MIT Art Design and Technology University

MIT School of Computing, Pune

Economics for Engineers

Class - S.Y. (SEM-III)

Unit – III Engineering Economics

Prof. Gurunath Waghale &
Prof. Kiran Shinde

AY 2024-2025 SEM-I
 Unit III - Syllabus

Unit III – Engineering Economics 6 Hours

• Opportunity Cost – Comparisons and Alternatives
• Decision Making Under Uncertainty
• Cost-Benefit Analysis
• Engineering Project Evaluation
• Risk Management in Engineering Projects
• Sustainable Engineering Economics
 Opportunity Cost – Comparison and Alternatives
• Definition:
• Opportunity cost refers to the value of the next best alternative that
must be forgone when a choice is made.
• In simpler terms, it's the cost of what you're giving up to do
something else.
• It plays a crucial role in decision-making as it helps in comparing
various alternatives.
 Key Concepts under Opportunity Cost
• Scarcity of Resources - Resources like time, money, labor, and raw
materials are limited. This scarcity forces individuals, businesses, and
governments to make choices on how best to allocate them.
• Trade-Offs - Every decision involves choosing one option over
another. The trade-off is what is given up in terms of potential gain
from other alternatives.
• Explicit Vs Implicit Costs - Explicit vs Implicit Costs:
• Explicit Costs: Direct monetary expenses, like buying equipment or paying
wages.
• Implicit Costs: Indirect costs that are harder to measure, such as the value of
the time or resources you could have used elsewhere.
 Opportunity Cost in Decision Making
• Individual Level – Time, Money • Business Level – Investment
Decisions, Production Choices

• Government Level – Public

Spending
 Measurement of Opportunity Cost
• Cost-Benefit Analysis: • Marginal Analysis:
• A method used to compare the potential benefits of • Involves looking at the additional benefits and
an action against the costs of the alternatives. costs of a decision. Economists often compare
marginal benefits to marginal costs to determine
if the decision is worth it.

• Example: A student deciding whether to take a gap • Example: A firm deciding whether to hire one
year before college must weigh the potential personal more worker will compare the additional
growth and work experience against the opportunity worker's productivity (marginal benefit) with the
cost of lost academic time additional cost of hiring them (marginal cost).
 Comparison of Alternatives
• When comparing different alternatives, it’s crucial to look at:
• Monetary Gains: What financial benefits or profits could you earn from
each alternative?
• Non-monetary Gains: Consider factors like personal satisfaction, skill
development, long-term career growth, and societal impact.
• Risk: Some choices involve higher risk. High-risk alternatives may have a
higher potential return but come with a higher opportunity cost if they fail.
• Time: Some alternatives may take longer to deliver returns. The
opportunity cost may include the delayed benefits from other choices.
• Resources: How resource-intensive is each alternative? Consider the
impact on time, labor, and capital.
Cost-Benefit Analysis
 Introduction to Cost-Benefit Analysis
• Cost-Benefit Analysis (CBA) is a systematic process used to evaluate the strengths
and weaknesses of alternatives.
• It involves comparing the total expected costs of a project or decision against
the total expected benefits, to determine whether the benefits outweigh the
costs and by how much.

