INTRODUCTION TO

ENGINEERING

FUNDAMENTALS OF ENGINEERING
PROJECT ECONOMICS - 1

Prepared by Prof T.M.Lewis

 Introduction
• Our concern here is with project economics –
so we are interested in how economics
interfaces with engineering projects
• We will look at using economics as a tool for
examining the feasibility of implementing a
project.
 Economic Analysis.
• “Economic analysis as applied to engineering is concerned
with assessing the real cost of using resources in order to
establish priorities between competing proposals. Its purpose
is to provide the engineer with a means of judging the relative
economic merits of alternative schemes and of ensuring that
available resources shall be used to achieve the desired end
with the minimum expenditure of means” The Institution of Civil
Engineers (London)
• Use economics to choose between alternative projects on the basis of the
returns that are generated and the resources that are consumed.
 What is Economics?
The study of choice and decision-making in a world
with limited resources. It explores:
1. The principles of supply and demand and how
prices are determined
2. Growth and productivity
3. Global interdependence and trade
4. The interrelated roles of consumers, producers,
and government in an economic system
 Wikipedia Definition
• “Economics is the study of human choice
behavior and how it effects the production,
distribution, and consumption of scarce
resources. Economics studies how individuals and
societies seek to satisfy needs and wants through
incentives, choices, and allocation of scarce
resources.”
• Engineers use scarce resources, that have
alternative uses, to produce goods for distribution
and consumption in the market.
 Economics
Economics is based on a number of principles and assumptions:
1. People will normally act in a way that reflects their self-
interest
2. People normally act rationally
3. People normally prefer more to less
4. People will normally choose to do things the easy (efficient)
way rather than the harder (less efficient) way.
5. If we have to choose between buying from two suppliers we
will normally choose to buy from the one with the lower
price (other things being equal)
6. If it will cost more to make something than it can be sold
for, we would not normally make it.
 Economics
• Not all economic choices are clear cut.
• People want food, clothing, shelter, security,
transportation and entertainment for example
• But they also want BETTER food, clothing,
accommodation etc.
• Choices become more complicated the more
options there are.
 Scarcity
• Choice is a problem because of
‘scarcity’.
• The problem is that we want more
things than we can afford, and so we
have to make choices.
• Once we have to choose, it means we
have to give something up, so scarcity of
resources leads to the need for choices
to be made.
 Scarcity
• There are times when we have plenty and times
when we have little - sometimes, when the seine is
pulled it has fish, sometimes the net is empty.
• When it is full they set something aside for the times
when it is empty
• People do not consume all they have immediately,
they save some for later.
• If what they have is perishable they may want to
exchange it for something that is not.
 Money
• In ancient times when people had a surplus they
bartered what they had for what they wanted.
• The world soon became too complex for bartering to
work, and besides, people wanted something more
durable - so a medium of exchange as a “store of
value” was introduced. At first it was some rare and
precious commodity (e.g. rare shells or teeth, or
precious metals – silver/gold)
• Nowadays it is (mainly paper) money.
Money has no intrinsic value - simply a piece of
paper which has an agreed store of value
(sometimes has a ‘promise to pay’).
Its value depends on it being scarce

This is worth about US16¢

 It comes in all sorts of values
Why is some money worth more than others?

This is worth about US$16

Because some money is more scarce
 NOTE !!!
• MONEY DOES NOT HAVE A FIXED VALUE.
• IT CAN VARY QUITE A LOT FROM DAY TO DAY –
ESPECIALLY IN TIMES OF HIGH INFLATION
 INFLATION

In 1980 the Zimbabwean dollar was worth more than the

U.S. dollar, with ZWD 1 = USD 1.47

In May 2008 ZWD 250,000,000 = US20 ¢

Some countries have it worse than others: A

500,000,000,000 (500 billion) Yugoslav dinar banknote
is the largest nominal value ever officially printed
(circa 1993) .
In 2009 due to the effects of hyper-inflation
3 eggs cost ZW$100 billion

Inflation rate is 11 million % per annum – 20%

per hour.
Every five hours prices double!
Due to be revalued on the basis of new Z$1 for
old Z$10 billion
 Hyperinflation
• The value of the currency keeps falling so
dramatically because they keep printing more
and more of it.
• It is not scarce
• There is no demand for it
• Too much money is available and chasing the
same goods
 Interest & Inflation 1

