Engineering Economics

ME - 325

INFLATION
INFLATION
Inflation is the rate of increase in prices over a given period of time, leading
to a decrease in the purchasing power of money.
Effects of Inflation
• Erodes purchasing power of consumers.
• Can lead to uncertainty in business investment.
• Causes menu costs (costs of changing prices).
• Can redistribute wealth, hurting savers and fixed-income earners.
• Sometimes encourages spending and investment before prices rise
further.
 Creeping (Mild)

Walking (Moderate)
Rate: Speed of Inflation
Galloping (Running)

Hyperinflation
Types Of Inflation

Demand-Pull

Cause: Why Inflation Occurs Cost-Push In

Built-In

Open
Control : Government Policies
Suppressed (Repressed)

Domestic
Origin: Where Inflation Starts
Imported

Sectoral Inflation
Scope: Whether Price Rise is Limited or
Widespread General (Comprehensive) Inflation
 Based on Rate: Creeping Inflation
(Mild Inflation)
Cause: Impact / Effect:
• Gradual, stable increase in consumer • Encourages spending and investment.
demand.
• Predictable for businesses.
• Moderate increase in money supply (not • Not harmful to economy: normal and
excessive). desired by central banks
• Healthy economic growth, low Examples:
unemployment.
• Developed economies with 2% target
Scenario:
inflation (US Federal reserves, EU, ECB:
• Prices rise slowly, about 1–3% per year. European Central Bank).
• Most common in stable, advanced • Stable year to year increase in restaurant or
economies. grocery prices.
 Walking (Moderate) Inflation

Cause • Workers demand wage increase

• Demand increasing more rapidly. • May require early policy intervention: rate
• Moderate increase in production costs. hike, subsidies

• Structural constraints Examples

Scenario • Emerging or developing economies like

India or Indonesia experiencing 5 - 7%
• Prices rise 3–10% yearly. inflation.
• Noticeable to consumers. • Increase in urban housing rentals year after
Impact / Effect year.
• Cost of living increases. • Regular price increases in essential goods
• Value of savings erodes.
 Galloping/Running (high) Inflation

Cause • Double to triple digit annual inflation (20 →

• Very rapid expansion of money supply or 200%)
uncontrolled government spending. • Price rise monthly, not just yearly
• Major supply shortages: food, fuel, imports • Week exchange rates
• Economic unbalance: fiscal deficits, Impact / Effect
currency depreciation • Serious loss of purchasing power.
• Political instability – reduced investor
• Investments become risky.
confidence
• People shift to real assets (land, gold).
• Poor monetary control with weak central
bank control • Businesses hoarder: stockpiling
Scenario • Less jobs
 Hyperinflation (Runaway Inflation)

Cause before it loses value.

• Massive printing of money, without • Goods become scares
economic backing
Impact / Effect
• Collapse of production: supply cannot meet • Currency collapses: cash becomes
demand worthless.
• War, civil unrest or political instability: lost of • Savings evaporate completely.
confidence
• Barter systems reappear
Scenario
• Economic activity slows dramatically;
• Prices rise > 50% per month to daily. investment collapses.
• People rush to spend money immediately
 Based on Cause: Demand-Pull Inflation

Cause • GDP initially rises.

• Demand increases faster than supply: • Unemployment falls.
higher consumer income, increase in
• Prices increase (inflation).
government spending, investment boom,
low interest rates. • If uncontrolled → overheating of economy.
Scenario • Decreases purchasing power.
• Economy is growing. Examples
• People have more money → spend more. • Post-COVID recovery in 2021–22 where
consumer spending surged.
• Businesses cannot increase production
immediately → prices rise. • Festival season high demand raising prices
of electronics.
Impact / Effect
 Cost-Push Inflation

Cause • Output may fall (stagflation risk: stagnant

• Increase in production cost: Raw materials, economic growth with high unemployment).
Wages, energy costs, Supply chain • Consumers face higher prices with no
disruptions increase in income.
Scenario Examples
• Factories face higher input costs. • Floods damaging crops → Food Inflation.
• Businesses pass on higher costs to • Europe Fuel Crisis (Post Russia-Ukraine
consumers: rates increase War, 2022–23)
Impact / Effect • Pakistan Electricity Crisis (2007 - 2010;
2013)
 Built - In Inflation (Wage – Price Spiral)