• The Objective is to provide a framework for decision making

Steps in Conducting Cost-Benefit Analysis
1. Identify the Costs and Benefits
2. Monetize the Costs and Benefits
3. Discount the Costs and Benefits
4. Compare Costs and Benefits
Steps in Conducting Cost-Benefit Analysis
• . Identify the Costs and Benefits:
• All direct and indirect costs and benefits should be identified. These could
include:
 Direct Costs: Direct costs are expenses that can be directly traced to a specific project, product, or
activity. These costs are easily identifiable and directly linked to the production of goods or
services.
Ex: Wages, materials, capital equipment.
 Indirect Costs: expenses that cannot be directly attributed to a specific project, product, or activity.
These costs are necessary for the overall operation but are shared across multiple projects or
departments.
Ex: Rent, Utilities, Administrative Salaries, opportunity costs, externalities.
 Direct Benefits: Revenue generation, cost savings.
 Indirect Benefits: Improved public health, environmental quality.
 Steps in Conducting Cost-Benefit Analysis
• . Monetize the Costs and Benefits:
• Assign a monetary value to each identified cost and benefit. This can be complex, particularly
for non-market goods like environmental impacts or public health improvements.
• Example: For an infrastructure project like building a highway
Steps in Conducting Cost-Benefit Analysis
• 3. Discount the Costs and Benefits:
• Future costs and benefits should be discounted to their present value. This is because money
has a time value; benefits (or costs) that occur in the future are worth less than those that
occur today.
• Formula:
• PV=FV/(1+r)n ​
• Where:
• PV = Present Value
• FV = Future Value of Cost and Benefits
• r = Discount rate
• n = Number of periods
• Example: For a project expected to yield benefits over the next 10 years, a
discount rate (e.g., 5%) will reduce the value of those future benefits when
compared to the costs incurred today.
Steps in Conducting Cost-Benefit Analysis
• 4. Compare Costs and Benefits:
• Once costs and benefits are discounted to the present value, compare them.
A project is viable if the Net Present Value (NPV) is positive.
• NPV=Total Present Value of Benefits−Total Present Value of Costs
• A positive NPV suggests the benefits exceed the costs, while a
negative NPV suggests the costs outweigh the benefits.
Key Considerations in Cost-Benefit Analysis
• Time Horizon: Long-term projects may have benefits or costs far into the future, which makes
discounting crucial.
• Risk and Uncertainty: Future costs and benefits are uncertain. Risk analysis (e.g., sensitivity
analysis, scenario planning) is often incorporated into CBAs.
• Intangible Costs/Benefits: Some costs and benefits cannot be easily monetized, such as
environmental impact or quality of life improvements. Methods like contingent valuation or
hedonic pricing are used to estimate these.
• Contingent Valuation It involves directly asking people about their willingness to pay (WTP) for a
specific good or service, or their willingness to accept (WTA) compensation for its loss or
degradation.
• Hedonic Pricing is a method used in economics to estimate the value of a good or service by
breaking down its overall price into the value of its individual characteristics or attributes. It is
commonly used to assess how different factors (both tangible and intangible) affect the prices of
goods.
• Ex: in markets like real estate, where many characteristics influence the price of a property, such
as location, size, and nearby amenities.
 Examples of Cost-Benefit Analysis
• Building a Wind Farm for Renewable Energy • Step 2: Monetize the Costs and Benefits
• Step 1: Identify the Costs and Benefits • Let’s assume the following:
• Costs: • Costs:
• Initial Construction Costs: Costs to build and install • Initial Construction Costs: $10 million
the wind turbines. • Annual Maintenance Costs: $500,000 per year
• Maintenance Costs: Annual costs to maintain and • Annual Land Leasing Costs: $100,000 per year
operate the wind farm.
• Land Leasing Costs: Annual costs for leasing the • Benefits:
land for the wind farm. • Revenue from Selling Electricity: $3 million per
year
• Benefits: • Environmental Benefits: Valued at $200,000 per
• Revenue from Selling Electricity: Income generated year in reduced carbon emissions.
by selling the electricity to the grid.
• Energy Cost Savings: $400,000 per year from
• Environmental Benefits: Reduction in carbon cheaper energy compared to fossil fuels.
emissions and environmental impact.
• Energy Cost Savings: Savings on energy compared to
traditional energy sources.
• Step 3: Discount the Costs and Benefits
• Assume the project will last for 10 years, and
the discount rate is 5%.
• Formula for Present Value (PV): PV=FV/(1+r)n
Since the Net Present Value (NPV) is positive ($13,165,100), the
project is profitable and worth pursuing. The benefits from the
wind farm, when discounted to present values, exceed the costs by
a significant margin.
This process of CBA helps in making informed decisions by
considering both the time value of money (through discounting)
and a thorough comparison of costs and benefits.
Decision Making Under Uncertainty
 Decision Making
• Decision making is an integral part of management planning,
organizing, controlling processes
• The decision maker selects one strategy (course of action) over others
depending on some criteria, like utility, sales, cost or rate of return.
 Types of Decisions
• Strategic Decision – Concerned with external environment of the
organization.
• Administrative Decision – Concerned with structuring and acquisition
of the organization’s resources so as to optimize the performance of
the organization.
• Operating Decision – Concerned with day to day operations of the
organization such as pricing, production scheduling, inventory levels,
etc.
 Key Terminologies in Decision Making
• Risk vs. Uncertainty:
• Risk refers to situations where the decision-maker knows the potential outcomes
and can assign probabilities to them.
• Uncertainty, on the other hand, refers to situations where the probabilities of
outcomes are unknown or cannot be calculated.
• Course of action: refers to the decision alternatives or actions that is been
chosen by the decision-maker.
• States of nature: Exhaustive list of possible future events/alternatives.
Decision maker has no direct control over the occurrence of particular
event.
• Payoff: Benefits which accrues from a given combination of decision
alternatives (Course of action) and state of nature.
• Payoff Matrix: A Payoff matrix is a rectangular array of pay-offs for a
set of actions and states of nature arranged in rows and columns
 STEPS IN DECISION MAKING
• Clearly define the problem in hand
• List the possible alternatives
• Identify the possible outcomes or states of nature
• List the payoff or profit of each combination of alternatives &
outcomes
• Select one of the mathematical decision theory models
• Apply the model and make your decision
 DECISION THEORY
• DECISION-MAKING UNDER CERTAINTY : Decision makers know with
certainty the consequence of every alternative or decision choice. Naturally
they will choose the alternative that will result in the best outcome.
• Example is making a fixed deposit in a bank.
Several criteria exist for making decision under these conditions :
• 1. Maximax (optimistic)
• 2. Maximin (pessimistic)
• 3. Criterion of realism (Hurwicz)
• 4. Equally likely (Laplace)
• 5. Minimax regret
Case Study – Expansion of Production
Capacity
• ABC person is the President of a company.
• His problem is to identify whether to expand his product line by
manufacturing and marketing a new product : Refrigerator.
• In order to make a proposal for submitting to his board of directors,
ABC thought of following three alternatives that are available to him.
• 1. To construct a large new plant to manufacture the washing
machine
• 2. To construct a small plant to manufacture the washing machine
• 3. No plant at all ( that is he has the option of not developing the new
product line).
Case Study – Expansion of Production
Capacity
• ABC determines that there are only two possible state of natures :
• 1. The market for the washing machine could be favorable, meaning that there is a high demand for the
product
• 2. it could be unfavorable, meaning that there is a low demand for the washing machine.
• he evaluated the profits associated with various outcomes. He thinks :
A) Large Plant
1. With a favorable market, a large facility would result in a profit of Rs.2,00,000 to his firm. (But Rs.2,00,000
is a conditional value because ABC’s receiving the money is conditional upon both his building a large
factory and having a good market.)
2. The large facility and unfavorable market would result in net loss of Rs.1,80,000
B) Small Plant
1. A small plant with a favorable market would result in a net profit of Rs.100,000 .
2. A small plant with unfavorable market would result in a net loss of Rs.20,000 .
3. Doing nothing, that is neither to make large facility nor a small plant, in either market would result in no
profits.
Pay off Matrix
 Maximax Criteria
(Optimistic)
• The maximax criterion is used to find the alternative that maximises the maximum
payoff.
• First locate the maximum payoff for each alternative, and then pick that alternative with
the maximum number.
• It locates the alternative with the highest possible gain : therefore it is called an
optimistic decision criteria.

