Unit – 1

Fundamentals of Economic Analysis

 Basis of economics
▪ The scarcity of resources in a country and unlimited wants of the people, form
the basis of economics.
▪ If the resources were unlimited, we can go on producing goods to satisfy our
unlimited wants. But the resources are limited, i.e., scarce.
▪ Therefore, we have to make some decisions in utilizing the limited resources
efficiently and maximizing the satisfaction.
 Decision making
▪ Selecting one action from two or more alternative courses of action.
▪ Selecting one from various alternatives.
▪ Choice is due to scarcity of resources.

Forward planning
▪ It means establishing plans for the future.

Problems in decision making and forward planning

▪ Uncertainty about the future.
▪ In business land, labour, capital and management is limited. Therefore, these
resources should be used optimally to maximize profits.
Decisions in business
▪ Product (what to produce? design to be developed?)
▪ Capital (from where to get? and at what rate of interest?)
▪ Number and type of labourers to be used in production
▪ Number of machines to be used (new machines to be employed, size of
machines)
 Central Problems of an Economy
▪ Allocation of resources

✔ What to produce?

✔ How to produce?

✔ For whom to produce?

⮚ There must be efficient utilisation of resources.

 Nature of Economics
(Definitions of Economics)
(1) Wealth Definition
▪ Adam Smith (1723-1790), in his book, “An inquiry into the Nature and Causes of
the Wealth of Nations” defined economics as, “a science which studies the
nature and causes of wealth of nations”.
▪ According to the definition, the scope of Economics is limited to earning and
spending of wealth.
(2) Scarcity Definition
▪ Lionel Robbins defined Economics as follows: “Economics is a science which
studies human behaviour as a relationship between ends and scarce means
which have alternative uses”.
 Engineering economics
▪ Engineering Economics is a branch of engineering that applies economic
principles and methodologies to evaluate and make decisions about
engineering projects and investments.

Engineering economic problems

▪ When an electric utility is considering updating its computer networking
capability and has to decide between upgrading its existing computer
servers, and scrapping them for new computer systems. If it opts for the
latter, then should it buy or lease?
 Approaches to Economic Analysis

→ Classical economists analyzed economic problems through consumption,

production, exchange, distribution and public finance.
→ Modern economists analyzed economics through Micro and Macro
analysis.
→ Prof. Ragnar Frisch in 1933, introduced Micro and Macro analysis.
Micro Economics