Cause: Expected Inflation Impact / Effect

• Workers anticipate price rise, demand • Inflation becomes self-sustaining.
higher wages. • Hard to control without monetary
• Firms give wage increase, raise prices tightening: interest rates increase
to maintain profit. • Reduce real income if wages don’t
Scenario match inflation.
• Self Prices Wage Examples
Increase ↑ Increase ↑
Reinforcement • Automatic annual salary increments
cycle develops: tied to inflation (COLA).
Production
Cost Increase ↑
Based on Control: Government Policies
1. OPEN INFLATION: Prices rise freely due to 2. SUPPRESSED (REPRESSED)
market forces and there is No government INFLATION: Government controls or
freezes prices
intervention.
• Shortages of goods: Rationing, Black
• Demand or cost increases. markets emerge.
• Consumers feel inflation immediately: • Hidden inflation that bursts once
transparent and painful. controls are lifted.

Examples: Examples
• Price controls on wheat/sugar during
• Petrol price increases due to rise in global oil
shortages and festive seasons
prices.
• Surge pricing (Uber, airlines, hotels).
Based on Origin: Where Inflation Starts
1. DOMESTIC INFLATION: 2. IMPORTED INFLATION:
Caused by internal factors (money supply, Increase in prices due to higher import
rising wages, local shortage of goods). prices. Depreciation of local currency.
• Scenario: Prices rise due to demand - Scenario:
pull or cost - push within the country • Oil prices rise globally → domestic fuel
and transport costs rise.
• Impact/ Effect: Cost of living increase
which can lead to overall economic • Tariff war: Expensive imported goods
inflation Impact / Effect
• Example: Food Production • Increases cost of production.
• Contributes to cost - push inflation.
Based on Scope: Whether Price Rise is
Limited or Widespread
1. SECTORAL INFLATION: 2. GENERAL (COMPREHENSIVE)
• Price rise in a specific sector. Due to INFLATION:
supply shortage or increased demand • Broad increase in money supply,
• Partial inflationary pressure. May demand, or production costs.
become general inflation if • Prices rise across all sectors.
widespread. • Cost of living rises nationwide. And
Examples central bank intervenes with monetary
• Tomato or onion price spikes due to policy.
crop failure. Examples
• Housing market inflation in major • Price increases in food, fuel,
cities. transport, and services together.
 IMPACT OF INFLATION ON MARKET
STRUCTURES
Short-Run Effects Long-Run Effects
Perfect Firm exits → supply falls → higher prices,
Shutdowns, profit squeeze, output fall
Competition new equilibrium
Monopolistic Strong brands raise prices; weaker firms Market consolidation, higher entry barriers,
Competition struggle fewer firms
Stable high profits; regulator scrutiny; more
Oligopoly Quick coordinated price increases
concentration
Aggressive price hikes, minimal Potential output reduction if incomes fall;
Monopoly
competition regulatory intervention

Buyer loses power, supplier pressure Supplier consolidation; shift to substitutes;

Monopsony
increases weaker monopsony power
1. PERFECT COMPETITION (Many Firms, Identical Products, Price Takers)

Characteristics Under Inflation • Output falls temporarily as loss-making firms

reduce production.
• Thin profit margins → highly vulnerable when
input costs rise. • Market price may lag behind rising costs →
profit squeeze.
• Strong cost-push pressure: Inflation raises
prices Long-Run Effects
• Firms frequently re-optimize output under • Loss-making firms exit → industry supply
inflation uncertainty. decreases.
• High interest rates raise financing costs → • Higher equilibrium price emerges as remaining
slows entry, accelerates exit. firms survive.

