NED University of Engineering and Technology
APPLIED ECONOMICS FOR ENGINEERS
TOPIC # 2 ECONOMIC ENVIRONMENT
Learning output: Goods and Services, Consumer and Producer Goods, Definition
of Market, Demand and Supply Concepts, Elasticity of Demand
and Supply, Price-supply-Demand Relationship, Various Costs,
Revenue and Profit Maximization.
GOODS AND SERVICES
Almost all things can be separated into goods and services. These are very different from each
other, though in todays world there are a variety of companies that offer both goods and
services. Hence, it is often overlapping and companies are trained in both to offer proper goods
as well as adequate services.
Goods: In economics, goods are considered as tangible objects. These are obviou things
that you can see, touch, smell, taste, etc. In order for a good to be classified as good, it
must something a person can hold, taste, consume or use. Goods are also easily
transferable from one person to another. Goods also have a physical dimension and take
up space someplace.
Services: Services are something completely different from goods. Services are
intangible commodities that cannot be touch, felt, tasted, etc. They are the opposite of
goods, where goods are something that can be traded for money; services are when you
hire a person or someone to do something for you in exchange of money. Services are
usually hired or rented, they cannot be owned like goods can. Since it requires people and
one cannot legally own a person in todays world, services are said to be hired even if
those are purchased..
Mainly there are two categories of goods and services.
Consumer goods and services are those that are directly and finally used and consumed
by the end users to satisfy their needs and wants. Consumer goods can be classified as
consumables and durables such as juice pack is a consumables item while electronic
items or a refrigerator is considered as a durable item.
Producer goods and services are those goods and services which are used by the
manufacturers and producers in the process of producing consumer goods and services to
be finally used by end-users and consumers: machine tools, factory buildings, buses and
farm machinery are the examples of producer goods and services.
MARKET
Market is a point or place where buyers and seller interact with each other for the purpose of
exchanging and trade of goods and services for their mutual benefits and satisfaction. Market is
any arena, however abstract or far-reaching, in which buyers and sellers make transactions.
Goods and Services market, Money and Assets market, Factors of Production market etc are
major types and categories market. A market can be one to one, one - many, many - one,
physical or virtual or on-line market such as e-commerce and e-business like e-bay and OLX. In
an ideal market place we assume that buyers and seller both have perfect and up to date
information required.
MARKET FORCES
In any market there are always two opposite directional forces in action. These are the forces of
Aggregate Demand and Aggregate Supply and both fight for price. Whenever these two forces
come into agreement with each other the market becomes into equilibrium. Here we will discuss
1) Law of Demand first in detail and then we will discuss 2) Law of Supply and then 3) Market
Equilibrium.
LAW OF DEMAND
The law of demand states that, if all other factors remain equal, the higher the price of a good,
the less people will demand that good. In other words, the higher the price, the lower the quantity
demanded. The amount of a good that buyers purchase at a higher price is less because as the
price of a good goes up, so does the opportunity cost of buying that good. As a result, people will
naturally avoid buying a product that will force them to forgo the consumption of something else
they value more.
General relationship between price and demand
Here c is the intercept on the price axis and m is the slope of the line.
Price equals some constant value minus some multiple of the quantity demanded
The relationship between price and demand can be expressed as a linear function:
(1.1)
Thus, m represents the amount by which demand increases for each unit decrease in P. Thus,
(1.2)
General relationship between price and demand for necessities and luxuries
The relationship between price and demand shown in this figure is expected to be different for
necessities and luxuries. It is easy to realize that the consumers would give up the consumption
of luxuries if the price is increased, but it would be very difficult for them to reduce the
consumption of necessities. Figure depicts the price-demand relationship for necessities and
luxuries.
ELASTICITY
The degree to which demand is affected due to change in price is referred to as elasticity of the
demand. The demand for products is said to be elastic when decrease in selling price results in
considerable increase in their demand. On the other hand, if a change in selling price produces
little or no effect on the demand, the demand is said to be inelastic. Thus, it is clear from above
figure that luxuries exhibit elastic demand whereas; the demand for necessities is inelastic in
nature.
The price elasticity of demand (PED) is a measure that captures the responsiveness of a good's
quantity demanded to a change in its price. More specifically, it is the percentage change in
quantity demanded in response to a one percent change in price when all other determinants of
demand are held constant.
The formula for the coefficient of Price Elasticity of Demand is:
/ %
= = x OR
/ %
The law of demand states that there is an inverse relationship between price and demand for a
good. As a result, the PED coefficient is almost always negative. However, economists tend to
ignore the sign in everyday use. Only goods that do not conform to the law of demand, such as
Giffen goods (highly inferior goods) and Veblen goods (high-status goods) have positive PED.
The numerical values for the PED coefficient could range from zero to infinity. In general, the
demand for a good is said to be inelastic (or relatively inelastic) when the PED is less than one
(in absolute value): that is, changes in price have a less than proportional effect on the quantity of
the good demanded.
The demand for a good is said to be elastic (or
relatively elastic) when its PED is greater than one.
In this case, changes in price have a more than
proportional effect on the quantity of a good
demanded.
