE 1840
Export, X 0401
Import, M 0394
Net Export (X - M) 0007
Statistical Discrepancy 0001 Indirect Taxes 0186
GDP (market prices) 1848 GDP (market prices) 1848
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Source: Australian Bureau of Statistics (www.abs.gov.au)
• CONTRIBUTIONS TO GDP (2017-2018)
- Consumption 56%
- Investment 24%
- Government 19%
- Net Export <1%

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 Relative Contribution of Various Components (C, I, G, X-M)

GDP for 1989-1990 ($bn) Consumption, C 0223 (55%) Wages 0199 (49%)
Investment, I 0112 (28%) Interest, Profit, Rent 0164 (40%)
Government, G 0070 (17%) Indirect Taxes 0042 (11%)
Net Export (X - M) 00-8 (-2%)

Nominal GDP 0404 Nominal GDP 0404

GDP for 2017-2018 ($bn)

Consumption, C 1044 (56%) Wages 0871 (47%)

Investment, I 0447 (24%) Interest, Profit, Rent 0791 (43%)
Government, G 0346 (19%) Indirect Taxes 0186 (10%)
Net Export (X - M) 0007 (~0%)

Nominal GDP 1848 Nominal GDP 1848

44
Source: Australian Bureau of Statistics (www.abs.gov.au)
 GDP (Contd.)
MACROECONOMIC IMPACTS OF POLICY CHANGES
• Example: Sharma, Sandu & Misra (2014), Energy Efficiency Improvements in Asia:
Macroeconomic impacts, ADB Working Paper No. 406.

45
• Consumption & investment play crucial roles in a
nation’s economy

High C, Low I => Low Growth

Low C, High I => High Growth
C I Per-capita GDP
(%GDP) (%GDP) growth (%pa)
China 39 44 6.2
India 59 31 6.0
Indonesia 57 34 3.8
Singapore 36 28 3.6
S. Korea 48 31 2.6
Italy 61 18 1.8
Brazil 64 15 0.3
Afghanistan 80 19 0.1
Nigeria 80 15 -1.8
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Source: World Bank’s World Development Indicators (2017 data)
 SIGNIFICANCE OF INVESTMENT
• INVESTMENT IS THE MOST CRITICAL COMPONENT OF
GDP

• WHY?

• MULTIPLICATIVE EFFECT OF INVESTMENT

- Increase in investment will increase national income by
a multiplied amount – by an amount greater than
itself!

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 Significance of Investment (Contd.)

• CONCEPTS

- Increase in income = Consume + Save

- Propensity to consume: Response of consumption to

change in income

- Marginal Propensity to Consume (MPC): Extra amount

consumed when income increases by a dollar

- Marginal Propensity to Save (MPS): Extra amount

saved when income increases by a dollar
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 Significance of Investment (Contd.)

• MARGINAL PROPENSITY TO CONSUME (MPC)

e.g. $1 (income) = 70c (consumption) + 30c (saving)
MPC = 0.7
MPC for Society = ƩMPC/Individuals

• MARGINAL PROPENSITY TO SAVE (MPS)

MPS = 1 – MPC
= 1 – 0.7
MPS = 0.3

• DETERMINANTS OF ‘C’ (Or Savings)

- Income
- Tax structure
- Price levels 49
 Significance of Investment (Contd.)

• MULTIPLICATIVE EFFECT

INCREASE IN INCOME Income ($) MPC Spending ($)

CARPENTER + LUMBER PRODUCER 1000 2/3 667

Producer I 667 2/3 444

Producer II 444 2/3 296

Producer III 296 2/3 197

Producer IV 197 2/3 132

… … … …

Total Income 3000

Source: Samuelson (1980)
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 Significance of Investment (Contd.)