• ABC’s maximax choice is the first alternative “construct a large plant”.

 CRITERION OF REALISM
(HURWICZ CRITERION)
• The criterion of realism is a compromise between an optimistic
(Maximax) and a pessimistic (Maximin) decision.
• A coefficient of realism (α) is used to measure the degree of
optimism of the decision maker. this coefficient, α lies between o
and 1.
• The weighted average is computed as follows:
• Weighted average = (α) x (maximum in row) + (1 – α) x (minimum in
row)
 CRITERION OF REALISM
(HURWICZ CRITERION)
• In the given case, ABC sets α = 0.80 • Calculating Weighted Average for the Alternatives
• 1. Building a large plant
• Weighted average = (α) x (maximum in row) + (1 – α) x (minimum in row)
• Weighted average = (0.80) x (2,00,000) + (1 – 0.80) x (-1,80,000)
• Weighted average = 1,60,000 – 36,000 = 1,24,000
• Weighted average = 1,24,000
• 2. Building a small plant
• Weighted average = (α) x (maximum in row) + (1 – α) x (minimum in row)
• Weighted average = (0.80) x (1,00,000) + (1 – 0.80) x (-20,000)
• Weighted average = 80,000 – 4,000= 76,000
• Weighted average = 76,000
CRITERION OF REALISM
(HURWICZ CRITERION)
• In the given case, John Thompson sets α = 0.80 and thus the best
decision would be to construct a large plant as shown in table below.
 Equally Likely Criteria
(Laplace Criteria)
This criterion uses all the payoffs for each • Calculating Average Returns of State of Natures
alternative.
This is also called laplace, decision criterion.
This criteria finds the average payoff for each
alternative and select the alternative with
highest average.
This criterion assumes that all probability of
occurrence for the state of nature are equal,
and thus each state of nature is equally likely.
• ABC’s choice as per this criterion is the second
alternative, “construct a small plant”
 Minimax Regret Critrion
• This decision criterion is based on opportunity loss or regret
• The opportunity loss or regret is the amount lost by not picking the
best alternative in a given state of nature.
• The first step is to create the opportunity loss table.
• Opportunity loss for any state of nature , or any column, is calculated
by subtracting each payoff in the column from the best payoff in the
same column.
 Minimax Regret Critrion
• ABC’s opportunity loss table is shown in following • Next, looking at these maximum values,
Opportunity Lost Table pick that alternative with minimum
number
• We can see that minimax regret choice is the
second alternative, “construct a small plant”

