ENME619.

12 Fundamentals of Pipeline Economics

TOPIC 1 INTRODUCTION TO ECONOMICS

Textbook:
• Riggs, J.L., Bedworth, D.D., Randhawa, S.U., and Khan, A.M., Engineering
Economics, 2nd Canadian Edition, McGraw Hill, 1997, Chapter 1.

Supplementary Readings:
• Blank, L., and Tarquin, A., Engineering Economy, 6th Edition, McGraw Hill, 2005,
Chapter 1.
• Park, C.S., Pelot, R., Porteous, K.C., and Zuo, M.J., Contemporary Engineering
Economics, 2nd Canadian Edition, Addison Wesley Longman, 2001, Chapter 1.
• Steiner, H.M., Engineering Economic Principles, 2nd Edition, McGraw Hill, 1996,
Chapters 1, 2.

1.1 What is Engineering Economics?

a. A historical review
• A.M. Wellington (1887) proposed the concept of engineering economic analysis
through mathematical models. [The Economic Theory of the Location of Railways,
John Wiley & Sons, New York, 1887]

• O.B. Goldman (1920) proposed a compound-interest procedure for determining

comparative values of investments [Financial Planning, John Wiley & Sons, Inc.,
New York, 1920]

• C.L. Fish (1923) formulated an investment model related to the bond market.
[Engineering Economics, 2nd edition, McGraw-Hill, New York, 1923]

• E.L. Grant (1930) established the classical engineering economy. [Principles of

Engineering Economy, The Ronald Press, New York, 1930]

• J. Dean (1951) set up the base for modern engineering economics through
approaches to discounted cash flow and capital rationing for analysing the effects of
supply and demand for investment funds in allocating resources [Capital Budgeting,
Columbia, New York, 1951].

• Current developments: risk analysis; sensitivity analysis; effects of inflation, tax,

depreciation; intelligent decision support;

b. Engineering Economics answers the following questions:

• Which one of several competing engineering designs should be selected?
• Should the machine now in use be replaced with a new one?
• With limited capital available, which investment alternative should be funded?
• Would it be preferable to pursue a safer conservative course of action or to follow a
riskier one that offers higher potential returns?

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• How many units of production have to be sold before a profit can be made?
• Among several proposals for funding that yield substantially equivalent worthwhile
results but have different cash flow patterns, which is preferable?
• Are the benefits expected from a public service project large enough to make its
implementation costs acceptable?

c. A definition extracted from Steiner and Riggs et al.

Engineering economics focuses on the problems of engineering-related investments
and it is closely aligned with conventional microeconomics. It employs the principles
of microeconomics and contemporary computation methods from an applied
mathematic branch called “Operations Research” to analyse or evaluate engineering
related investment alternatives.

1.2 Definition of terms

a. Investment: means using resources to create an addition to the present facilities.
From an economist’s standpoint is the diversion of resources from consumption to
uses that will improve the efficiency of the production process.
• Private: the resources come from private companies or organizations.
• Public: the resources come from public funds.

b. Mutually exclusive investments: If two investments are under consideration and to

select one of them will in fact to reject the other one, these two investments are
called mutually exclusive investments.
c. Mutually independent investments: They are the investments which have no
technical links between each other.

d. Mutually interdependent investments: They are the ones which have to be jointly
considered in economic analysis.

e. Externality: any costs or benefits which are not counted directly on the books of
accounts, e.g. benefits from public investments (such as road systems), pollution
cost, etc.

f. Opportunity cost: It is the benefit forgone by choosing one mutually exclusive

alternative rather than another.

g. Cost of capital:
• opportunity cost.
• financial cost, e.g. interest or mortgage.

1.3 Investment choice

a. Two important points to set decision criteria
• They must be in line with objectives.
• Decision maker may face conflict objectives.

b. Decision procedure

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• Step 1: Set objectives

• Step 2: Examine alternative ways
• Step 3: Predict consequences
• Step 4: Evaluation
• Step 5: Decision

c. Viewpoint
• Institutional position: Different analysts may view differently on an investment due
to their different servicing organisations. The word: “Institutional” here is a term in
social science. It means an entity in the society in which the analyst is located.
• Different viewpoints result in different evaluations.
• Avoid the cross-eyed view, the short-sighted view and tunnel vision view.

d. System analysis
It means the investigation of an interrelated entity whose interdependent parts and
their effects on each other must be studied as a whole. To buy a new machine (say a
CNC milling machine), for example, besides the direct economic evaluation on this
investment (such as cost of the machine, expected annual return, etc.), also need to
consider its influence on the whole production system and company’s finance
situation.

e. Time horizons and equal service lives

• Time horizon: a study time period.
• Service life: The lifetime of an investing project or facility.
• The decision shall be made under the same time horizon which is reasonable to the
service life of the evaluating facilities.

f. Differential-consequences principle
Only the different elements of alternatives are considered for decision making. We
evaluate two computer systems just by their different added features and ignore their
common system configurations.

g. With/without criterion and before-after criterion

To evaluate the alternatives under assumption of with or without investment, and
before and after investment. A manufacturing company can evaluate the
effectiveness of a CNC machine by using this criterion.

h. Common unit rule.

