ES 91 Chapter 1 The Economic Environment

ES 91
Engineering Economy
Chapter 1
Sullivan: Introduction to Engineering Economy
Sta. Maria: The Economic Environment
Maria Cristina P. Vegafria

Copyright ©2012 by Pearson Education, Inc.
Engineering Economy, Fifteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
Engineering Economy…
 involves the systematic evaluation of the
economic merits of proposed solutions to
engineering problems (Sullivan)
 the analysis and evaluation of the factors
that will affect the economic success of
engineering projects to the end that a
recommendation can be made which will
insure the best use of capital (Sta. Maria)
The purpose of this book is to develop and
illustrate the principles and methodology
required to answer the basic economic question
of any design:
Do its benefits exceed its costs?

Solutions to engineering problems must:
• promote the well-being and survival of an organization,

• embody creative and innovative technology and ideas,
• permit identification and scrutiny of their estimated
outcomes, and
• translate profitability to the “bottom line” through a valid
and acceptable measure of merit.

Roles engineering economic analysis
can play in many types of situations.
• Choosing the best design for a high-efficiency gas
furnace.
• Selecting the most suitable robot for a welding operation
on an automotive assembly line.
• Making a recommendation about whether jet airplanes
for an overnight delivery service should be purchased or
leased.
• Determining the optimal staffing plan for a computer help
desk.

Seven Fundamental Principles of
Engineering Economy
• Develop the alternatives
• Focus on the differences
• Use a consistent viewpoint
• Use a common unit of measure
• Consider all relevant criteria
• Make uncertainty explicit
• Revisit your decisions

Engineering Economic Analysis
Procedure
• Problem definition
• Development of alternatives
• Development of prospective outcomes
• Selection of a decision criterion
• Analysis and comparison of alternatives.
• Selection of the preferred alternative.
• Performance monitoring and post-evaluation of
results.

Electronic spreadsheets are a powerful
addition to the analysis arsenal.
• Most engineering economy problems can be
formulated and solved using a spreadsheet.
• Large problems can be quickly solved.
• Proper formulation allows key parameters to be
changed.
• Graphical output is easily generated.

The Economic Environment
Consumer goods and services

 those products or services that are directly used
by people to satisfy their wants
Producer goods and services

 used to produce consumer goods and services
or other producer goods

Demand
Demand
 The quantity of a certain commodity that is
bought at a certain price at a given place and
time
Elasticity of Demand (ED)

 Responsiveness of the quantity demanded of a
commodity to changes in one of the variables on
which demand depends
https://www.toppr.com/guides/business-economics/theory-of-demand/elasticity-of-demand/
 The percentage change in quantity demanded divided by
the percentage change in one of the variables on which
demand depends
Variables on which demand can depend:

• Price of the commodity
• Prices of the related commodities
• Consumer’s income, etc.

https://www.tutor2u.net/business/reference/income-elasticity-of-demand-1
Elastic Demand
 Occurs when a decrease in selling price results in a greater
than proportionate increase in sales
Inelastic Demand
 Occurs when a decrease in the selling price produces a
less than proportionate increase in sales

Price Elasticity of Demand (PED)
 If PED = 0 , demand is perfectly inelastic - demand does not

change at all when the price changes – the demand curve will be
vertical.
 If PED is between 0 and 1 (i.e. the % change in demand from A to B
is smaller than the percentage change in price), then demand is
inelastic.
 If PED = 1 (i.e. the % change in demand is exactly the same as the %
change in price), then demand is unit elastic.
 If PED > 1, then demand responds more than proportionately to a
change in price i.e. demand is elastic.

Engineering Economy, Fifteenth Edition https://www.tutor2u.net/economics/reference/price-elasticity-of-demand
Perfectly Inelastic Demand (PED = 0)
If the coefficient of PED = 0, demand is perfectly inelastic
(i.e. demand does not vary with a change in price)
• A perfectly inelastic demand curve

is an extreme case for it implies
that consumers are willing and
able to pay any price for the
product.
• If supply falls, equilibrium market
price can rise without any
contraction in the quantity
demanded.

Inelastic Demand (0 < PED < 1)
If the coefficient of PED < 1, then demand is said to be
price inelastic.
• Inelastic means that when

the price goes up, consumers' buying
habits stay about the same, and when
the price goes down, consumers'
buying habits also remain unchanged
• Following a change in price, the total
revenue earned by the producing firm
will depend on the PED for its product.
• If the coefficient of PED < 1, a rise in
market price (e.g. from P1 to P2) will
lead to an increase in total revenue.
Inelastic Demand (0 < PED < 1)
If the coefficient of PED < 1, then demand is said to be
price inelastic.
• With a much steeper curve

• Large changes in price barely affect
the quantity demanded.
• Following a change in price, the total
revenue earned by the producing firm
will depend on the PED for its product.
• If the coefficient of PED < 1, a rise in
market price (e.g. from P1 to P2) will
lead to an increase in total revenue.