▪ According to Prof. Boulding, Micro economics is, “the study of particular

firms, particular households, individual prices, wages, incomes, individual
industries, particular commodities”.
▪ The fields covered by micro economics are:
⮚ Theory of product pricing
⮚ Theory of factor pricing
▪ Therefore, micro economics is also known as ‘Price theory’.
Macro Economics
▪ According to Prof. Boulding, “Macro economics deals not with individual
quantities as such, but with the aggregates of these quantities, not with
individual incomes, but with national income; not with individual prices but
with the price level; not with individual outputs but with the national output”.
▪ The areas covered by macro economics are: Theory of employment and
income, Theory of general price level, Theory of economic growth (GDP).
 Scope of engineering economics
1. Circular flow in an economy
▪ The circular flow model demonstrates how money moves through society.
▪ It shows how money moves from producers to households and back again in
an endless loop.
▪ In an economy, money moves from producers to workers as wages and then
back from workers to producers as workers spend money on products and
services.
2. Demand and supply
▪ Demand
⮚ Demand is defined as, “a desire for a commodity backed by willingness and ability
to pay the price”.
⮚ Law of demand - It shows the relation between price and the quantity
demanded.
⮚ Demand forecasting – Estimating future demand
▪ Supply
⮚ Supply means the commodity offered for sale at a price (by retailers and
wholesalers) during some given period.
⮚ Law of supply – It shows the relation between price and quantity supplied.
3. Cost
▪ Total amount of money spent on the production of a commodity.
Topics to be covered:
▪ Types of cost
▪ Cost-output relationship – Short-run & Long-run
▪ Make/Buy decision
⮚ In a business organization, a component or product can be made within the
organization or bought from a subcontractor (each decision involves cost).
⮚ Evaluate each of the alternatives and select an alternative which results in
lowest cost.
4. Inventory control
▪ Inventory can be classified into raw materials, in-process, & finished
goods inventory.
▪ Two basic inventory decisions are:
⮚ When should the inventory of an item be replaced?
⮚ How much of an item is to be ordered when the inventory of that
item has to be replenished?
5. Depreciation
▪ Any equipment which is purchased today will not work for ever due to wear and tear
of the equipment or obsolescence of technology.
▪ Hence, it has to be replaced at proper time & it involves money.
▪ The recovery of money from the earnings of an equipment for its replacement
purpose is called depreciation fund.
▪ Depreciation means decrease in the value of any physical asset with the passage of
time.
▪ Methods of depreciation
⮚ Straight line method of depreciation
⮚ Diminishing/declining balance method of depreciation
6. Pricing
▪ Pricing is a process of fixing the value that a manufacturer will receive in the
exchange of goods and services.
▪ Topics to be covered:
⮚ Pricing practices and strategies
7. Revenue
▪ The income that a firm receives from the sale of a good or service to its
customers.
▪ Topics to be covered:
⮚ Concepts of revenue
8. Cost-Volume-Profit (CVP) analysis
▪ It is a method of evaluating how changes in costs and volume will impact
profits.
▪ CVP analysis is a comprehensive analysis that examines the relationship
between sales volume, costs, and profit to determine breakeven points and
profit targets.
▪ Break-even analysis only identifies the sales volume required to break even
(no-profit no-loss).
9. Value analysis/Value engineering
▪ Value analysis is the application of a set of techniques to an existing product
with a view to improve its value. It is thus a remedial process.
▪ Value engineering is the application of exactly the same set of techniques to a
new product at the design stage, when no hardware exists to ensure that
unnecessary features are not added. Value engineering, therefore, is a
preventive process.
10. Capital budgeting
▪ Capital budgeting is the process by which investors determine the value of a
potential investment project.
▪ It involves choosing projects that add value to a company.
▪ It includes acquiring land or purchasing fixed assets like an equipment or
machinery.
▪ Project appraisal techniques
⮚ Pay-back period
⮚ Internal Rate of Return (IRR)
⮚ Net Present Value (NPV)
11. Project management
▪ A project involves completing tasks to achieve an objective with a limited set of
resources and a finite timeline.
▪ Project management is a process that allows project managers to plan,
execute, track and complete projects with the help of a project team.
▪ Project management techniques
⮚ Program Evaluation Review Technique (PERT)
⮚ Critical Path Method (CPM)
12. Economic growth and development
▪ National income
▪ Inflation – Control measures: Monetary & Fiscal Policy
▪ Banking – Technological innovation
▪ Sustainable Development Goals (SDGs)
▪ Circular economy
 Circular flow in an economy
▪ The circular flow model is an economic model that presents how money,
resources, goods, and services move between sectors in an economic system.
▪ It highlights the interactions between the households, firms, government,
foreign sector, and the financial sector.
 Institutions / Decision-making Agents of an economy
▪ Households
⮚ Households are consumers. They may be single individuals or group of
consumers (families make joint decision regarding consumption).
⮚ They are owners of factors of production – land, labour, capital and
entrepreneurial ability.
⮚ They sell the services of these factors and receive income in the form of
rent, wages, interest and profit respectively.
▪ Firms
⮚ The decision to produce goods and services is taken by a firm.
⮚ For this purpose, it employs factors of production and makes payments to
their owners.
⮚ Firms produce goods & services to make profit.
▪ Government
⮚ In a mixed economy, the government strengthens the market system.
⮚ It regulating the activities of the private sector.
⮚ The government also uses resources to produce goods and services itself
which are sold to households and firms.
▪ Foreign sector
⮚ The overseas sector turns a closed economy into an open economy.
⮚ When local firms export goods and services to the foreign markets,
injections are made to the circular flow model.
⮚ Injections increase the money in the circular flow because firms receive
foreign exchange for goods sold to other countries.
▪ Financial sector
⮚ It includes banks and other institutions that provide borrowing and lending
services to the other sectors.
⮚ Financial sector act as intermediaries.
⮚ It provides the facility for the households/business to save their share of
income and for business/households to borrow some amount of money.
 Circular flow in a two-sector economy
▪ It is the most basic model containing only two sectors: consumers or
households and business firms.
▪ In the two-sector model, it is assumed that households spend all their income
as consumer expenditures and purchase the goods and services produced by
businesses.
▪ Thus, there are no taxes, savings, or investments that are associated with
other sectors.
 Circular flow in a three-sector economy
▪ The circular flow of income in a three-sector economy includes households,
firms, and the government sector.
▪ In this model, money flows from households and businesses to the
government in the form of taxes (outflows or leakages from circular flow).
▪ The government pays back in the form of government expenditures through
subsidies, benefit programs, public services, purchases etc (inflows or injection
into the circular flow).
▪ Taxes reduce consumption and saving of the household sector. This in turn,
reduces the sales and incomes of the firms.
▪ Taxes on business firms reduce their investment and production.
▪ Injections – Investment, Government spending, Exports.
▪ Leakages – Savings, Taxes, Imports.
▪ To offset these leakages the government purchases goods & services from the
business sector and buys services of the household sector. These are injection
in the circular flow.
 Circular flow in a four-sector economy
▪ The four-sector model contains the foreign sector (overseas/external sector).
▪ Injection (Exports) - When firms sell goods and services to foreign countries,
they earn foreign currency. It is spent on domestic goods and services.
▪ Leakages (Imports) - When goods and services are purchased from foreign
countries, it reduces the amount of money available for spending on domestic
goods and services.
▪ The circular flow of income for a nation is said to be balanced when leakage
equal injections.
▪ For a healthy and stable economy, it's desirable to have leakages and
injections roughly balanced.
▪ If leakages are too high, the economy might stagnate. Conversely, if injections
are too high, it could lead to inflation.
 Demand
▪ Demand is defined as, “a desire for a commodity backed by willingness and
ability to pay the price”.
Law of demand
▪ It shows the relation between price and the quantity demanded.
▪ There is inverse relationship between price and quantity demanded.
▪ Law of demand according to Marshall is, “the amount demanded increases
with a fall in price and diminishes with a rise in price”.
▪ Demand curve is downward sloping from left to right.
 Demand Schedule