A PED coefficient equal to one indicates demand
that is unit elastic; any change in price leads to an
exactly proportional change in demand (i.e. a 1%
reduction in demand would lead to a 1% reduction
in price).
A PED coefficient equal to zero indicates perfectly inelastic demand. This means that demand
for a good does not change in response to price and infinity means no control.
Price Elasticity of Supply (PES) can be calculated in similar manner
ELATIONSHIP BETWEEN TOTAL REVENUE AND DEMAND
The total revenue R that can be generated by selling a particular good during a given period is
obtained by multiplying the selling price per unit P with the number of units sold D. Thus
If the relationship between price and demand is used, then,
The relationship between total revenue and demand for the condition expressed in Eq. (1.4) may
be depicted by the curve shown in the graph below.
General relationship between total revenue and demand. This schedule depicts how revenue (R) goes negative. It does not happen in
case of perfect competition since they are price takers.
In order to determine the optimum demand D* that would yield maximum total revenue, we
differentiate Eq. (1.4) with respect to D and equate it to zero as
Thus,
The maximum total revenue can be obtained as:
It should be noted that the term is called the incremental or marginal revenue.
Example A floor tiles manufacturer estimates the relationship between sales volume D and the
unit selling price P as
How many units of tiles should the company produce and sell to maximize the total revenue?
Solution We know that the total revenue is given as:
For maximum total revenue, =
LAW OF SUPPLY
Like the law of demand, the law of supply demonstrates the quantities that will be sold at a
certain price. But unlike the law of demand, the supply relationship shows an upward slope. This
means that the higher the price, the higher the quantity supplied. Producers supply more at a
higher price because selling a higher quantity at higher price increases revenue.
EQUILIBRIUM
When supply and demand are equal (i.e. when the supply function and demand function
intersect) the economy is said to be at equilibrium. At this point, the allocation of goods is at its
most efficient because the amount of goods being supplied is exactly the same as the amount of
goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the
current economic condition. At the given price, suppliers are selling all the goods that they have
produced and consumers are getting all the goods that they are demanding.
General relationship between price, supply and demand
The equilibrium occurs at the intersection of the demand and supply curve, which indicates no
allocative inefficiency. At this point, the price of the goods will be P* and the quantity will be
Q*. This figure is referred to as equilibrium price and quantity. In the real market place
equilibrium can only ever be reached in theory, so the prices of goods and services are constantly
changing in relation to fluctuations in demand and supply.
MARKET DISEQUILIBRIUM CONDITION
The market forces of demand and supply oscillate between the north and south of equilibrium
and ultimately reach to an equilibrium position.
COST ESTIMATING
It is used to describe the process by which the present and future cost consequences of
engineering designs are forecasted. When a company engages in a project, it needs to come up
with a relatively accurate estimate of cost.
Cost estimating is used to:
Provide information used in setting a selling price for quoting, bidding, or evaluating
contracts
Determine whether a proposed product can be made and distributed at a profit (e.g. price
= cost + profit)
Evaluate how much capital can be justified for process changes or other improvements
Establish benchmarks for productivity improvement programs
Cost Estimating Approaches
One approach that a company can use is the top-down method of estimating, and another is the
bottom-up method of estimating project cost. These methods approach the estimating process
from different angles but try to accomplish the same goal.
Top-Down Approach
Top-down estimating is a process that involves looking at a project from a broad view and
coming up with a total cost for it. This method is typically done by upper management who
want to come up with a budget for a lower division. This method may involve comparing the
project to other similar projects in the past and then coming up with a budget to work with.
These budgets may not be accurate, but they are easier to come up with.
Uses historical data from similar engineering projects
Used to estimate costs, revenues, and other parameters for current project
Modifies original data for changes in inflation / deflation, activity level, weight, energy
consumption, size, etc.
Best use is early in estimating process
Bottom-Up Approach
With the bottom-up estimating method, companies rely on those who will actually be doing
the project to come up with an accurate estimate, in most cases. This method looks at the
individual components that will make up the cost of the project and adds them together. This
is a much more detailed way to estimate the cost of a project.
More detailed cost-estimating method. It attempts to break down project into small,
manageable units and estimate costs, etc.
Smaller unit costs added together with other types of costs to obtain overall cost estimate
Works best when detail concerning desired output defined and clarified
VARIOUS COSTS
1) Cash Cost Versus Book Cost
Cash cost is a cost that involves payment in cash and results in cash flow;
Book cost or noncash cost is a payment that does not involve cash transaction;
book costs represent the recovery of past expenditures over a fixed period of time;
Depreciation is the most common example of book cost; depreciation is what is
charged for the use of assets, such as plant and equipment; depreciation is not a
cash flow;
2) Sunk Cost And Opportunity Cost
A sunk cost is one that has occurred in the past and has no relevance to estimates
of future costs and revenues related to an alternative course of action;
An opportunity cost is the cost of the best rejected ( i.e., foregone ) opportunity
and is hidden or implied;
3) Life-Cycle Cost
Life-cycle cost is the summation of all costs, recurring and nonrecurring, related to a product,
structure, system, or service during its life span. Life cycle begins with the identification of
the economic need or want (the requirement) and ends with the retirement and disposal
activities.