• One unit increase in investment results in more than one

unit increase in national income

• Investment $1000

• Total income $3000 = 3 × 1000

$1000 investment resulted in increase in national income
by $2000

• Investment Multiplier:
𝟏
𝟏−𝑴𝑷𝑪
𝟏
∆𝒀 = × ∆𝑰
𝟏−𝑴𝑷𝑪

51
 Significance of Investment (Contd.)

• Typical Sources of Investment

Purchase of Business fixed Additions to

residential plant & inventory
structures equipment

Generally, the most important component of I

52
 Significance of Investment (Contd.)

• ROLE OF INVESTMENT
- Short-run: increase of total demand, output, and
employment
- Long-run: capital formation (additions of capital stock)

• RECESSIONARY TIMES
- Low private consumption
- Low business investment

• POSSIBLE WAY TO INCREASE NATIONAL INCOME

Increase I through G (Taxes) – Keynesian
Increase I through private sources – Neo-classical
53
 DETERMINANTS OF INVESTMENT

INCOME

54
 Determinants of Investment (Contd.)

• INCOME
- Level of GDP – an important determinant

• COST OF INVESTING
- Interest rates (cost of borrowing)
- Taxes (for example, personal, corporate)

• EXPECTATIONS
- Business confidence (domestic and abroad)

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 BALANCE OF PAYMENTS

• Balance of payments of a country is a record of economic

transactions between the country & the rest of the world

• Current account … difference between a country’s total

exports and total imports of goods (i.e., merchandise) and
services (e.g., shipping/air transport, tourism, insurance,
financial/consultancy services)
– exports ˃ imports → Trade Surplus
– exports < imports → Trade Deficit

• Capital account … tracks the ownership of assets held by

foreigner and ownership of foreign assets. It is the capital
inflow (outflow) that is needed to offset the deficit
(surplus) on the current account 56
 57
Source: Australian Bureau of Statistics (www.abs.gov.au)
 Balance Of Payments (Contd.)

• Income
- Dividends from Australian companies to overseas
owners share-holders or investors
- Foreign earnings of Australian investors
- Interest payments on loans & credits

• Unrequited transfers
- Money brought by newly arrived migrants & other
people
• National Debt
- Cumulative effect of past borrowings
58
APPROPRIATENESS OF GDP AS A MEASURE OF
ECONOMIC WELFARE?

• does not verify distribution of income; according to Kuznets (1934),

“economic welfare cannot be adequately measured unless the
personal distribution of income is known … the welfare of a nation
can, therefore, scarcely be inferred from a measurement of national
income”
• does not consider externalities, unpaid activity, domestic work, etc
• does not consider difference in exchange rate
• a country with large income disparities (lower standard of living)
may look economically stronger than another country with smaller
income disparities (higher standard of living)

59
 ALTERNATIVE TO GDP?

• Example: Genuine Progress Indicator (GPI)

60
Source: Talberth et.al. (2007) The Genuine Progress Indicator 2006, The Nature of Economics. Redefining Progress, Oakland, CA.
• Australia’s GPI

Source: Kenny et.al. (2019) Australia's Genuine Progress

Indicator Revisited, Ecological Economics, Vol. 158, pp.1-10.

61
 ALTERNATIVE TO GDP?
• Better Life Index
• Gallup Happiness Survey
• World Values Survey
• …

No measure can be totally objective, not even income numbers or GDP. Such
alternative measures may give us a sense of false consciousness.

Not everything that counts can be measured. Not everything that can be
measured counts. – Albert Einstein

Despite weaknesses the measures in economics are still important. We just

need to be fully aware of what these measures do and don’t tell us.

62
 INSTRUMENTS OF MACROECONOMIC POLICY

Definition: a policy instrument is an economic variable

under the direct or indirect control of the government;
changes in policy instruments affect one or more of
the macroeconomic objectives

63
 Instruments Of Macroeconomic Policy (Contd.)

FISCAL POLICY GOVT. EXPENDITURE

TAXATION

MONEY IN CIRCULATION
MONETARY POLICY
INTEREST RATES

POLICY INTERNATIONAL TRADE POLICIES (TARIFFS, QUOTAS)

INSTRUMENTS SECTOR POLICY EXCHANGE RATES

WAGE & INCOME WAGES

POLICIES PRICES

STRUCTURAL LONG-TERM
POLICIES STRUCTURE/GROWTH
64
 Instruments Of Macroeconomic Policy (Contd.)

• A change in macroeconomic policy through any of the

policy instruments will affect all national objectives
(output, employment, prices, trade)

• Each policy instrument has a marked impact on a specific

objective, but affects other as well

• ‘Trade-offs’ are inevitable

• Choice depends on objectives

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NEXT WEEK

MICROECONOMICS

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