Engineering Economy

Unit 1: The Economic Environment

This part of the module will give you knowledge and understanding about economic environment,
especially in engineering field. Thus, it is important to spend time to understand things about the origins and
principles of engineering economy, the engineering economy and the design process, concepts of value and
utility, consumer and producer goods and services, economic aspects of exchange, classification of cost,
necessities and luxuries, demand, market situations, competition, monopoly and oligopoly, the law of supply
and demand, and the law of diminishing return.

Unit Objectives:

1. Learn the principles and importance of economy in engineering.

2. Explain the engineering process in making sound decision for engineering proposals.

Unit Outline:

A. Introduction
B. Engineering and Science
C. The Bi – Environmental Nature of Engineering
D. The Engineering Process
E. Plan for Engineering Economy Studies
F. The Engineering Economy and The Engineer
G. Definition of Engineering Economy
H. Origins of Engineering Economy
I. Principles of Engineering Economy
J. Engineering Economy and The Design Process
K. Concepts of Value and Utility
L. Consumer and Producer Goods and Services
M. Economic Aspects of Exchange
N. Classification of Cost
O. Necessities and Luxuries
P. Demand
Q. Market Situations, Competition, Monopoly and Oligopoly
R. The Law of Supply and Demand
S. The Law of Diminishing Return

Unit Content:

A. Introduction

Engineering activities of analysis and design are not an end in them but are a means for satisfying
human wants. Thus, engineering has two aspects. One aspect concerns itself with the materials and forces
of nature; the other is concerned with the needs of people. Because we live in a resource – constrained
world, engineering must be closely associated with economics. It is essential that engineering proposals be

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evaluated in terms of worth and cost before they are undertaken. In this unit and throughout the text, it
emphasize that an essential prerequisite of successful engineering application is economic feasibility.

B. Engineering and Science

Engineering is not a science, but an application of science. It is an art composed of skill and ingenuity
in adapting knowledge to the uses of humanity. The Accreditation Board for Engineering and Technology has
adopted the definition that “Engineering is the profession in which knowledge of the mathematical and
natural sciences gained by study, experience, and practice is applied with judgment to develop ways to
utilize, economically, the materials and forces of nature for the benefit of mankind.” This, like most other
accepted definitions, emphasizes the applied nature of engineering.

The role of the scientist is to add to mankind’s accumulated body of systematic knowledge and to
discover universal laws of behaviour. The role of the engineering is to apply this knowledge to particular
situations to produce products and services. To the engineer, knowledge is not an end in itself but is the raw
material from which he or she fashions structures, systems, products, and services. Thus, engineering
involves the determination of the combination of materials, forces, and human factors that will yield a
desired result. Engineering activities are rarely carried out for the satisfaction that may be derived from
them directly. With few exceptions, their use is confined to satisfying human wants.

Modern civilization depends to a large degree upon engineering. Most products and services used to
facilitate work, communication, transportation, and national defense and to furnish sustenance, shelter, and
health are directly or indirectly a result of engineering activity. Engineering has also been instrumental in
providing leisure time for pursuing and enjoying culture. Through the development of instant
communication and rapid transportation, engineering has provided the means for both cultural and
economic improvement of the human race.

Science is the foundation upon which the engineer builds toward the advancement of mankind.
With the continued development of science and the worldwide application of engineering, the standard of
living may be expected to improve and further increase the demand for those things that contribute to
people’s love for the comfortable and beautiful. The fact that these human wants may be expected
increasingly to engage the attention of engineers is, in part, the basis for the incorporation of humanistic
and social considerations in engineering curricula. An understanding of these fields is essential as engineers
seek solutions to the complex socio-technological problems of today.

C. The Bi – Environmental Nature of Engineering

Engineers are confined with two important interconnected environments, the physical and
economic. Their success is altering the physical environment to produce products and services depend upon
knowledge of physical laws. However, the worth of these products and their services lies in their utility
measured in economic terms. These are numerous examples of structures, machines, processes, and
systems that exhibit excellent physical design but have little economic merit.

Much less, particularly of a quantitative in nature, is known about the economic environment. Since
economics is involved with the actions of people, it is apparent that economic laws be based upon their
behavior. Economic laws can be no more exact than the description of the behaviour of people acting singly
and collectively.