Quantity
Price per unit (Rs)
demanded (Units)
10 50

8 60

6 70

4 80

2 90
Demand Function
▪ Law of demand is based on Ceteris Paribus assumption.
▪ Only one factor changes, other factors being constant is Ceteris Paribus
assumption (Price alone changes and other factors are constant).
▪ Only with Ceteris Paribus assumption the law will operate.
 Factors influencing demand/Demand determinants
1. Level of income
2. Tastes and preferences of consumers
3. Existence of substitutes
4. Expectation about future
5. Type of commodity
6. Changes in weather
▪ All these factors are assumed to be constant. Price alone changes.
 Types of demand
1. Price Demand
▪ Q = f (P, Y, PR, W)
▪ Price (P) alone changes, all other factors are constant.
2. Income Demand
▪ Q = f (P, Y, PR, W)
▪ Income (Y) alone changes, all other factors are constant.
3. Cross Demand
▪ Q = f (P, Y, PR, W)
▪ Price of related goods (PR) alone changes, all other factors are constant.
Substitutes Complementary goods
 Elasticity of Demand
▪ Marshall introduced the concept of elasticity of demand.
▪ It shows the extent of change in quantity demanded to a change in
price.
▪ In the words of Marshall, “The elasticity of demand in a market is
great or small according as the amount demanded increases much
or little for a given fall in the price and diminishes much or little for a
given rise in price”.
Elastic demand
▪ A change in price may lead to a great change in quantity demanded.
Inelastic demand
▪ A change in price is followed by a small change in demand.
I.Price elasticity of demand
▪ Price elasticity of demand is the extent of change in quantity demanded to a
change in price.
ep= Proportionate change in quantity demanded
Proportionate change in price

▪ Price elasticity of demand is negative.

 Demand forecasting
▪ Demand forecasting is estimating future demand for the product.
▪ Forecasting for a new product.
 Methods of demand forecasting
I. Opinion polling / Survey method
▪ It is one of the most common and direct methods of forecasting demand in
the short term.
▪ In this method, an organization conducts surveys with consumers/dealers to
determine the future demand for their products.
1. Opinion survey method
→ It is known as sales-force-composite method or collective opinion method.
→ Forecasting is done by getting the opinion of salesmen.
Advantages
▪ It is simple.
▪ It requires minimum statistical work.
▪ It is economical (less costly).
Disadvantages
▪ Highly subjective (more personal opinion)
2. Expert opinion
→ Opinion from dealers or distributors
→ E.g. Automobile companies
Advantages
▪ Quick and cheap forecasts
▪ Useful for new products
Disadvantage
▪ Subjective
3. Consumers’ interview method
▪ Direct interview with the consumers (about their preferences)
Advantage
▪ First hand information
Disadvantage
▪ Costly and difficult
Consumers interview is done in 3 ways:
i. Complete enumeration method
▪ All the consumers are interviewed.
▪ Advantage - First hand information
▪ Disadvantage - Costly and difficult
ii. Sample survey method
▪ A sample of consumers are selected for the interview
▪ It is easy, less costly and highly useful.
iii. End-use method
▪ Demand for textile machinery = f(expansion of textile industry)
II. Statistical methods
⮚ It is used for long-run forecasting.
⮚ Statistical and mathematical techniques are used to forecast demand.
⮚ This method relies on past data.
1. Trend projection method
▪ It is concerned with the movement of variables through time.
▪ It requires long time – series data.