Short-Run Effects • Industry eventually stabilizes at a new

equilibrium with fewer firms and higher prices.
• Many firms face shutdown because they cannot
pass higher costs to consumers quickly.
2. MONOPOLISTIC COMPETITION (Many Firms, Differentiated Products:
Restaurants, Cosmetics, Fashion)

Characteristics Under Inflation higher exit risk.

• Product differentiation allows partial shifting of • Advertising becomes more important but more
inflation to consumers. expensive → profit pressure.
• Strong brands increase prices much easily; and Long-Run Effects
weaker firms struggle.
• Market consolidation: weaker firms exit, leaving
• Shrinkflation and product modifications preserve stronger differentiated brands.
margins.
• Higher entry barriers reduce new competition →
• Higher interest rates increase startup costs → increased pricing power for survivors.
higher entry barriers.
• Product innovation may slow if inflation erodes
Short-Run Effects R&D budgets.
• Strong brands raise prices with minimal loss of
demand.
• Small or weak firms lose customers and face
3. OLIGOPOLY (Few Firms, Strategic Pricing: Cement, Telecom, Airlines,
Banks)

Characteristics Under Inflation • Consumers face immediate and steep price

hikes.
• Inflation increases incentives to avoid price
wars Long-Run Effects
• Firms often engage in coordinated or parallel • Regulators may intervene if price movements
pricing appear coordinated.
• One firm acts as price leader, others follow. • Industries may become even more
concentrated (smaller firms exit or get
• Menu costs rise from frequent price changes.
acquired).
• Inelastic demand allows profit preservation.
• Long–term profitability stays relatively high due
Short-Run Effects to sustained pricing power.
• Fast price pass-through to consumers because • Persistent inflation may push firms to automate
firms follow the price leader. or cut labour costs.
• Tacit collusion strengthens as firms avoid
uncertainty and competition.
4. MONOPOLY (Single Seller: Utilities, Transport, Special Services)

Characteristics Under Inflation • If consumer incomes fall, some

• Monopolist can raise prices reduction in output may occur.
aggressively, often faster than inflation. Long-Run Effects
• Inflation provides a justification for • If inflation becomes persistent and
opportunistic pricing (price hikes incomes fall, monopolist may restrict
exceed cost increases). output due to declining demand.
• Very weak competitive pressure → • Regulatory bodies may impose price
limited motivation for efficiency. caps, limiting abuse of market power.
Short-Run Effects • Long-term consumer welfare declines
• Quantity demanded falls slightly if as purchasing power shrinks and
demand is inelastic. substitution options remain limited.
5. MONOPSONY (Single Dominant Buyer: Government Defence
Procurement, Large Retailers)

Characteristics Under Inflation Long-Run Effects

• Suppliers face rising production costs and • Persistent inflation may force a structural
resist low prices. shift (import substitution, cheaper suppliers).
• Monopsonist may need to raise purchase • Supplier exit reduces competition → supplier
prices to maintain supply. consolidation.
• Buyer may shift to cheaper inputs, imports, • Monopsony power may erode permanently
or automation. unless switching inputs is easy.
Short-Run Effects • Long-term contracts may be renegotiated at
higher prices.
• Suppliers demand higher prices due to rising
input costs. Their bargaining power weakens
• Temporary supply shortages or delays may
occur if suppliers cannot cover costs.
 Impact of inflation on Banks & Specialized
Credit Institutions
Banks and specialized credit institutions offer deposits, loans, and credit facilities, mobilize
savings, allocate credit, support trade and industry, and transmit monetary policy.
Impact of Inflation:
• Higher Interest Rates: Loans become more expensive; borrowing slows
• Credit Risk: Increased chances of defaults and non-performing loans
• Asset-Liability Mismatch: Fixed-rate loans lose real value; funding costs rise
• Reduced Real Returns: Depositors earn less on savings
• Profit Margin Pressure: Net interest margins shrink; operational costs rise
• Investment Risk: Bond values drop; equities fluctuate
• Strategic Response: Short-term loans, inflation-linked deposits, hedging
Business Organization and Industrial
Relationship
Business Organization: Defines how ownership, control, and
responsibility are structured within an enterprise, shaping
decision-making, profit sharing, risk bearing, capital raising, and
engineering economic decisions.
Industrial Relationship: Refers to interactions between
management and employees within an organization and industry,
including labor relations, wage structures, working conditions,
management coordination, and government regulations.