To measure different alternatives by a common unit.

i. Ignore sunk costs.

A sunk cost is a hidden cost which has been incurred in the past.

j. Take the depreciation into consideration

Depreciation is the cost of a useful asset allocated over its estimated life.

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k. Incremental analysis
To compare the marginal cost against its marginal benefit (e.g. revenue) of an
alternative over another. The incremental analysis is in fact the application of the
standard rule of classical microeconomics to engineering economy.

1.4 Tutorial questions

a. Qualitative Questions
1) Robinson Crusoe is able to catch three fish per day by spear fishing. After he
produces five hooks from one day’s work, he is able to catch three fish in one-third
of a day. He needs three fish per day to stay alive. What is his annual rate of return
on his investment of one day’s work producing fishhooks, assuming that the hooks
will last exactly 1 year?
2) What is the difference between mutually exclusive and mutually independent
investments? Give an example of your own of each type of investment.
3) Identify the following as mutually exclusive, independent, or interdependent
investment situations.
i) The state of Texas has before it 76 projects to be funded in its farm-to-market
road program. No project has any technical effect on any other.
ii) Three makes of commercial sewing machines are being analyzed by Perfect
Fit Company with a view to replacing the existing machines. Because
maintenance and repair are facilitated by the use of a single make, only one
make of those proposed will be chosen.
iii) The Northern Tier Power Company has before it 15 major proposals for
components of its distribution system. Three of these involve alternative ways
of solving a specific problem. None of the 15 proposals has a technical effect
on another.
4) Do you have an opinion on which activities are most appropriately performed by
government and which by the private sector? (A most interesting writer on this
subject is Nobel Laureate Milton Friedman.) What about roads and highways? Or
hydroelectric power? Or telephone service?

b. Problem 1
You want to compare two possible places for spending your 3 months of leave. You
prepare the following table, showing your estimate of what you and your family will
spend while renting a house in Mexico or passing the time at your home in the
United States. The amounts are in dollars for the three months period.
Mexico United States
Rent $2,400 $0
Utilities $100 $300
Travel $1,200 $0
Food $750 $1,500
Entertainment $300 $600
Clothes $500 $500
Dentist $80 $240

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Transportation $200 $400

While in Mexico, you can rent your house in the United States for $1,500 per month.
Your tenants will pay the utilities. Your mortgage payments of $1,800 per month you
will continue to pay.
On the basis of all costs, neglecting the pleasures of staying in either place, what will
be the difference in economic cost between staying in the United States and passing
your vacation in Mexico?

c. Problem 2
You have an opportunity to purchase a part interest in a small firm for $3,000. You
will be a silent partner, going no work and collecting profits at the rate of $850 per
year for as long as you wish to do so. Should you join the firm in this way, you
intend to pass on the rights to your children. In other words, the profits may be
considered to be perpetual. A friend to whom you have told your good fortune
offers you $2,000 now to turn over your opportunity to him. Your wife, who has
been reading your engineering economy book over your shoulder, recommends that
you take this offer immediately since it represents an infinite rate of return on your
investment to date (which is zero). Your personal minimum attractive rate of return,
which you can receive any time for any amount, is 20 percent. Should you follow
her advice? Why or Why not?

d. Problem 3
Your company has spent $700,000 in developing a new electric toothbrush that will
result in a total profit (total revenue minus total costs) to the company of
$1,100,000 over the life of the venture. (The $700,000 has already been included in
the total costs.) You are absolutely certain that the expenditure of $600,000 more,
that is, over and above the $700,000 already spent, will ensure the predicted total
income. On the other hand, if the extra money is not invested, you are equally sure
that the venture will have to be abandoned. Should you recommend the expenditure
of $600,000? Defend your decision.
Answers to tutorial questions
a. Qualitative Questions:
1) Annual rate of return = 24,333%
2) In mutually exclusive investments, only one of the alternatives proposed will be
built. In mutually independent investments, no technical relation exists between the
projects under consideration.
3)
(i) Independent.
(ii) Mutually exclusive.
(iii) The 15 projects are mutually independent, but the three that involve
alternative solutions are, insofar as the solutions are concerned, mutually
exclusive.
4) This is an extremely controversial question. Depending on one’s politics, the answer
can range from “Nothing should be built or controlled by government,” which is an
anarchist’s answer, to “Everything should be built or controlled by government,”

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which is the socialist’s answer.

Give some examples by yourself.

b. Problem 1 $2,510 in favour of Mexico

c. Problem 2: Accept the $2,000, since NPV=$1,250 < $2,000.
d. Problem 3: NPV=$1,800,000. Yes, you should recommend.

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