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling http://theentrepreneurcoaches.com/elastic-and-inelastic-demand/
Unitary Elastic Demand (PED = 1)
A demand curve with unitary price elasticity has a
coefficient of PED = 1 (unity) throughout.
• With a demand curve of unitary

price elasticity, a change in price
is met with a proportionate change
in demand.
• Total spending by consumers on
the product will remain the same
at each price level.

Elastic Demand (PED > 1)
If the coefficient of PED > 1, then demand is said to be
price elastic (i.e. highly responsive to a change in price)
• With a flatter curve

• If demand for a product is price
elastic, a supplier stands to gain
extra revenue if they reduce their
prices.
• The change in quantity demanded
will be proportionately higher than
the reduction in price.
• People would rather stop
consuming this product or switch
to some alternative rather than
pay a higher
Engineering price
Economy, Fifteenth Edition
https://www.tutor2u.net/economics/reference/price-elasticity-of-demand
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling http://theentrepreneurcoaches.com/elastic-and-inelastic-demand/
• If demand for a product is
perfectly elastic, a change in
market supply will not lead to any
change in equilibrium price.
• This demand curve applies to
highly competitive markets where
no supplier has any “pricing
power”).

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koellinghttps://www.tutor2u.net/economics/reference/price-elasticity-of-demand
Income Elasticity of Demand (IED)
FIVE TYPES
1. High (IED > 1): A rise in income comes with bigger increases in the
quantity demanded (Income Elastic).
2. Unitary (IED = 1): The rise in income is proportionate to the
increase in the quantity demanded.
3. Low (0 < IED < 1): A jump in income is less than proportionate than
the increase in the quantity demanded (Income Inelastic).
4. Zero (IED =0): The quantity bought/demanded is the same even if
income changes (Perfectly Inelastic)
5. Negative (IED < 0): An increase in income comes with a decrease
in the quantity demanded.
https://www.investopedia.com/terms/i/incomeelasticityofdemand.asp
IED
Interpretation
1. Normal Goods
 With positive IED
 As consumers’ income rises, more goods are demanded at each
price level
a. Necessity goods : 0< IED < 1
As income rises, the proportion of total consumer expenditures on
necessity goods typically declines.
b. Luxury Goods: IED > 1
Consumers will buy proportionately more of a particular good
compared to a percentage change in their income.
2. Inferior Goods
 With negative IED (IED < 1)
 As consumers’ income rises, they buy fewer inferior goods
(e.g.Economy,
Engineering margarine – much cheaper than butter, cheap
Fifteenth Edition cars)
Normal Good vs Inferior Good

https://saylordotorg.github.io/text_principles-of-economics-v2.0/s08-02-responsiveness-of-demand-to-ot.html
Necessities vs Luxuries
Necessities (0 < IED < 1, Income Inelastic)
 Those products or services that are required to support human life and
activities, that will be purchased in somewhat the same quantity even
though the price varies considerably
 Goods that are critical to our day-to-day life
 Examples: water, electricity, staple groceries (e.g. bread, milk, eggs)
Luxuries (IED > 1, Income Elastic)

 Those products or services that are desired by humans and will be
purchased if money is available after the required necessities have been
obtained
 Goods we would like to have but are not likely to buy unless our income
jumps or the price declines sharply
 Examples: premium cars, jewelries

Necessities vs Luxuries
Copyright ©2012 by Pearson Education, Inc. /

https://economix.blogs.nytimes.com/2010/08/19/from-luxury-to-necessity-and-back-again
Different Market Organizations
Copyright ©2012 by Pearson Education, Inc. /

https://www.toppr.com/guides/business-economics/meaning-and-types-of-markets/types-of-market-structures
1. Perfect Competition
 Occurs in a situation where a commodity or service is supplied by a
number of vendors and there is nothing to prevent additional vendors
entering the market
2. Monopoly
 The opposite of perfect competition
 Exists when a unique product or service in unavailable from a single
vendor and that vendor can prevent the entry of all others into the
market

3. Monopolistic Competition
 A common form of industry (market) structure in the US, characterized
by a large number of firms, none of which can influence market price by
virtue of size alone
 New firms can enter and established firms can exit such an industry with
ease.
 Some degree of market power is achieved by firms producing
differentiated products
Product Differentiation
 A strategy that firms use to achieve market power
 Accomplished by producing products that have distinct positive identities
in consumers’ minds

4. Oligopoly
 A form of industry (market) structure characterized by a few dominant
firms
 The behavior of any one firm in an oligopoly depends to a great extent
on the behavior of others
 Exists when there are so few suppliers of a product or service that action
by one will almost inevitably result in similar action by the others

