Module 1

(Introduction and Basic Concepts)

TOPICS: Basic economic problems – Production Possibility Curve – Utility – Law of diminishing
marginal utility –Demand: Factors determining demand – Law of Demand – Demand curve- Price
elasticity of demand- measurement of price elasticity and its applications – Supply: factors
determining supply - Law of supply – Supply curve- Equilibrium price determination- Changes in
demand and supply and its effects on equilibrium price and quantity Production: Production
function - Law of variable proportion –Returns to scale- Cobb-Douglas Production Function
What is Engineering Economics-
Definition: Engineering economics is the application of economic principles and tools in engineering
problems and decisions.
Importance: Engineering economics enables engineers in;
a) Evaluating alternatives
b) Making decisions
c) Optimising profit
d) Forecasting business fluctuations
Scarcity and choice
Scarcity:
 Scarcity means shortage of resources.
Reason: Human wants are unlimited and the means (resources) to satisfy them are limited (Scarce).
Choice:-means choose the best from available alternatives.
The problem of choice is another economic problem as the scarce resources have alternative uses.
Basic/Central/Fundamental Economic Problems;-
Scarcity of resources creates three basic economic problems in every economy.
1. What to produce & How much to produce?
This question deals with the problem of resource allocation
2. How to produce?
This question deals with production technique.
3. For whom to produce?
This question deals with the problem of distribution.
Production Possibility Curve (PPC) Or
Production Possibility Frontier [PPF]
Production Possibility Curve is a graphical representation of the combinations of the quantities of
two commodities that can be produced with the given resources and technology.
Assumptions;- PPC is based on the following assumptions
 Only two commodities are produced
 Full employment of resources
 Factors are fixed
 Technology remains constant, and
 Time period is short.
Based on these assumptions we can draw a production possibility curve.

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 The curve ‘AF’ is the PPC.
PPC is also called ‘Transformation curve or PPF (Production possibility Frontier).
When the combination point lies;
• Anywhere on the PPC shows - Full employment of resources.
• Inside the PPC shows - Underemployment of resources (or underutilization of resources.
• Outside the PPC shows – Unattainable combination.
Shifting of PPC:-
PPC will shift upward (A2F2) when a society discovers some new resources or there is an
improvement in technology.
PPC shifts downward (A1F1) when there is a natural calamity, resources will be destroyed.

Utility Analysis
Utility is the want satisfying power (or capacity or quality) of a commodity / service.
Total Utility (TU):
TU is the total satisfaction derived from the consumption of different units of a commodity.
TUn = U1 + U2+ U3 + ……. + Un
Where U1, U2, etc. are utility from respective units.
Marginal Utility (MU):
Marginal Utility is the utility (satisfaction) from an additional unit consumed. It is the addition to total
utility.
MUn = TUn – TUn-1
Law of Diminishing Marginal Utility:
The law states that as a consumer consumes more and more units of a commodity, the marginal utility
goes on diminishing.

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 Assumptions:
o Utility is cardinal
o Utility is additive
o Different units of the commodity consumed are identical (homogeneous)
o No time gap between the consumption of different units.
o Consumer is rational
o Consumer’s income remains constant
o Consumers taste and preferences remain constant.
The following table and diagram explain this law and the changes in his marginal utility and total utility.
No: of MU TU
Apples
Consumed
1 10 10
2 8 18
3 6 24
4 4 28
5 2 30
6 0 30
7 -2 28
8 -4 24
The relation between TU & MU:
1. When MU is positive (diminishes), TU increases at a decreasing rate)
2. When MU= 0(MU touches the X-axis), TU is at maximum
3. When MU is negative (MU lies below the X-axis), TU decreases.
Limitations of the Law:
1. Utility cannot be measured. It is subjective.
2. There will be time gap between the consumption of different units.
3. Commodity consumed may not be in identical size.
4. Consumer’s income may change.
5. Consumer’s taste and preference may change.
6. Not correct in the case of rare collections like stamps, old paints etc.
Importance:
1. Basis of economic laws
2. Basis of the theory of taxation.
3. Good guide to consumers and producers.
4. Gives a satisfactory explanation to the theory of value.
Demand Analysis
Demand is the quantity of a thing purchased at a price, backed by desire, ability to pay and
willingness to pay for a commodity.
Determinants of Demand/ Factors influencing Demand:
1. Price of the Product:

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2. Income of the Consumer:
3. Price of related goods
4. Taste and preferences of a consumer:
5. Population:
6. Advertisement:
7. Savings:
8. Expectations of future price & income:
Law of Demand
The law states that “other things remaining the same, the demand for a commodity expands with a
fall in price and contracts with a rise in price”.
It indicates the inverse relation between price and quantity demanded. i.e., when price rises demand
falls and when price falls demand rises.
The law of demand can be explained with the help of a schedule and a curve.

