UCHUT346

ECONOMICS FOR
ENGINEERS

Module 2
SYLLABUS

Cost concepts – Social cost, private cost – Explicit and

implicit cost – Sunk cost - Opportunity cost - short run
cost curves - Revenue concepts Firms and their
objectives – Types of firms – Markets – Perfect
Competition – Monopoly - Monopolistic
Competition - Oligopoly (features and equilibrium of a
firm) Behavioral Economics – Decision-making biases,
bounded rationality, and engineering applications.
COST OF PRODUCTION
(CONCEPTS)
• Cost is the expenditure incurred y a firm in the
production of a commodity.
• Cost Concepts
• Explicit Cost: it is the expenses actually met by
the producer while producing a commodity. (
Raw materials)
• Implicit Cost: is the opportunity cost of the
factor services supplied by the firm itself. (Rent)
CONTD…

• Accounting Costs – this is the monetary outlay for

producing a certain good. Accounting costs will
include your variable and fixed costs you have to
pay.

• Sunk Cost: These are costs that have been

incurred and cannot be recouped.

• Social Costs. This is the total cost to society. It

includes private costs plus any external costs.
CONTD…

• Private cost: It is the cost incurred by the

producer in the production of a good.

• External Cost: When a commodity is produced it

may cause damages to the environment in the
form of fair pollution, water pollution etc.

• Replacement cost is the amount of money

required to replace an existing asset with an
equally valued or similar asset at the current
market price.
 TYPES OF COST

• Short run cost : Cost refers to a certain period of

time where at least one input is fixed while others
are variable.

• Long run cost : The long run is a period of time in

which all factors of production and costs are
variable.
CONTD…
SHORT RUN
COST TC = TFC +
TVC
• Total Cost (TC)
Total expense incurred during production
• TFC / FC
Cost that do not vary with output. Eg: salary , rent

• TVC / VC
Cost that vary according to change in output Eg: Raw
materials
CONTD…
• Average Cost (AC) / Average Total Cost (ATC)
AC = TC / Q (TFC + TVC) /Q AFC + AVC

• Average Variable Cost (AVC) AVC = TVC / Q

• Average Fixed Cost (AFC) AFC = TFC / Q

MARGINAL COST (MC)

It is the addition to total cost for producing an

additional unit of a commodity.

MC = TC n – TC n –1
MC = d(TC)/ d(Q)
CONTD…
LONG RUN COST

• In long run all costs varies

• There is no fixed cost in long run

• Long Run Average Cost (LAC)

• It is also known as Envelope Curve or
Planning curve
• LAC is derived from short run AC
• LAC is termed as the collection of SAC
CONTD…
 LONG RUN MARGINAL COST
CURVE ( LMC )
• LMC is ‘U’ shaped curve
• LMC passes through the lowest point of LAC
 REVENUE
• Revenue means receipts from sale of output by a firm
in a given period

Total Revenue (TR)

• It is the total amount of money received by a firm
from the sale of goods and services during a certain
period

TR = Q x P i.e PQ
Q = Quantity P = Price
CONTD…

• Average Revenue (AR)

• AR = TR/Q
• PxQ/Q=P
i.e AR = P
• Marginal Revenue (MR)
It is the addition to total revenue from the sale of an
additional unit of output
MR = TR n - TR n-1 MR = d(TR) / d(Q)
SHUT DOWN POINT

• A shut down point is a point where the firm

experience no benefit in continuing operations or
productions.

• Shutdown point is defined as that point where the

market price of the product is equal to the AVC in the
short run

• P = AVC
CONTD…
 P/V RATIO

• P/V Ratio (Profit Volume Ratio) is the ratio of

contribution to sales.

• P/V Ratio = Sales – Variable cost (V)/Sales (S)

(S – V)/S

• or, P/V Ratio = Fixed Cost + Profit/Sales F + P/S

FIRM AND TYPES

• A firm is a for-profit business organization such as

a corporation, limited liability company (LLC), or
partnership that provides professional services.

• TYPES OF FIRM:

• A sole proprietorship or sole trader is owned by

one person, who is liable for all costs and obligations,
and owns all assets.