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 Want satisfaction in the economic environment and engineering proposals in physical environment
are linked by the production or the construction process. The usual functions of engineering are to
manipulate the elements of one environment, to create value in a second environment, the economic.
However, engineers sometimes have a tendency to disregard economic feasibility and are often appalled in
practice by the necessity for meeting situations in which action must be based on estimates and judgment.
Yet today’s engineering graduates are increasingly finding themselves in positions in which their
responsibility is extended to include economic considerations.

Engineers can readily extend their inherent ability of analysis to become proficient in the analysis of
the economic aspects of engineering application in the analysis of the economic aspects of engineering
application. Furthermore, the engineer who aspires to a creative position in engineering will find proficiency
in economic analysis. The large percentage of engineers who will eventually be engaged in managerial
activities will find such proficiency a necessity.

The Total Environment

Physical Environment Economic Environment

Engineering Production or
Want Satisfaction
Proposals Construction

Figure: Engineering Process

Both individuals and enterprises possess limited resources. This makes it necessary to produce the
greatest output for a given input – that is, to operate at high efficiency. Thus, the search is not merely for a
good opportunity for the employment of limited resources, but for the best opportunity.

People are continually seeking to satisfy their wants. In so doing, they give up certain utilities in
order to gain others that they value more. This is essentially an economic process in which the objective is
the maximization of economic efficiency.

Engineering is primarily a producer activity that comes into being to satisfy human wants. Its
objective is to get the greatest end result per unit of resource expenditure. This is essentially a physical
process in which the objective is maximization of physical efficiency.

The objective of engineering application is to get the greatest end result per unit of resource input.
This statement is an expression of physical efficiency, which may be stated as

Where: Physical efficiency is always be less than unity or less than 100%.

On the second level are economic efficiencies. These are expressed in terms of economic units of
output divided by economic units of input, each expressed in terms of a medium of exchange such as
money. Economic efficiency may be stated as

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 Where: Economic efficiency exceeds 100% and must dos so for economic undertakings to be
successful.

In the final evaluation of most ventures, even those in which engineering plays a leading role,
economic efficiencies must take precedence over physical efficiencies. This is because the function of
engineering is to create utility in the economic environment by altering elements of the physical
environment.

D. The Engineering Process

Engineering activities dealing with the physical environment take place to meet human needs that
arise in an economic setting, as was illustrated in the figure.

1. Determination of objectives
2. Identification of strategic factors
3. Determination of means
4. Evaluation of engineering proposals
5. Assistance in decision making

E. Plan for Engineering Economy Studies

The engineering process described in the previous section involves a creative element based on the
employment of engineering economy studies. These economy studies can be made either haphazardly or on
the basis of a logical plan. This plan involves:

1. The creative step

2. The definition step
3. The conversion step
4. The decision step

F. The Engineering Economy and The Engineer

Economy, the attainment of an objective at low cost in terms of resource input, has always been
predominantly physical. Thus, a great innovation, the wheel, awaited invention, not because it was useless
or costly, but because the mind of man could not synthesize it earlier. But, with the development of science,
things have become physically possible that people are interested in only slightly or not at all. Thus, a new
type of communication system may be perfectly feasible from the physical standpoint but may enjoy limited
use because of its first cost or cost of operation.

The engineer is often concerned by the lack of certainty associated with the economic aspect of
engineering. However, it must be recognized that economic considerations embrace many of the subtleties
and complexities characteristics of people. Economics deals with the behaviour of people individually or
collectively, particularly as their behaviour relates to the satisfaction of their wants.

Those who have a part in satisfying human wants must accept the uncertain action of people as a
factor with which they must deal, even though they find such action unexplainable. Much or little progress
has been made in learning how to predict human reactions, depending upon one’s viewpoint. The idea that

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human reactions will someday be well enough understood to be predictable is accepted by many people;
but even though this has been the objective of the thinkers of the world since the beginning of time, it
appears that progress in psychology has been meagre compared to the rapid progress made in the physical
sciences. In spite of the fact that human reactions can be neither predicted nor explained, they must be
considered by those who are concerned with satisfying human wants.