• Using the opportunity loss table, the minimax regret

criterion finds the alternative that minimises the
maximum opportunity loss within each alternative
• First find the maximum opportunity loss for each
alternative
Engineering Project
Evoluotion
 Understonding the Importance of Engineering Proj

] Definition of 2 Importance of 3 Variability of 4 Common Principles

Engineering Project Evaluation Evoluotion Methods in Evoluotion
Evoluotion

Engineering project evaluation It is crucial to ensure that a Evaluation methods may vary Despite the variability, some
involves assessing various project meets its objectives depending on the type of project, common principles apply across
aspects of a project to determine within the defined constraints of highlighting the need for tailored most engineering projects,
its viability, effectiveness, and time, cost, and quality. approaches. ensuring a baseline for
overall impact. evaluation.
Key Aspects of Engineering
Project Evoluotion
Key Aspects of Engineering
Project Evaluation
 Project Feasibility Study

Legal and
Technical Economic Operational Environmental
Feasibility Feasibility Feasibility Feasibility
Evaluates whether the project can be Focuses on the financial aspects to Assesses if the organization or project Ensures compliance with legal,
technically realized, including the determine economic viability, team can effectively operate the regulatory, and environmental
assessment of technology availability, including cost-benefit analysis, return project, considering human resources, requirements, including safety
technical expertise, and necessary on investment (ROI), and potential for skills, and operational infrastructure. standards, environmental impact
resources profitability. assessments, and zoning laws.
Understanding Cost-Benefit Anolysis (CBA)
Definition of CBA
Indirect Costs
Indirect Costs
Direct Costs
Cost-Benefit Analysis (CBA) is a
Indirect costs encompass
fundamental tool in project Direct costs include tangible
overheads, administrative costs,
evaluation that assesses the expenses such as labor,
and other expenditures that are
economic value of a project by materials, and equipment
not directly tied to project
comparing the costs involved necessary for project execution.
activities.
with the expected benefits.

Intangible Benefits
Tangible Benefits
Intangible benefits, while harder
Tangible benefits are easily to quantify, are critical for project
measurable outcomes resulting evaluation, including aspects like
from a project, such as increased improved safety, customer
productivity or revenue. satisfaction, and environmental
sustainability.
 Risk Identification
Recognizing potential risks that could impact the project, such as technical failures, cost
overruns, and schedule delays

Risk Anolysis and

Risk Countrification
Management in Estimating the probability and impact of identified risks to understand their potential effects on
the project.
Projects
Risk Mitigation
Developing strategies to reduce or eliminate the negative impacts of risks through methods like
contingency planning, insurance, or contract clauses.
 Net Present Value (NPV)
The present value of cash inflows minus the present value of cash outflows over
the project's life. Projects with a positive NPV are generally considered financially
viable.

Internal Rote of Return (IRR)

Financial Evaluation The discount rate at which the NPV of all cash flows equals zero. A project is viable
if its IRR exceeds the required rate of return.
Methods for
Engineering Projects Payback Period
The time it takes for a project to generate enough cash flow to recover the initial
investment. Shorter payback periods are typically preferred.

Profitability Index (PI)

The ratio of the present value of future cash flows to the initial investment, helping
to compare different projects.
Evoluoting Sustainability and Environmentol lmpoct
Sustainability and Environmental Impact Assessment (EIA)

Modern Engineering Projects Sustainability Practices

Increasingly evaluated for their environmental and social impact. Incorporating renewable resources, recycling, and eco-friendly
materials.

Environmental I m p a c t Assessments (EIA)

Performed to evaluate the ecological consequences of the project. Compliance with Environmental Regulations
6 Ensuring the project meets all relevant environmental laws and
standards.
Energy Efficiency
Ensuring the project uses energy in a sustainable manner.

