ENS 331 Engineering Economics

Course Description
This course deals with the study of concepts of the time value of money and equivalence; basic
economic study methods; decisions under certainty; decisions recognizing risk; and decisions
admitting uncertainty.

Course Outcomes
After completing this course, the student must be able to:
1. Solve problems involving interest and the time value of money;
2. Evaluate project alternatives by applying engineering economic principles and methods
and select the most economically efficient one; and
3. Deal with the risk and uncertainty in project outcomes by applying the basic economic
decision-making concepts.
Engineering Economics Topics/Outline

• Simple Interest and Compound Interest

• Notation and Cash Flow Diagram
• Interest Formulas Relating Present and Future Equivalent Values of Single Cash Flow
• Interest Formulas Relating to a Uniform Series (Annuity) to its Present and Future
Equivalent Value
• Deferred Annuities, Uniform Series with Beginning-of-Period Cash Flows
• Equivalence Calculations Involving Multiple Interest Formulas
• Interest Formulas Relating a Uniform Gradient of Cash Flows to its Annual and Present
Worth
• Interest Formulas Relating a Geometric Sequence of Cash Flows to its Annual and
Present Worth
• Nominal and Effective Interest Rates
• Interest Problems with Compounding More Often than Once a Year
• Interest Problems with Cash Flows Less Often than Compounding Period, Interest Rate
that Vary with Time
• Basic Economic Study Methods: The Present Worth Method. The Future Worth Method
• The Benefit/Cost Ratio Method
• Decisions under Certainty

Grading System

• Chapter Exam – 50%

• Attendance – 15%
• Assignment – 35%
Why do we need to study Engineering Economics?

The Economic Environment

Engineering Economy is the analysis and evaluation of the factors that will affect the economic
success of engineering projects to the end that a recommendation can be made which will
insure the best use of capital.

“Oikonomia”
The word “economics” is derived from a Greek word “oikonomia” which means “household
management” or “management of house affairs” i.e., how people earn income and resources and
how they spend on their necessities, comforts, and luxuries.
Income and Resources > Needs, Comforts and Luxuries

Chapter 1: Consumer and Producer, Goods and Services

Goods and Services

Characteristic Goods Services

Tangibility Tangible Intangible

Ownership
Production and Consumption
Ownership cannot be
Ownership can be transferred
transferred from buyer to
from buyer to seller
seller
Production and consumption
Production and consumption
can be separated in time and
occur simultaneously
space

Storability Can be stored Cannot be stored

Can be separated from the Cannot be separated from
Separability
producer the producer

Consumer and Producer

Characteristic Consumer Producer

Primary Role Buy goods and services Creates goods and services
Goal To satisfy needs and wants To make a profit
Economic Terms and Concepts

• Necessities and Luxuries

o Necessities are those products or services that are required to support human life
and activities, that will be purchased in somewhat the same quantity even though
the price varies considerably.
o The 4 Basic Material Needs:
▪ Food
▪ Shelter
▪ Clothing
▪ Healthcare

o Luxuries are those products or services that are desired by humans and will be
purchased if money is available after the required necessities have been obtained.

Characteristic Necessity Luxury

Definition Essential for survival or well- Not essential for survival, but
being. desired for comfort, pleasure,
or status
Examples Food, water, shelter, clothing, Fine dining, vacations,
healthcare, education, jewelry, luxury cars, designer
transportation clothes, expensive electronics
Income Elasticity Low High
Cultural norms Generally consistent across May vary depending on
cultures culture
Personal Preferences May vary depending on May vary depending on
individual needs and individual values and priorities
circumstances
Market Stucture

• Perfect Competition – occurs in a situation where a commodity or service is supplied by

several vendors and there is nothing to prevent additional vendors entering the market.
• Monopoly – is the opposite of perfect competition. A perfect monopoly exists when a
unique product or service is available from a vendor can prevent the entry of all others into
the market.
• Oligopoly – exists when there are a few suppliers of a product or service that action by
one will almost inevitably result in similar action by the others.

Characterictic Competition Monopoly Oligopoly

Number of sellers Many One Few

Degree of
High Low Medium
competition

Control over price Low High Medium

Barriers to entry Low High Medium

Supply and Demand

• Demand – is the quantity of a certain commodity that is bought at a certain price at a given
place and time.
o ELASTIC DEMAND – Occurs when a decrease in selling price result in a greater
than proportionate increase in sales.
o INELASTIC DEMAND – Occurs when a decrease in the selling price produces a
less than proportionate increase in sales.
o PERFECTLY INELASTIC DEMAND – Occurs when the mathematical product of
volume and price is constant.
 • Supply – is the quantity of a certain commodity that is offered for a sale at a certain price
at a given place and time.