Exceptions to law of demand: This law not applicable in case of;

1. Veblen goods (Status /Prestige goods) - Price and demand is directly related.
2. Necessary goods
3. Giffen goods/Inferior goods – When the price of inferior goods falls, the income of people increases
and they substitute superior goods.
4. Expectation of price rise in future
5. Ignorance of people about the market conditions.
Elasticity of Demand:
Elasticity of demand refers to the responsiveness of demand to a change in price, income, and price of
related goods.
Types of Elasticity of Demand: - 3 types;
1. Price Elasticity of Demand,
2. Income Elasticity of Demand, and
3. Cross Elasticity of Demand.
Price Elasticity of Demand (ep):-
The responsiveness of demand to a change in price is called price elasticity of demand.

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 Q- Initial/old demand
Q1 - New demand
P - Old/ initial price
P1 -New price.
For normal goods, price elasticity of demand is negative, &
For Giffen goods, price elasticity of demand is positive.
Example; If Q = 2000, Q1 = 2500, P = 10, P1 = 9, Then; EP

(2500 -2000)/2000 = (500 ÷ -1) × (10÷2000) = -2.5

(9-10)/10
Negative sign shows inverse relation between price & demand.
Types (Degrees) of Price Elasticity of Demand:-
Price elasticity of demand is classified in to five as follows;
1. Perfectly elastic demand (ep=∞): - when a slight change in price causes infinite change in
quantity demanded. That is ep=∞. The demand curve is a horizontal straight line, parallel to the ‘X’ axis.

2. Perfectly Inelastic Demand (ep=0): -Quantity demanded remains constant. That is ep=0. The
demand curve will be a vertical straight line, parallel to ‘Y’ axis.

2. Unit Elastic Demand (ep=1): when a given change in price brings an equal and proportionate
change in demand. Here ep=1. In the figure QQ1=PP1.

4. More elastic or elastic demand ep > 1:-when a given change in price brings more than
proportionate change in quantity demanded. Here ep > 1. In the figure QQ1 greater than PP1.

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 5. Less elastic Or inelastic demand (ep < 1) :-when a given change in price brings less than
proportionate change in quantity demanded. Here ep<1. In the figure QQ1 less than PP1.

Methods for measuring price elasticity of demand; - are the following;

1. Total Outlay or Expenditure method:
2. Proportionate method Percentage method:

3. Point method / Geometric method:

The formula to measure elasticity at a point on a straight-line demand is;
Ep= Lower segment of the demand curve at a point
Upper segment of the demand curve at a point

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 Uses or Applications of Price Elasticity of Demand:
It is useful
1. to the government in fixing the tax on a product.
2. to the producers in fixing the price of a product.
3. to the trade unions in wage bargaining.
4. to the policy makers.
Law of Supply
The law states that other things remaining the same, the price and supply of a commodity are
directly related.

It can be seen that as price increases from Rs 1 to 5, the quantity supplied increases from 10 to 50
units.
Equilibrium Price:
Equilibrium Price is that price at which quantity supplied and demanded are equal. That is,
Quantity Demanded = Quantity Supplied, (QD=QS)
Equilibrium Price can be explained with the help of a schedule and diagram.

This schedule shows that 3 is the Equilibrium Price and 30 is the equilibrium quantity.
Changes in demand and supply, and its effects on equilibrium:
1. Increase in demand:
When demand increases the demand curve shifts rightward (D2D2), and equilibrium price as well as
equilibrium quantity increases. The new equilibrium point is E2, price is P2, and quantity is OQ1.

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2. Decrease in supply:
When supply decreases, supply curve shifts leftwards (S1S1), and the new equilibrium point is E1, and
equilibrium price increases to OP1 and equilibrium quantity decreases to OQ1.

3. Demand and Supply increase equally:

When there is an equal increase in demand and supply there will not be any change in equilibrium
price but equilibrium quantity increases.

Numerical Example:
Demand f unction of a product is given as D=50-2P and supply function S=20+3P. What will be
the equilibrium price and quantity of the product? Find the excess demand of the product when
price equals Rs. 3.
Ans: At equilibrium point, Demand=Supply
That is, 50-2P=20+3P,
5P= 30.
Therefore, P=6
Thus equilibrium price of the product is Rs. 6
To find equilibrium quantity, substitute equilibrium price in equations.
When equilibrium price is substituted in demand function we get;
D=50-2×6=38, S=20+3×6=38
Thus equilibrium quantity of the product is 38
When P=3, D=50-2×3=44, S=20+3×3=29
Therefore excess demand when P=3 is 15 (44-29=15)
Production Function
 Production function refers to the functional relationship between inputs and output.
 it is the transformation of inputs in to output.
 Production function can be written as;
Q= f (L, K, N, T)
Where; Q – Output, L – Labour, K- Capital, N – natural resources including land, T – Technology.
Types Production function: Two types.
I. Short run Production function &
II. Long run Production function
Short run Production function Or Law of Variable Proportion
Or Production Function with One Variable input.
Law of Variable Proportion describes the changes in output with one variable factor by
keeping other factors constant. This happens in the short run. Hence it is Short run Production
function.