21
 Cooperative / Public
Sole Proprietorship Partnership Corporation
Ownership
Shareholders (separate legal
Ownership Single individual Two or more partners Members or the State
entity)

Limited or shared among

Liability Unlimited personal liability Joint and several liability Limited to amount invested
members

Member contributions or public

Capital Source Personal savings Partner contributions Sale of shares / stock
funds

Public services / welfare sectors

Control & Decision Small-scale business Medium enterprise Large-scale / industrial
Democratic or government-
Making Full control by owner Shared decision-making Managed by Board of Directors
controlled

Shared among members or

Profit Distribution Entirely to owner Shared among partners Dividends to shareholders
reinvested

• Partners share risks, but

disagreements may arise over • Better ability to absorb inflation • Inflation can reduce the
• High vulnerability as personal
pricing, cost management, or due to access to equity, debt, purchasing power of members
and business finances are
investment decisions during and diversified operations. or shareholders.
closely tied.
inflation. • Larger firms can adjust pricing, • Decision-making may be
• Rising costs reduce profit
Impact of inflation • Profits are eroded by rising hedge risks, and invest in cost- slower due to collective
margins; owner bears full risk.
input costs; capital injection saving technologies. processes.
• Limited access to capital
may be needed from partners. • Inflation may still affect profit • Pricing and cost adjustments
makes financing expansion or
• Partnerships may be more margins and shareholder may be politically sensitive,
coping with inflation harder.
flexible in responding than sole returns. limiting flexibility.
proprietorships. 22
 IMPACT OF INFLATION ON INDUSTRIES
• Rising input costs: Higher prices of raw materials, energy, and imports squeeze profit
margins.
• Wage pressure: Increased wage demands raise labour costs.
• Reduced consumer demand: Falling purchasing power lowers demand for non-
essential goods.
• Higher borrowing costs: Rising interest rates delay expansion and strain loan-
dependent firms.
• Supply chain disruptions: Price volatility complicates procurement and logistics.
• Currency effects: Import costs rise; exporters may benefit from weaker currency.
• Profit and market changes: Firms raise prices, cut output, or exit—especially smaller
firms.
 Impact Of Inflation On Businesses
Operations B. Cost Estimation Errors
• Inflation complicates forecasting of
A. Pricing Decisions
material, labour, overhead, and production
• Firms adjust prices to protect profit costs.
margins.
• Estimation errors lead to:
• Menu costs rise due to frequent updates of
• Project under-budgeting
price lists, packaging, and labels.
• Cash-flow shortages
• Delayed price revisions reduce real
• Uncompetitive bids in fixed-price or
revenue and profitability.
long-term contracts
• Repeated price hikes in sensitive markets • Lower real profits due to reduced
may trigger customer resistance. purchasing power
Financial Decisions • Higher nominal rates increase loan
costs.
Higher Nominal Interest Rates
• Capital-intensive industries face
• Lenders raise rates to offset inflation. financing constraints.
• Central banks tighten monetary policy. • Rising cost of capital discourages new
• Borrowing costs rise for businesses and investments.
consumers. Debt vs. Equity Financing Shifts
Lower Real Returns to Investors Inflation alters financing choices:
• Inflation erodes real earnings: • Debt becomes less attractive due to
Real Return = Nominal Return − high interest rates.
Inflation • Firms may favor equity despite
• Investors shift toward real assets, ownership dilution.
commodities, inflation-linked bonds, and • Investors demand higher returns,
short-term securities. raising the cost of equity.
Costlier Borrowing
 IMPACT OF INFLATION ON THE STOCK
MARKET
Stocks: Represent ownership in a company. Buying stock makes you a shareholder, giving
you a claim on profits through dividends and potential capital gains.
• Higher interest rates: Borrowing costs rise, business expansion slows, and stock prices
may fall.
• Reduced profits: Rising input and operating costs squeeze margins, lowering earnings
and valuations.
• Investor sentiment: Inflation uncertainty increases volatility; investors shift toward safer
assets.
• Most affected stocks: Consumer goods, utilities, telecom, and financials.
• Relatively resilient stocks: Commodities, energy, and export-oriented firms.
• Real returns: Inflation erodes dividends and capital gains.
Common Stock (Ordinary Shares):
• Basic ownership in a company
• Voting rights (elected board, major decision ion making)
• Dividends depend on company profits
Examples (PSX): OGDC, Lucky Cement, Meezan Bank, Hub Power
(HUBC)
Inflation Impact: ↑ Inflation → ↑ Business costs → ↓ Profits → ↓ Dividends
• Share prices may fall as investors demand higher returns
• Cyclical stocks (consumer goods, industrials) are more affected
• Defensive stocks (utilities, banks) are relatively resilient
Preferred Stock (Preference Shares):
• Pays fixed dividend
• Priority over common stock in liquidation
• Usually no voting rights
• Limited potential for capital gains
Examples: Bank Alfalah, other banks
Inflation Impact:
• Fixed dividends lose real value as inflation rises
• Market price falls when interest rates increase (similar to bonds)
Dual-Class Shares (Class A / Class B)
• Companies issue multiple share classes with different voting rights or
dividend policies
• Often used to retain founder control
Examples: Google, Meta
Inflation Impact:
• Founder-controlled firms may pursue long-term strategies to hedge
inflation
• Investors may favor shares with strong dividend history or higher liquidity
Redeemable and Convertible Shares