Perfect Monopoly Monopolistic Oligopoly
Competition Competition
Number of firms Many One Many Few
Product Homogeneous A single, Differentiated Either
differentiated or unique product
homogeneous
Price a decision No Yes Yes, but limited Yes
variable
Easy Entry Yes No Yes Limited
Distinguished by No price Still Price and Strategic
competition constrained by quality behavior
market demand competition
Examples Wheat farming Public utility Restaurants Manufacturing
Textile firm Patented drug Clothing stores industries (e.g.
automobiles,
computers)

https://www.slideshare.net/JacelDeLaRoca/case-micro08-ppt14
Economics and Consumer Demand
Macroeconomics
 studies the economic behavior and relationships of an
entire society
Microeconomics
 examines relationship between individual consumers
and producers

UNT in partnership with TEA, Copyright © All rights reserved.
Demand and Supply
Consumers
 Market participants buying goods and services
Producers
 Market participants selling goods and services
Equilibrium
 The price-quantity pair where the quantity demanded is equal to the
quantity supplied, represented by the intersection of the demand and
supply curves
Equilibrium Price
 The money payment at which consumers and producers agree to
transact
Equilibrium Quantity
 The amount of output exchanged at the equilibrium price
Market Price
 Point where supply and demand for a product are equal
(i.e. Point
Engineering Economy,where supply and demand curves intersect)
Fifteenth Edition
Demand and Supply
Quantity Demanded
 The amount of a good or service consumers are willing
and able to buy at a particular price
Quantity Supplied
 The amount of a good or service producers are willing
and able to sell at a particular price
Demand shows the relationship between price and quantity

demanded, all other factors being equal.
Supply shows the relationship between price and quantity

supplied, all other factors being equal.
Factors Affecting Demand
• How strong is the need or want?
• How available is the supply of products and services to
satisfy individual needs?
• What alternative products could satisfy consumer
needs?
Price of other goods ( substitute or complementary)

Outlook (consumer expectation of future income and prices)
Income (normal goods versus inferior goods)
Number of potential customers (pop.of market)
Taste (fads or fashions)
Factors Affecting Supply
Productivity (Improvements in machines and production
processes of a good or service)
Inputs ( Change in the price of inputs required to produce
the good or service.)
Government Actions (Subsidies, Taxes and Regulations)
Technology (Improvements in machines and production

processes of a good or service)
Outputs ( Price changes in other products produced by the
firm)
Expectations (outlook of future prices and profits)
Size of Industry (Number of firms in the industry)

The Law of
Demand
• When the price of a product is increased, less will be

demanded.
• Quantity demanded and price are negatively related
(i.e. The demand is downward sloping.)
Reasons: income effect and substitution effect

The Law of
Supply
• More will be supplied as prices increase.

• Quantity supplied and price are positively related
(i.e. The supply is upward sloping.)
Reason: Profitability

The Law of Four Basic Laws
1.If demand increases and supply
Supply and remains unchanged, then it leads to
Demand higher equilibrium price and
quantity.
higher
2.If demand decreases and supply

remains unchanged, then it leads to
lower equilibrium price and lower
quantity.
3.If supply increases and demand
lower equilibrium price and higher
quantity.
4.If supply decreases and demand
higher equilibrium price and lower
quantity.
The Law of Diminishing Returns
“ When the use of one of the factors of production is limited, either in
increasing cost or by absolute quantity, a point will be reached beyond
which an increase in the variable factors will result in a less than
proportionate increase in output”
 Also called The Law of Diminishing Marginal Returns, The Principle
of Diminishing Marginal Productivity and The Law of Variable
Proportions
At some point, adding an additional factor of production results in

smaller increases in output.
Example:
A factory employs workers to manufacture its products, and, at some
point, the company operates at an optimal level.
With other production factors constant, adding additional workers
beyond this optimal level will result in less efficient operations.

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ES 91

Maria Cristina P. Vegafria

Do its benefits exceed its costs?

Copyright ©2012 by Pearson Education, Inc.

• promote the well-being and survival of an organization,

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

Consumer goods and services

Producer goods and services

Copyright ©2012 by Pearson Education, Inc.

Elasticity of Demand (ED)

Variables on which demand can depend:

Engineering Economy, Fifteenth Edition

Copyright ©2012 by Pearson Education, Inc.

 If PED = 0 , demand is perfectly inelastic - demand does not

Copyright ©2012 by Pearson Education, Inc.

• A perfectly inelastic demand curve

Copyright ©2012 by Pearson Education, Inc.

• Inelastic means that when

• With a much steeper curve

Copyright ©2012 by Pearson Education, Inc.

• With a demand curve of unitary

Copyright ©2012 by Pearson Education, Inc.

• With a flatter curve

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

Luxuries (IED > 1, Income Elastic)

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Copyright ©2012 by Pearson Education, Inc. /

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

Demand shows the relationship between price and quantity

Supply shows the relationship between price and quantity

Price of other goods ( substitute or complementary)

Technology (Improvements in machines and production

Copyright ©2012 by Pearson Education, Inc.

• When the price of a product is increased, less will be

Copyright ©2012 by Pearson Education, Inc.

• More will be supplied as prices increase.

Copyright ©2012 by Pearson Education, Inc.

2.If demand decreases and supply

At some point, adding an additional factor of production results in

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