• A partnership is a business owned by two or more

people; there is no limit to the number of partners that
can have a stake in ownership. A partnership's
owners each are liable for all business obligations,
CONTD…

• Corporation: Owners of a corporation are not liable

for any costs, lawsuits, or other obligations of the
business. A corporation may be owned by
individuals or by a government. A firm that is
owned by multiple people is often called a
company.

• A financial cooperative is similar to a corporation in

that its owners have limited liability, with the
difference that its investors have a say in the
company's operations
 FIRMS AND ITS OBJECTIVES

The main objectives of firms are:

• Profit maximisation

• Sales maximisation

• Increased market share/market

dominance

• Social/environmental concerns

• Co-operatives – Welfare oriented

Market Structures

• Market is a term which is commonly used for a

particular place or locality where goods are bought and
sold.

• Market structure refers to the competitive environment

within which a firm operates.

• According to Prof. Samuelson, “A market is a

mechanism by which buyers and sellers interact to
determine the price and quantity of a good or service.
”
Market Structures-
Classification
Based on competition, the market structure has been
classified into two broad categories:

1. Perfectly competitive. (Perfect Competition)

2. Imperfectly competitive. (Monopoly, Monopolistic

competition and Oligopoly)
Perfect Competition
• Perfect competition is defined as a market structure
in which an individual firm producing
homogenous commodities cannot influence the
prevailing market price of the product on its own.

• Market structure where there is a perfect degree of

competition and single price prevails.

• Perfect competition is a market structure

characterized by complete absence of rivalry among
individual firms. (Price taker)
Features of Perfect
Competition

• Very Large Number of Buyers and

Sellers.
• Homogeneous and undifferentiated
product.
• Free Entry or Exit of Firms.
• Perfect Knowledge.
• Economic rationality
• Perfect Mobility of Factors of Production.
• Absence of Transportation Cost
Demand Curve under
Perfect Competition
Equilibrium of a firm under
Perfect Competition
• We know that the necessary and sufficient conditions
for the equilibrium of a firm are:
• MC = MR
• MC curve cuts the MR curve from below
Equilibrium of a firm
using MC and MR
curves
Monopoly
• The word monopoly is derived from two Greek
words ‘mono’ means single and ‘polo’ means to sell

• Monopoly is a market in which a single seller sells

a product which has no substitutes

• E.g. RBI , Rail transport

Features of Monopoly
• Single seller
• Restriction on entry
• Price maker
• No close substitutes
• Price discrimination
Demand Curve Under
Monopoly
Equilibrium under
Monopoly

Under monopoly, for the equilibrium and price

determination there are two different conditions
which are:

1. Marginal revenue must be equal to marginal cost.

2. MC must cut MR from below.
Equilibrium under Monopoly
Regulation of Monopoly

• Promote competition

• Quality of service

• Prevent excess prices

Dumping

• It means a monopolist sells his product at a higher price

in the home market and lower price in the international
market
Monopolistic Competition

• It is a market structure at which large number of

sellers dealing with differentiated commodities.

• The term Monopolistic comp was given by Prof.

Edward H Chamberlin.

• The main feature of monopolistic competition is

Product Differentiation

• Product Differentiation means commodities

marketed by each seller can be distinguished from
the products marketed by other seller in the form of
size , shape , brand , colour etc.
Features of Monopolistic
Competition

• Large number of sellers

• Product Differentiation

• Freedom for entry and exit

• Advertisement and selling cost

• Lack of Perfect Knowledge

Price – Output determination
under Monopolistic Competition
Oligopoly

• The word oligopoly is derived from two Greek

words ‘Oligo’ means Few and ‘Polo 'means to sell

• It is a market with few sellers dealing with

homogenous and differentiated commodities

• In oligopoly one firm’s action will cause its

competitors to react. This shows that firms has
interdependence under oligopoly
Features of Oligopoly

• Few sellers

• There are barriers for entry

• Homogenous and heterogeneous commodities

• Interdependence between firms

• Independent decision making

Price – Output
determination under
Oligopoly

Kinked Demand Curve

Collusive Oligopoly

• According to Samuelson “Collusion denotes a situation

where two or more firms jointly set their prices or
output, divide the market among them, or make the
business decisions”

• Cartel ----- OPEC

Behavioral Economics
• Behavioral Economics is a field that blends insights
from psychology and economics to understand how
humans make decisions.