Since economic factors are the strategic consideration in most engineering activities, engineering
practice may be either responsive or creative. If the engineer takes the attitude that he should restrict
himself to the physical, he is likely to find that the initiative for the application of engineering has passed on
those who will consider economic and social factors.

G. Definition of Engineering Economy

Engineering Economy is 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.

Engineering Economy deals with the concepts and techniques of analysis useful in evaluating the
worth of systems, products, and services in relation to their cost.

Engineering Economy involves the systematic evaluation of the economic merits of proposed
solutions to engineering problems. To be economically acceptable (i.e., affordable), solutions to engineering
problems must demonstrate a positive balance of long-term benefits over long-term costs, and they must
also

1. Promote the well-being and survival of an organization,

2. Embody creative and innovative technology and ideas,
3. Permit identification and scrutiny of their estimated outcomes, and
4. Translate profitability to the “bottom line” through a valid and acceptable measure of merit.

A few more of the myriad situations in which engineering economy plays a crucial role come to
mind:

1. Choosing the best design for a high-efficiency gas furnace.

2. Selecting the most suitable robot for a welding operation on an automotive assembly line.
3. Making a recommendation about whether jet airplanes for an overnight delivery service should be
purchased or leased.
4. Determining the optimal staffing plan for a computer help desk.

H. Origins of Engineering Economy

Cost considerations and comparison are fundamental aspects of engineering practice. However, the
development of engineering economy technology which is now used in nearly all engineering work is
relatively recent. However, the perspective that ultimate economy is a primary concern to the engineer and
the availability of sound techniques to address this concern differentiate this aspect of modern engineering
from the past.

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 In 19th century, Arthur M. Wellington, a civil engineer address the role of economic analysis in
engineering projects and his particular area of interest was railroad building in the United States in which
the emphasis was on techniques that depended primarily in financial and actual mathematics. In 1930,
Eugene Grant published the first edition of his textbook and his emphasis on developing an economic of
view in engineering and this point of view involves a realization that quite as definite a body of principles
govern the economic aspects of an engineering decision as governs its physical aspects. In 1942, Woods and
De Garmo wrote the first edition of Engineering Economy.

I. Principles of Engineering Economy

The following are the procedure and principles of engineering economy.

1. Develop the Alternatives

The choice (decision) is among alternatives. The alternatives need to be identified and then defined
for subsequent analysis.

2. Focus on Differences

Only the differences are expected for future outcomes among the alternatives are relevant to their
comparison and should be considered in the decision.

3. Use a Consistent Viewpoint

The prospective outcomes of the alternatives, economic and other, should be consistently
developed from a defined viewpoint (perspective).

4. Use a Common Unit of Measure

Using a common unit of measurement to enumerate as many of the prospective outcomes as

possible will make easier the analysis and comparison of the alternatives.

5. Consider All Relevant Criteria

Selection of a preferred alternative (decision making) requires the use of a criterion (or several
criteria). The decision process should consider both the outcomes enumerated in the monetary unit and
those expressed in some other unit of measurement or made explicit in a descriptive manner.

6. Make Uncertainty Explicit

Uncertainty is inherent in projecting (or estimating) the future outcomes of the alternatives and
should be recognized in their analysis and comparison.

7. Revisit Your Decision

Improved decision making results from an adaptive process; to the extent practicable, the initial
projected outcomes of the selected alternative should be subsequently compared with actual results
achieved.

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J. Engineering Economy and the Design Process

As we study engineering economy you can accomplished using a structural procedure and
mathematical modelling techniques. The economic results are then used in decision situation that involves
two or more alternatives and normally includes other engineering knowledge and input.

1. Problem Definition

a. It provides the basis for the rest of the analysis.

b. It includes all decision situations for which an engineering economy analysis is required.
c. It includes refinement needs and requirements for evaluation process.

2. Development of Alternatives

a. Concentrate on redefining one problem at a time.

b. Develop many redefinitions for the problem.
c. Avoid making judgements as new problem definitions are created.
d. Attempt to redefine a problem in terms that are dramatically different from the original (problem
definition).
e. Make sure that the true problem is well researched and understood.