Sales (in
Year
000s)
2011 53

2012 49

2013 61

2014 42
▪ This method is based on the assumption that the factors liable for the past
trends in the variables shall continue to play their role in future in the same
manner and to the same extent.
2. Barometric technique
▪ In this method, estimation of time-series is done through certain indicators to
predict the future.
▪ Eg: Personal income, unemployment rates, automobile registration
 Econometric methods of demand forecasting
▪ The econometric methods make use of statistical tools and economic
theories in combination to estimate the economic variables.
▪ The econometric methods are:
(i) Regression method
(ii) Simultaneous equation model
Regression
▪ Regression analysis is about how one variable affects another.
▪ It focuses on the relationship between a dependent variable and one or more
independent variables (or 'predictors').
▪ It is a statistical approach to forecast change in a dependent variable due to
change in one or more independent variables.
▪ It shows the extent of relationship between variables; i.e., how the value of
the dependent variable changes when one of the independent variable is
varied, while other independent variables are fixed.
▪ Eg: D=f(P); extent of relation i.e., 98% or 39%
▪ In the above equation, there is only 1 independent variable ie., P
▪ If D=f(P,Y,PR, W) – There are several independent variables i.e., P,Y,PR,W etc.
▪ Identifying the functional relationship with 1 independent variable is simple
regression; and with several independent variables is known as multiple
regression.
 Regression models
▪ In this method the demand function is estimated with demand as the
dependent variable and its determinants as the independent variables, using
the classical linear equation
Yi = F(Xi) + ui
▪ Standard regression model is
Yi = β0 + β1Xi + ui
Where,
Yi is dependent variable (demand)

Xi is explanatory variable (Price, income…)

ui is disturbance term or error term (accounts for all omitted variables)

β0 is intercept or constant

β1 is slope or parameter
▪ Two regression models used in demand forecasting are:
⮚ Simple linear regression model
⮚ Multiple linear regression model
 Problem - 1
1. The data of price and quantity demanded are given below. Estimate the
demand function for the product Y = β0 + β1X + u

Quantit 8 3 4 7 8 0
y
(000’s)
Price 2 4 3 1 3 5
(Rs.)
Forecast the demand when price increases to 8.
Quantity Price (X) XY X2
(Y)
8 2 16 4
3 4 12 16
n=6
4 3 12 9
7 1 7 1
8 3 24 9
0 5 0 25
 Do it yourself
The data of price and quantity demanded for product Y are given
below. Estimate the demand function for the product Y = β 0 + β 1X
+u

Quantit 100 120 140 125 150 170 70

y
(000’s)
Price 30 29 24 21 12 9 40
(Rs.)
Forecast the demand when price increases to 50.
 Supply
▪ Supply means the commodity offered for sale at a price (by retailers
and wholesalers) during some given period; say a month or week or
3 months or 6 months, etc.
▪ ↑Price ↑Supply (Direct relation)
 Factors determining supply
1. State of technology
2. Cost of production
3. Natural factors
4. Labour trouble
5. Change in government policy
 Law of supply
▪ The law of supply states that, “Other things being constant, the price of a
commodity has a direct influence on the quantity supplied. As the price of a
commodity rises, its supply is extended; as the price falls, its supply is
contracted”.
Supply=f(Price) ; ↑Price↑Supply ; ↓Price↓Supply
▪ There is a direct relation between price and supply.
▪ Other factors are assumed to be constant.
Supply schedule
 Market price determination
▪ Market price is determined at a point where demand and supply are equal.
▪ Market price is determined by the aggregate demand and aggregate supply.
▪ The equilibrium price is determined where D=S.
Market price determination

▪ At equilibrium price, both the buyers and sellers

are satisfied (because D=S).
o If price is higher than the equilibrium price;
S>D (↑P; sellers bring down the prices to
dispose the excess stock. Ultimately, the
price reaches the equilibrium).
o If price is less than the equilibrium price;
D>S (↓P; buyers bid up the prices to get the
product. When buyers bid up the price, the
price reaches the equilibrium).
 Types of efficiency
▪ Efficiency of a system is defined as the ratio of its output to input.
▪ Efficiency can be classified as:
(i) Technical efficiency
(ii) Economic efficiency
(i) Technical efficiency
▪ Technical efficiency is the effectiveness with which a given set of inputs is
used to produce an output. It occurs when a firm produces a given level of
output by using the least amount inputs.
▪ A firm is said to be technically efficient if a firm is producing the maximum
output from the minimum quantity of inputs, such as labour, capital, and
technology.
▪ Technical Efficiency = (Actual Output from given inputs/Maximum potential
output from given inputs) x 100
(ii) Economic efficiency
▪ Economic efficiency occurs when the firm produces a given level of output at
the least cost.
▪ It means using the method that produces a given level of output at the
lowest possible cost.
 Difference between technical & economic efficiency
▪ Technical efficiency
⮚ Technical efficiency means the quantity of inputs used in production for a
given level of output.
▪ Economic efficiency
⮚ Economic efficiency refers to the cost of the inputs used.
Thank you