Redeemable Shares: Company can buy Convertible Shares: Can be converted into
back these shares after a fixed time or common stock after a specific period or at a
fixed price
under certain conditions
Purpose: Raise capital now, offer fixed
Purpose: Temporary capital raising, avoid dividends + future equity upside
permanent ownership dilution, provide fixed Who buys: Institutional investors, private
dividends equity, large investors seeking income +
growth
Who buys: Banks, insurance companies,
mutual funds, large private investors Inflation Impact:
• Rising interest rates → conversion
Inflation Impact:
becomes less attractive
• High inflation → companies may delay • If company’s stock price rises with
redemption due to cash constraints inflation → conversion can benefit
investors
• Investors may lose real value if
redemption price lags inflation
Treasury Stock:
• Shares repurchased by the company from the market
• Can be reissued to investors later if needed
Examples: Lucky Cement, Engro, Habib Bank Ltd., Apple, Microsoft, Meta,
Coca-Cola
Inflation Impact:
• High inflation → companies may delay buybacks due to higher cash costs
• Falling share prices (panic selling) → buybacks become more attractive
• Treasury shares can be reissued later to raise capital when needed
.
DEPRECIATION
Depreciation is an accounting method that systematically allocates the cost
of a tangible asset over its useful life, reflecting wear, tear, and
obsolescence (not market value). It spreads the asset’s cost across years to
match expenses with revenues, reduces accounting profit, is tax-deductible,
and is a non-cash expense.

Purpose in Financial & Engineering Economics:

• Measures asset value decline
• Affects income tax calculation
• Impacts cash flow via tax savings
• Guides investment, pricing, and operational decisions
Impact on Financial Decisions:
• Investment Planning: Helps decide asset replacement and expansion timing
• Tax Management: Lowers taxable income → reduces tax liability
• Cash Flow Management: Non-cash expense increases available cash for
operations
• Pricing & Profitability: Inflation-adjusted depreciation ensures realistic pricing
and margins

Depreciation and Inflation:

• Inflation increases → replacement cost of assets rises
• Book depreciation (historical cost) may understate real cost, affecting profit
analysis
• Firms adjust financial planning or accelerate depreciation to reflect true economic
cost
 IMPACT OF INFLATION ON
ENGINEERING ECONOMICS

1. Project Costs
2. Investment Decisions
3. Financial Analysis
4. Pricing and Cost Estimation
5. Funding and Borrowing
6. Risk and Uncertainty
7. Strategic Planning