• Inflation is a measure of the increase in

the price of goods in a market
• It represents a decline in the purchasing
power of money because the price of
goods is going up.
• Deflation is a measure of the decrease in
prices
 Interest & Inflation 2
• Interest represents a rate of growth of
money savings.
• If you save money, interest increases its
purchasing power.
• Interest increases the value of your
money while inflation decreases it.
• The net effect is obviously important.
 Caribbean Interest Rates
What you have to pay to borrow money
Caribbean Interest Rates
What you get for saving money
 Spreads - 2006
(The Difference) - What the Bank takes for handling your money
Countries Lending Deposit Spread As % of
Rate Rate Deposit Rate
Antigua & Barbuda 10.00 1.00 9.00 900
The Bahamas 5.50 3.17 2.33 74
Barbados 10.15 5.25 4.90 93
Belize 14.20 8.20 6.00 73
Dominica 8.50 1.00 7.50 750
Grenada 8.50 1.00 7.50 750
Guyana 14.54 2.48 12.06 486
Jamaica 21.90 2.50 19.40 776
Montserrat 9.50 2.00 7.50 375
St Kitts & Nevis 8.50 1.00 7.50 650
St Lucia 9.50 1.00 8.50 750
St Vincent & Grenadines 9.50 1.00 8.50 750
Trinidad & Tobago 11.06 2.68 8.38 313
Caribbean Inflation Rates
 Effect of Inflation
• Over the year of 2006 if you had savings of
$100 you would have earned interest but
prices would have gone up – the net effect in:
• Barbados : $5.25 – 7.3 = -$2.05 LOSS
• Jamaica : $2.5 – 5.8 = -$3.30 LOSS
• Trin & Tob : $2.68 – 8.3 = -$5.62 LOSS
• Guyana : $2.48 – 5.2 = -$2.72 LOSS
 Exchange and Value
• Why do different currencies have different values?
• Because goods cost different amounts of (local)
money
• The exchange rate is supposed to make the costs of
buying things equal in every market
• What costs TT$6.3 in T&T should cost US$1 in the
USA or the exchange rate is not properly in balance.
• It is rarely fully in balance because there are so many
different goods to compare
Caribbean Exchange Rates
 Money illusion
• Many people think that the T&T $ is weaker than the
Barbados $ because its exchange rate against the
US$ is higher in T&T (6:1) than Barbados (2:1) - but,
it all depends what you can buy for TT$1 here and
what that same item costs in Barbados in B$.
• In other words, people tend to think of currency in
nominal, rather than real, terms – this is called
Money illusion
• The value on the note is NOT as important as what it
can buy in that country.
• Real value is determined by Purchasing Power
 Purchasing Power Parity CHICKENOMICS
• The KFC chicken sandwich is a standard ‘good’ and is available
in all the Caribbean islands.
• Based on prevailing exchange rates to the US$, Guyana is the
cheapest place to buy a KFC chicken sandwich in the region;
the most expensive is Cayman Islands with Barbados not far
behind i.e. their currencies are over-valued compared with
the US$.
• Within the OECS, St Lucia was the cheapest with Antigua &
Barbuda tying with St Kitts & Nevis for most expensive.
• Guyana, Suriname and Trinidad were the only countries
cheaper than the United States to buy a KFC chicken sandwich
– i.e. their currencies are under-valued compared with the
US$.
 Project Economics
• Our concern is with the economics of
engineering projects
• We want to build the projects that deliver the
highest benefit at the lowest cost.
• We need to be aware of the currencies that
will be required, if all cannot be paid for in
local $.
• We need to know when the bills will have to
be paid
 Principles of Project Appraisal
• In general terms the projects with which engineers
tend to be involved are investment projects (i.e. they
last a relatively long time) in which a capital
expenditure is involved (i.e. they generate benefits
over their working life).
• This usually means that there is a current outlay of
cash in return for an anticipated future flow of
benefits.
• On public sector projects especially there will be
significant non-cash benefits
 Principles of Project Appraisal
• Projects with non-cash costs or benefits must involve
an economic evaluation as well as a financial
evaluation: -
– building a school
– constructing a mass-transit system
– developing agricultural land,
– determining whether to rent or buy facilities, equipment
or services (e.g. office buildings)
– building a road,
– safety equipment (lights and crash barriers) on a road
– determining the degree of protection against flooding,
hurricanes and earthquakes.
 Effect of Time
• In the broadest terms the principles of project
appraisal relate to the quantification of costs and
benefits over the life of the project.
• However, it is not sufficient simply to examine the
total amounts of these costs and benefits because of
the 'time value of money'.
• Would you rather have $100 now or in five year’s
time? Why?
• Well – it is at least partly because of INTEREST
 Effect of Time
• People who receive income and do not buy all the
goods to which they are entitled save, and this
money is available for others to use in investments.
• The people who refrain from consumption are
compensated for this in the form of interest.
• Interest is a reward for choosing to abstain from
consumption
• The people who borrow have to pay interest for the
use of that money
 Interest
• Interest is the ‘price of money’ and is
determined by supply and demand
• Supply is determined by people’s willingness
to save – or their ‘marginal time preference
rate’
• Demand is determined by people’s
expectations regarding profits and inflation
 Savings
• Savings involve risks
– You may not be around to spend it
– The bank may not be around
– The economy may collapse so value may be destroyed or
choice reduced
– There may be local or international war
– Alternative investment opportunities may be lost
– Inflation rates may rise
– Currency may be devalued
• Hence the interest rate is a compensation for these
risks
 Time Value of Money
• If you save $100 today and put it in account
earning 5% interest per annum, for one year,
how much will you have at the end of that
year?
• $100 + 100*.05 = 100(1+0.05) = $105
• If you leave the money there, how much will
you have at the end of 2 years?
• $105 + 105*.05 = 100(1+.05)(1+.05)
=$110.25
 Time Value of Money
• i = interest rate
• n = number of periods (years)
• P = the sum of money you start with
• F = the sum of money you have in the future

• This can be expressed as

• F = P(1+i)n
 Time Value of Money
• So if you know that F = P(1+i)n
• This is the Future Worth of a sum of money
• You also know that P = F/(1+i) n
• This is the Present Worth of a sum of money