4 Wa s te Mo n o g e m e n t
Evaluating how waste generated by the project will be handled.
 Value of Work Planned
Planned Value
The value of work planned to be
(PVC completed by a certain date.

Common Project
Value of Work Completed
Earned Value
Evoluotion Models (EV)
The value of work actually
completed by that date
and Techniques

Actual Cost Incurred

Actual cost
The actual cost incurred for the work
(AC) completed.
Utilizing SWOT Anolysis in Project
Evoluotion
• Strengths, Weaknesses, Opportunities, Threats (SWOT) analysis is used to evaluate both
internal and external factors that could impact the success of the project.
Sustainable Engineering
Economics
Balancing Profit and Planet
Introduction
• Integrates economic principles with environmental, social, and ethical
considerations to promote long-term sustainability.

• The goal is to balance economic development with ecological preservation and

social well-being, ensuring that engineering projects are financially viable while
minimizing negative impacts on the environment and society.
 A. Triple Bottom Line (TBL) Approach:
1. Economic Sustainability
2. Environmental Sustainability
3. Social Sustainability

Key Principles of
B. Life Cycle Costing (LCC):
1. Initial Costs: Capital costs, including design, materials, construction, and equipment.

Sustainable 2.
3.
Operating and Maintenance Costs: Ongoing costs, including energy, labor, and materials.
End-of-Life Costs: Costs associated with decommissioning, dismantling, and recycling.

Engineering
Economics C.
1.
Energy Efficiency and Renewable Resources:
Energy-Efficient Designs
2. Use of Renewable Energy

D. Circular Economy:
1. Design for Disassembly
2. Waste-to-Resource Initiatives
 E. Internalizing Externalities:
1. Carbon Pricing: Assigning a cost to carbon emissions to reflect their
environmental damage and encourage more sustainable practices.
2. Polluter Pays Principle: Ensuring that those responsible for negative
externalities, such as pollution or waste, bear the cost of mitigation or
remediation.

Key Principles of E. Sustainable Infrastructure and Urban Development:

Sustainable 1. Green Building Standards: Using frameworks such as LEED (Leadership in

Engineering
Energy and Environmental Design).
2. Sustainable Transportation: Designing transportation systems that minimize

Economics
environmental impacts, such as electric vehicles, mass transit, and bike-sharing
systems.
3. Water and Waste Management.

G. Sustainable Materials and Supply Chains

G. Environmental Impact Assessments (EIA)

 Economic Evaluation Techniques for Sustainable Projects
1. Cost-Benefit Analysis (CBA) with Sustainability Metrics

o Traditional Cost-Benefit Analysis (CBA) is adapted to include sustainability factors by integrating environmental and social costs and benefits into the evaluation process.

 Environmental Costs: Costs associated with environmental degradation, such as pollution, resource depletion, and habitat destruction.

 Social Benefits: Positive impacts on local communities, such as job creation, improved health outcomes, and social equity.

2. Net Present Value (NPV) with Environmental and Social Adjustments

o In sustainable engineering economics, the Net Present Value (NPV) analysis is adjusted to account for environmental and social factors, in addition to financial costs and benefits.

 Green NPV: Including the costs of environmental impacts (e.g., carbon emissions, deforestation) in the cash flow analysis and the benefits of sustainability (e.g., lower energy costs, improved public health).

3. Environmental Payback Period

o The Environmental Payback Period measures how long it takes for a project to offset its environmental impacts through sustainability measures (e.g., energy savings, reduced emissions).

 Shorter Payback Periods: Preferred, as they indicate that the project achieves environmental sustainability more quickly.

4. Sustainability Indexes and Metrics

o Engineers use various indexes and metrics to assess the sustainability of projects, including:

 Ecological Footprint: Measures the environmental impact of a project by assessing resource consumption and waste generation.

 Carbon Footprint: Evaluates the amount of carbon dioxide emissions associated with a project’s activities.

 Social Return on Investment (SROI): Assesses the broader social impacts of a project, beyond financial returns, by monetizing social benefits (e.g., job creation, education improvements).
Importance of Sustainable
Engineering Economics

• Long-Term Cost Savings

• Reduced Environmental Impact
• Compliance with Regulations
• Enhanced Public and Stakeholder Trust
• Resilience to Future Risks
Challenges in Sustainable Engineering Economics

Higher Initial Complex Cost-

Costs Benefit Analysis

Lack of Stakeholder
Standardization Resistance