Note: Limitations in searching for superior alternatives: lack of time and money, preconceptions of what will
and what will not work and lack of knowledge.

3. Development of Prospective Outcomes

a. Meeting or exceeding expectations

b. Safety
c. Improving satisfaction
d. Maintaining flexibility to meet changing demands
e. Meeting or exceeding all requirements
f. Achieving good relationships

4. Selection of a Decision Criterion

5. Analysis and Comparison of Alternatives

6. Selection of the Preferred Alternative

7. Performance Monitoring and Post-evaluation of Results

Example of engineering economy and design procedure:

Engineering Economic Procedure Engineering Design

Step Activity
a.Problem recognition, definition and evaluation a.Problem/need definition
b.Development of the feasible analysis b.Problem/need formulation and evaluation

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 c.Development of the cash flows for each c.Synthesis of possible solutions (alternatives)
alternative
d.Selection of a criterion (or criteria) d.Analysis, optimization and evaluation
e.Analysis and comparison of the alternatives e.Analysis, optimization and evaluation
f.Selection of the preferred alternative f.Analysis, optimization and evaluation
g.Performance monitoring and post evaluation of g.Analysis, optimization and evaluation
results

K. Concepts of Value and Utility

Concepts are crystallized thought that have withstood the test of time. They are usually qualitative
in nature and not necessarily universal in application. The ability to arrive at correct decisions depends
jointly upon a sound conceptual understanding and the ability to handle the quantitative aspects of the
problem.

Value has variety of meanings, in economics; value designates the worth that a person attaches to
an object or service. Thus, the value of an object is inherent not in the object but in the regard that a person
has for it. Value should not be confused with the cost or the price of an object in engineering economy
studies. There may be little or no relation between the values a person ascribes to an article and the cost of
providing it, or the price that is asked for it.

Utility is the power to satisfy human wants. The utility of an object has for an individual is
determined by him or her. Thus, the utility of an object, like its value, inheres not in the object itself but in
the regard that a person has for it.

Utility and value in the sense used here are closely related. The utility that an object for a person is
the satisfaction he or she derives from it. Value is an appraisal of utility in terms of a medium of exchange.

L. Consumer and Producer Goods and Services

Good or commodity is defined as any tangible economic product (soap, car, shirts, tools, machines,
etc.) that contributes or indirectly to the satisfaction of human wants.

Service is defined as any tangible economic activity (hairdressing, insurance, banking, catering, etc.)
that contribute directly or indirectly to the satisfaction of human wants.

Economists classify goods and services as either “consumer goods and service” or “producer goods
or services”.

Consumer goods and services are those products or services that are directly used by people to
satisfy their wants. Examples of consumer goods are houses, cars, clothes, appliances, food, books, movies,
medical and dental services, etc.

Producer goods and services also satisfy human wants but indirectly in as much as they are used to
produce the consumer goods and services. Examples of producer goods and services are factory buildings,
machine tools, airplanes, ships, busses, etc.

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M. Economic Aspects of Exchange

Economy of exchange occurs when utilities are exchange by two or more people. in this connection,
a utility means anything that a person may receive in an exchange that has any value whatsoever – for
example, a lathe, a dozen pencils, a meal, music, or a friendly gesture.

1. Manual Benefits in Exchange

A buyer will purchase an article when money is available and when he or she believes that the
article has equal or greater utility than the amount required to purchase it. Conversely, a seller will sell an
article when he or she believes that the amount of money to be received for the article has greater utility
than the article. Thus, an exchange will not be affected unless at the time of exchange both parties believe
that they will benefit. Exchanges are made when they are thought to result in mutual benefit. This is
possible because the objects of exchange are not valued equally by the parties to the exchange.

2. Persuasion in Exchange

It is not uncommon for an equipment salesperson to call on a prospective customer, describe and
explain a piece of equipment, state its price, offer it for sale, and have the offer rejected. This is concrete
evidence that the machine has not posses’ sufficient utility at the moment to induce the prospective
customer to buy it. In such a situation, the salesperson may be able to induce the prospect to listen to
further sales talk, during which the prospect may decide to buy on the basis of the original offer. This is
concrete evidence that the machine now possesses sufficient utility to induce prospective customer to buy.
Because there was no change in the machine or the price at which it was offered, there must be a change in
the customer’s attitude or regard for the machine. The pertinent fact to grasp is that a proposition at first
undesirable now has become desirable as a result of a change in the customer, not in the proposition.

N. Classifications of Cost

The ultimate objective of engineering application is the satisfaction of human wants. But human
wants are not satisfied without cost. Alternative engineering proposals will differ in the costs they involve
relative to the objective of want satisfaction. The engineering proposal resulting in least cost will be
considered best if its end result is identical to that of competing proposals.

A number of cost classifications have come into use to serve as a basis for economic analysis. As
concepts, these classifications are useful in calling to mind the source and effect of costs that will have a
bearing on the end result of a proposal.

1. First cost the initial cost of a capitalized property, including transportation, installation for service, taxes
and other related initial expenditure in order to make the property or asset or equipment functional.
This is sometimes called investment cost.

2. Operation and maintenance cost

a. Operating costs are incurred by the operation of physical plant or equipment needed to provided
service – examples include items such as labor and raw materials.
b. Maintaining costs occur over time until the structure, system, or equipment item is retired from
service.
3. Fixed and variable cost

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 a. Fixed cost is a cost that remains constant over a wide range of activity as long as the business does
not permanently discontinue operations. This includes property taxes, overhead, interest of
borrowed capital, etc. It also refers to the cost that is not a function of the independent variable.
b. Variable cost is a cost that varies more or less directly with the volume of output. This includes
labor, material, power, etc.
4. Incremental and marginal cost
a. Incremental cost the additional cost that will result from increasing the output of a system by one
or more units.
b. Marginal cost the cost of an additional unit of a product.
5. Sunk cost refers to the cost in the past. This may include any past expenditure, the uncovered balance of
an investment and capital already invested that cannot be retrieved.

O. Necessities and Luxuries

Goods and services are divided into two types, necessities and luxuries.

Necessities are those products or services that are required to support human life and activities,
that will purchased in somewhat the same quantity even though the price varies considerably.

Necessity product or staple product is defined as any product that has an income-elasticity of
demand less than one. This means that as income arises, proportionately less income is spent on such
products. Examples of necessity products include basic foodstuffs like bread and rice, clothing, etc.

Luxuries are those products or services that are desired by humans and will be purchased if money
is available after the required necessities have been obtained.

Luxury product is defined as any product that has an income-elasticity of demand greater than one.
This means that as income rises, proportionately more income is spent on such products. Examples of luxury
products include consumer durables like electric appliances, expensive cars, holidays and entertainment,
etc.

Necessities and luxuries are relative terms because there are some goods and services which may be
considered by one person as necessity but luxury to another person.

For example, a man living in the Metropolis finds a car as an absolute necessity for him to be able to
go to his workplace and back to his home. If the same person lived and worked in another city, less
populated with adequate means of public transportation available, then a car will become a luxury for him.

P. Demand

1. Demand is the quantity of a certain commodity that is bought at a certain price at a given place and
time.

2. Elastic demand occurs when a decrease in selling price result in a greater that proportionate increase in
sales.

3. Inelastic demand occurs when a decrease in selling price produces a less than proportionate increase in
sales.

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4. Unitary elasticity of demand occurs when the mathematical product of volume and price is constant.
Q. Market situations, Competition, Monopoly and Oligopoly

The term “market” refers to the exchange mechanism that brings together the sellers and buyers of
a product, factor of production or financial security. It may also refer to the place or are in which buyers and
sellers exchange a well-defined commodity.

Buyer or consumer is defined as the basic consuming or demanding unit of a commodity. It may be
an individual purchaser of a good service, a household (a group of individuals who make joint purchasing
decisions), or a government.

Seller is defined as an entity which makes product, good or service available to buyer or consumer in
exchange of monetary decision.

The price of any commodity or product will depend largely on the market situation. The following is
a tabulation of the different market situations.

Market Situation Sellers Buyers

Perfect competition many Many
Monopoly one Many
Monopsony many One
Bilateral monopoly one One
Duopoly two Many
Duopsony many Two
Oligopoly few Many
Oligopsony few Few
Bilateral oligopoly few Few

Perfect competition also known as atomistic 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.