Law of Supply and Demand

“the price of a good or service is determined by the interaction of supply and demand”
The law of supply and demand can be summarized in two key points:

• As the price of a good or service increases, the quantity supplied increases, and the
quantity demanded decreases.
• As the price of a good or service decreases, the quantity supplied decreases, and the
quantity demand increases.

Supply Demand Price Scenario

Remains unchanged Increases Increases Shortage
Remains unchanged Decreases Decreases Surplus
Increases Remains Unchanged Decreases Surplus
Decreases Remains Unchanged Increases Shortage
The Law of Diminishing Returns
“When the use of one of the factors of
production is limited, either in increasing
cost or by absolute quantity, a point will
be reached beyond which an increase in
the variable factors will result in a less
than proportionate increase in output”

Interest and Money-Time Relationship

Over time, Money can Earn More Money or Interest

Basic Terms

• Present/Principal Amount (P) – initial amount of money invested or borrowed in the

transaction.
• Interest Rate (i) – a percentage that is periodically applied and added to an amount (or
varying amounts) of money over a specified length of time. Interest rate is in percentage
(%).
• Interest Period (n) – a time period that determines how frequently interest is calculated.
• Interest (I) – is the money paid for the use of borrowed capital or the income produced by
money which has been loaned. Interest is in Peso (or any currencies).
• Future Amount (F) – total amount of the effects of the interest rate over a number of
interest periods

Two Major Types of Interest

• Simple Interest – is calculated using the principal only, ignoring any interest that had
been accrued in preceding periods.
➢ I = Pni
➢ F = P(1+ni)
Where:
o I = interest
o P = principal or present worth
o n = number of interest periods
 o i = rate of interest per interest period
o F = accumulated amount of future worth
In practice, simple interest is pain or short-term loans in which the time of the loan is measured in
days.

✓ Two Types of Simple Interest

▪ Ordinary Simpe Interest is computed based on 12 months of
30 days each or 360 days a year.
1 interest period = 360 days
▪ Exact Simple Interest is based on the exact number of days in
a year, 365 days for ordinary year and 366 days for a leap year.
1 interest period = 365 days or 366 days (Leap Year)
To identify number of days in a month, we will use Knuckle Mnemonic
A knuckle bump will be equivalent to 31 days while a knuckle gap will
be 30 days.

Sample Problem
Determine the ordinary simple interest on P700 for 8 months and 15 days if the rate is 15%.
Solution:
I = Pni
Number of days = (8)(30) + 15 = 255 days
n = 255 days
P = P700
i = 15%
n = 255/360
255
I = Pni = P700 x x 0.15 = P74.38
360

Determine the exact simple interest of P500 for the period from January 10 to October 28, 1996
at 16% interest.
(Tip: To know if the year is leap year or not, simply divide the year by 4.)
If the answer is WHOLE NUMBER = Leap Year
If the answer HAS DECIMAL PLACES = Not a Leap Year
Solution:
Jan 10-31 = 21 days (excluding Jan. 10)
February = 29 days
March = 31 days
April = 30 days
May = 31 days
June = 30 days
July = 31 days
August = 31 days
September = 30 days
October = 28 days (including Oct. 28)
Total Days = 292 days

n = 292 days
292
Exact simple interest = P500 x x 0.16 = P63.83
366
• Compound Interest – in calculations of compound interest, the interest (I) for an
interest period (n) is calculated on the principal (P) plus total amount of interest
accumulated in previous periods. Thus, compound interest means “interest on top of
interest”.
➢ F = P(1+i)n

✓ Rate of Interest
▪ Nominal Rate of Interest – specifies the rate of interest and a
number of interest periods in one year.
𝑟
i=
𝑚
where:
i = rate of interest per interest period
r = nominal interest rate
m = number of computing periods per year

Note: If the nominal rate of interest (r) is 10% compounded

10%
quarterly, then i = = 2.5%, the rate of interest per interest
4
period (i).

▪ Effective Rate of Interest – is the actual or exact rate of

interest on the principal in a year. If P1.00 is invested at a
nominal rate of 15% compounded quarterly, after one year, this
will become:
0.15
P1 (1 + 4 )4 = P1.1586

The actual interest earned is P0.1586, therefore, the rate of

interest after one year is 15.86%. Hence:

Effective rate = F1 – 1 = (1+i)m – 1

Where F1 = the amount P1.00 will be after one year

 Sample Problem
Find the nominal rate which if converted quarterly could be used instead of 12% compounded
monthly. What is the corresponding effective rate?
Solution:
12% r
m = 12 = m=4

0,12 𝑟
(1+ )12 – 1 = (1+ )4 – 1
12 4
= 0.1212
= 12.12%