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 When more and more units are produced with one variable factor and other fixed
factors, TP (Total product), MP (Marginal product) and AP (Average product) passes through
three Stages;
Stages I - Increasing Returns:-
During this stage
 TP increases at an increasing rate.
 MP and AP are also rising. MP is higher than AP.
 First stage continues till MP=AP.
Stages II – Diminishing Returns:-
During this stage
 TP increases at a diminishing rate.
 MP and AP are falling.
 This stage ends when TP is maximum and MP=0. (i.e., when MP touches the X axis.)
Stages III –Negative Returns:-
During this stage
 TP declines and MP becomes negative (below the X axis.
The law can be explained with a diagram.

AP=TP/Q,
TP=AP× Q,
MPn = TPn – TPn-1

Relation between MP and TP:-

1. When MP increases TP increases at an increasing rate.
2. When MP decreases but remains positive, TP increases at a decreasing rate.
3. When MP=0, TP is at maximum.
4. When MP becomes negative, TP declines.
Relation between MP and AP:-
 When MP>AP, AP increases
 When MP=AP, AP is maximum.
 When MP<AP, AP decreases
Laws of Returns to Scale or Fixed proportion or
Long run Production function:-
(It is the period, which is sufficient to increase the quantities of all the factors).
 Long run (or fixed proportion/ returns to scale) production function describes the changes in
output when all inputs (factors) are changed in the same proportion.

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 o Initially the producer gets increasing returns to scale (Decreasing cost),
o Then constant returns to scale (Constant cost), and
o Finally decreasing returns to scale (Increasing cost).
Increasing returns to scale: means that increase in input brings more than proportionate
increase in output. That is 5% increase in input leads to more than 5%, increase in output.
Constant returns to scale: means that increase in input brings equal and proportionate
increase in output. A 5% increase in input leads to 5%, increase in output.
Decreasing returns to scale: means that increase in input leads to less than proportionate
increase in output. That is 5% increase in input leads to less than 5%, increase in output.

Increasing Returns to scale: A-B

Constant Returns to scale: B- C
Decreasing Returns to scale: C-D
Cobb – Douglas Production function:-
 The Cobb-Douglas Production function is used to represent the technological relationship
between the amounts of two inputs (Capital and Labour), and the amount of output that can
be produced by those inputs.
 This function is written as; Q=ALα Kβ
Where, Q- Total output, A-Total factor productivity, L- Labour, K- Capital,
α and β are the output elasticities of labour and capital.
 The Cobb-Douglas Production function is a homogeneous production function of degree one.
That is α+β=1.
If α+β=1, it is the case of constant returns to scale. It means that output changes in the same
proportion of input. If the inputs are increased by 10 times, output will also increase by 10
times. Thus Cobb-Douglas Production function is linearly homogeneous as α+β=1.
If α+β>1, it is the case of increasing returns to scale.
If α+β<1, it is the case of decreasing returns to scale.
 MPL= α× (Q/L)
Where, MPL- Marginal product of Labour
Q/L is Average product of Labour (APL).
 MPK= β × (Q/K)
MPK -Marginal product of Capital.
Q/K is Average product of capital (APK).
Numerical Examples:-
1. In the production function Q= 2L 1/2 K1/2., if L=36

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 a) How many units of capital are needed to produce 60 units of output?
b) Determine the % increase in output if labour increased by 10%, keeping capital
constant.
Ans: a) 60=2 ×6 K1/2
60= 12 K1/2
K1/2=60/12=5
K=25
b) L=36+3.6= 39.6
Q= 2×39.6 1/2×251/2
= 62.92, =63
% Increase in output= (∆Q/Q) × 100
(63-60)/60 × 100= 5%
2. Suppose the production function is given as Q= 2K 1/2 L1/2. L=36, and K= 16.
a) What will be the output?
b) What is MPL and APK?
c) Find the number of units of capital required to produce 40 units of output, if L=25.
Ans: Q= 2K 1/2 L1/2, L=36, and K= 16.
a) Q=2×4×6=48
b) MPL= α× (Q/L)= 1/2 × (48/36) =2/3
APK= Q/K =48/16=3
c) When Q=40 and L=25,
40= 2× K1/2 × 25 ½
40= 2× 5 K1/2
K1/2= 40/10=4
K=16
Numerical Example- Demand Function:

END
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