Perfect competition is a type of market situation characterized by the following:

1. Many sellers and many buyers: Since there are a large number of sellers and a large number of sellers
and a large number of buyers, each seller and buyer will become sufficiently small to be unable to
influence the price of the product transacted.

2. Homogeneous products: The products offered by the competing sellers are identical or not only in
physical attributes but are also regarded as identical by the buyers who have no preference between the
products of various producers.

3. Free market-entry and exit: There are no barriers to entry or impediments to the exit of the existing
sellers.

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4. Perfect information: All buyers and all sellers have complete information on the prices being asked and
offered in all other parts of the market.
5. Absence of all economic friction: There is a total absence of economic friction including transport cost
from one part of the market to another.

This market situation provides an assurance of complete freedom on the part of both the vendors
and the buyers though the latter benefits more from the reduced prices brought about by the competition
while more and better services are afforded by the vendors or players in the industry.

Monopoly is the opposite of perfect competition. A perfect monopoly exist when a unique product
or service is available from a single vendor can prevent the entry of all others in the market. This market
situation is characterized by the following:

1. One seller and many buyers: A market comprised of a single supplier selling to a multitude of small,
independently-acting buyers.
2. Lack of substitute products: There are no close substitutes for the monopolist’s product.
3. Blockaded entry: Barriers to entry are so severe that is impossible for other sellers to enter the market.

There exists a perfect monopoly if the single vendor can prevent the entry of all the vendors into the
market. The monopolist is in the position to set the market price.

A natural monopoly is a market situation where economist of scale is so significant that costs are
only minimized when the entire output of an industry is supplied by a single producer so that supply costs
are lower under monopoly than under competition and oligopoly.

Oligopoly exists when there are few suppliers of a product or service that action by one will almost
inevitably result in similar action by the others. This type of market situation is characterized by the
following:

1. Few seller and many buyers: The bulk of market supply is in the hands of a relatively few sellers who sell
too many small buyers.
2. Homogeneous of differentiated products: The products offered by the suppliers may be identical or
more commonly, differentiated from each other in one or more respects. These differences may be of a
physical nature, involving functional features, or may be purely “imaginary” in the sense that artificial
differences are created through advertising and sales promotion.
3. Difficult market entry: High barriers of entry which make it difficult for new sellers to enter the market.

R. The law of Supply and Demand

Supply is the quantity of a certain commodity that is offered for sale at a certain price at a given
place and time or is the amount of a product made available for sale.

If the selling price for a product is high, more producers will be willing to work harder and risk more
capital in order to reap more profit. However, if the selling price for a product declines, capitalists will not
produce as much because of the smaller profit they can obtain for their labor and work.

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 Demand is the need, want or desire for a product backed by the money to purchase it. In economic
analysis, demand is always based on “willingness and ability to pay” for a product, not merely want or need
for the product.

The demand of a product is inversely proportional to its selling price, i. e. as the selling price is
increased, there will be less demand for the product; and as the selling price is decreased, the demand will
increase.

Therefore, the relationship between price and supply is that they are directly proportional, i. e. the
bigger selling price, the more the supply; and the smaller the selling price, the less is the supply.

The law of supply and demand may be stated as follows:” Under conditions of perfect competition
the price at which a given product will be supplied and purchased is the price that will result in the supply
and the demand being equal.”

S. 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.

Thanks for spending time for the lesson. I know you got tired while studying the unit. You are now
about to dig in to the lesson more and submerge yourself into it. Do you still have energy and time for the
next process? If yes, click next. If not, have at least 5 to 15 minutes break then go back to this unit. Please be
reminded that you only have 3 hours to complete the whole unit 2, so please manage your time properly.

References:

1. Fundamental of Engineering Economics by Chan S. Park 2004

2. Engineering Economy by Jaime R. Tiong 2002
3. Engineering Economy 10th Edition by William Sullivan 1997
4. Engineering Economy 3rd Edition by Matias Arreola 1993
5. Engineering Economy 2nd Edition by Hipolito Sta. Maria 1993

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