• Unlike traditional economics, which assumes

individuals are perfectly rational, behavioral
economics acknowledges that cognitive limitations,
biases, and emotions significantly influence
decision-making.

• This is particularly relevant for engineering, where

decisions often need to be made in complex,
uncertain environments.
Decision-Making Biases

• Decision-making biases refer to the systematic

patterns of deviation from rationality in judgment
and decision-making.

• These biases can lead to suboptimal decisions,

especially in high-stakes situations.

• In engineering, where precision and efficiency are

key, recognizing these biases can help in improving
decision-making processes.
Some common biases include:

• Anchoring Bias: People tend to rely heavily on the

first piece of information they receive (the "anchor")
and adjust subsequent decisions around it.

• Example: If the initial cost estimate for a project is

too high, engineers may anchor future budget
estimates around that figure, even when new data
suggests a lower cost.
CONTD…
• Overconfidence Bias: Individuals overestimate their knowledge or
ability to make accurate decisions.

• Example: Engineers may overestimate the reliability of a new

design or technology based on past successes, potentially
overlooking risks or uncertainties.

• Availability Heuristic: People tend to judge the likelihood of an

event based on how easily examples come to mind, often giving
disproportionate weight to recent or vivid events.

• Engineering Example: After hearing about a recent infrastructure

collapse, engineers may overestimate the likelihood of similar
failures, leading to over-cautious decisions that might not be
justified by the actual risk.
CONTD…
• Status Quo Bias: People prefer things to remain the same
rather than change, even when alternatives might be better.

• Engineering Example: Engineers may resist adopting new

technologies or techniques, even if they are more efficient,
simply because they are accustomed to traditional methods.

• Loss Aversion: People tend to fear losses more than they

value gains of the same size, leading to risk-averse behavior
when faced with potential losses.

• Engineering Example: Engineers may prioritize avoiding minor

risks in the short term (e.g., a small cost increase) even when
doing so leads to greater long-term inefficiencies or higher
costs.
Bounded Rationality

• Bounded rationality, a concept introduced by

Herbert Simon, argues that individuals do not make
perfectly rational decisions due to cognitive
limitations and environmental constraints.

• Rather than evaluating every possible option,

people use heuristics or mental shortcuts to make
decisions that are "good enough" under the
circumstances.
Key Elements of Bounded
Rationality:

• Cognitive Limitations: The brain can only process a limited

amount of information at a time. This is why engineers often
simplify models or use approximate solutions.

• Time Constraints: In many engineering decisions, there is

limited time to gather and analyze data, forcing engineers to
make decisions with incomplete information.

• Information Overload: Engineers are often faced with vast

amounts of data. Bounded rationality explains why engineers
might focus on the most accessible or relevant information,
potentially overlooking critical details.
Engineering Applications of Decision-
Making Biases and Bounded
Rationality
Risk Management:

• Engineers must assess and mitigate risks in projects, but

cognitive biases like overconfidence or anchoring can lead to
underestimation of risks or over-commitment to a particular
solution. By recognizing these biases, engineers can take
steps to ensure a more balanced risk assessment.

• Loss aversion can lead to reluctance in taking necessary risks

for innovation. Understanding this bias can help engineers
encourage calculated risk-taking in new projects or
technologies.
CONTD…

Design and User Interaction:

• Bounded rationality explains why users often fail to understand

or correctly interpret complex engineering systems, such as
software or machinery. Engineers can use this knowledge to
design more intuitive, user-friendly interfaces that reduce
cognitive load and improve user performance.

• Nudging techniques (e.g., making certain options the default

choice) can be used in design to guide users towards more
efficient, safer, or sustainable choices.
CONTD…

Technology Adoption:

• Status quo bias can lead to resistance when trying to

introduce new technologies in the workplace or industry.
Engineers can use strategies like incremental implementation,
clear communication of benefits, and addressing concerns
about the change to overcome this bias.

• In situations where availability bias is present (e.g., when

engineers rely too much on past experience or recent
incidents), using data-driven decision-making processes can
help reduce the impact of such biases.
CONTD…

Project Management and Decision Support:

• Engineers can develop decision-support systems

that help teams overcome biases by presenting
data in a balanced and neutral manner.

• For example, project cost estimates should be

presented in ways that avoid anchoring bias, and
teams should be encouraged to consider alternative
solutions to mitigate confirmation bias.