4) Capital and Investment Cost
Investment Cost or capital investment is the capital (money) required for most
activities of the acquisition phase;
Working Capital refers to the funds required for current assets needed for start-up and
subsequent support of operation activities;
Operation and Maintenance Cost includes many of the recurring annual expense
items associated with the operation phase of the life cycle;
Disposal Cost includes non-recurring costs of shutting down the operation.
5) Fixed, Variable and Incremental Costs
Fixed costs are those unaffected by changes in activity level over a feasible range of
operations for the capacity or capability available. Typical fixed costs include
insurance and taxes on facilities, general management and administrative salaries,
license fees, and interest costs on borrowed capital. When large changes in usage of
resources occur, or when plant expansion or shutdown is involved fixed costs will be
affected.
Variable costs are those associated with an operation that varies in total with the
quantity of output or other measures of activity level. Example of variable costs
include: costs of material and labor used in a product or service, because they vary in
total with the number of output units -- even though costs per unit remain the same.
Incremental cost is the additional cost that results from increasing the output of a
system by one (or more) units. Incremental cost is often associated with go / no go
decisions that involve a limited change in output or activity level. For example the
incremental cost of driving an automobile might be $0.27 / mile. This cost depends
on mileage driven, mileage expected to drive, age of car;
6) Recurring and Nonrecurring Costs
Recurring costs are repetitive and occur when a firm produces similar goods and
services on a continuing basis. Variable costs are recurring costs because they repeat
with each unit of output. A fixed cost that is paid on a repeatable basis is also a
recurring cost: - Office space rental.
Nonrecurring costs are those that are not repetitive, even though the total expenditure
may be cumulative over a relatively short period of time; typically involve developing
or establishing a capability or capacity to operate; Examples are purchase cost for real
estate upon which a plant will be built, and the construction costs of the plant itself.
7) Direct, Indirect and Overhead Costs
Direct costs can be reasonably measured and allocated to a specific output or work
activity like labor and material directly allocated with a product, service or
construction activity;
Indirect costs are difficult to allocate to a specific output or activity -- costs of
common tools, general supplies, and equipment maintenance.
Overhead consists of plant operating costs that are not direct labor or material costs.
indirect costs, overhead and burden are the same;
Prime or Apportioned Cost is a common method of allocating overhead costs among
products, services and activities in proportion the sum of direct labor and materials
cost;
STANDARD COSTS
Representative costs per unit of output that are established in advance of actual production and
service delivery;
Standard Cost
Element Sources of Data
Direct Labor Process routing sheets, standard times, standard labor rates;
Direct Material Material quantities per unit, standard unit materials cost;
Factory Overhead Total factory overhead costs allocated based on prime costs;
SOME USES OF STANDARD COST
Estimating future manufacturing or service delivery costs;
Measuring operating performance by comparing actual cost per unit with the standard
unit cost;
Preparing bids on products or services requested by customers;
Establishing the value of work-in-process and finished inventories;
RELATION BETWEEN COST AND VOLUME
In almost all firms there are certain costs that remain constant irrespective of their level of
output. For example, interest on borrowed capital, property taxes and many other overhead costs
of firms remain constant regardless of the level of production. Such costs are referred to as fixed
costs FC. In addition, there are other costs that vary almost directly with the level of output, and
these are called variable costs. For example, costs associated with the labor, raw material, power
consumption are variable costs VC. The sum of the fixed costs and the variable costs is referred
to as total cost TC. The relationship of these costs with the number of units produced i.e.
demand D is depicted in the next figure.
Thus, at any demand D,
Let, the variable cost per unit is v.
Relationship between fixed cost, variable cost and total cost, with demand
When the total revenue-demand relationship shown previously and the total cost-demand
relationship shown here are combined together then it results in as shown below for the case
where (c v) > 0.
Figure below shows the
functional relationship
outcome if we overlap these
two graphs
This figure clearly shows the volume for which profit and loss take place. Here, we wish to know
the demand level that yields maximum profit. We can define profit as
We now take the first derivative with respect to D and equate it to zero:
The value of D that maximizes profit is
The figure above shows that the total revenue curve intersects the total cost line at two points.
Thus at these points, total revenue is equal to the total cost and these points are called breakeven
points. For a demand D, at the breakeven point
This is a quadratic equation with one unknown D; it can be solved for the breakeven points D1
and D2 which are, indeed, the two roots of the equation.
Example An electrical fitting manufacturer has found that the unit selling price P and the
sales volume D for one of its models of circuit breaker has the following relationship:
It therefore, articulates the unit selling price to control the sales volume in accordance with the
rate of production. The companys monthly fixed costs and the unit variable costs are Rs.75, 000
and Rs. 250 respectively. How many units, the company should produce and sell to maximize
the profit and what is the maximum profit?
Solution
We now take the first derivative with respect to D and equate it to zero:
The value of D that maximizes profit is
END OF TOPIC ..
Curve Shifts vs. Movement along Curve:
