Transcript Pre-Engineering Introduction to Engineering Lecture 1

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
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 the fishermen should 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 (farmers &
fishermen) 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
THE NUMBER ON THE NOTE IS NOT AN
ABSOLUTE MEASURE OF VALUE
Portugal – 500 Escudos Botswana – 10 Pula
This is worth about US$3
Chile – 5000 pesos
This is worth about US$8.5
This is worth about US$1.5
Britain – 20 pounds
This is worth about US$25
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
• inflation is a rise in the general level of
prices of goods and services in an
economy over a period of time.
• When the general price level rises, each
unit of currency buys fewer goods and
services.
• So inflation also reflects an erosion in
the purchasing power of money
INFLATION
• Inflation is often the result of an
increase in the ‘money supply’ without a
corresponding increase in production.
• So more money is chasing the same
basket of goods
• There are many instances where things
have gone badly wrong ---• Imagine you were a millionaire in 1980
in Zimbabwe
INFLATION
In 1980 the Zimbabwean dollar was worth more
than the U.S. dollar, with ZWD 1 = USD 1.47 – If
you had $1 million Zimbabwe you were worth
nearly US$1.5 million
In May 2008 this was worth about US20¢ and
your ZW$1 million was now worth less than 1¢
•It got worse
In 2009 – 3 eggs cost ZW$100 billion
Inflation rate was 11 million % per annum – 20% per hour.
Every five hours prices doubled
This is Hyper-inflation
• 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
Inflation & Deflation
• This is why governments are
concerned about inflation - it can
get out of control
• The poor and people on fixed
incomes (e.g. pensions) are very
badly affected.
• By comparison, deflation is a
measure of the steady decrease
in prices
Interest & Inflation
• 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
Rate
Deposit
Rate
Spread
As % of
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
•
+Interest – inflation = Nett
• 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
Effect of Inflation
• When inflation is higher than the interest
you get on savings, it is silly to save as
the purchasing power of your money will
decrease the longer you have it
invested.
• OBVIOUSLY, GOVERNMENTS
SHOULD TRY VERY HARD TO
CONTROL INFLATION – ESPECIALLY
WHEN INTEREST RATES ARE LOW
EXCHANGE RATES
• Why not just move all your money to
somewhere where it gains value or (at
least) loses least?
– Because of the cost e.g. the margin that
the money changers charge
– Because all currencies vary in value.
– Because there is a risk that you may not be
able to change it back when you need it.
– Because the interest rates on ‘hard
currencies’ are probably no better
Exchange and Value
• Why do different currencies have different face values?
• Because goods cost different amounts of (local) money a Carib that costs B$3 in Barbados costs TT$9 in
Trinidad – they are the same
• The exchange rate is supposed to make the costs of
buying things equal in every market
• Hence 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 US$1 here and what that same item
costs in Barbados.
• In other words, people tend to think of currency
in nominal, rather than real, terms – this is called
Money illusion
• The value on the note is NOT as important as
what it can buy in that country.
• Real value is determined by Purchasing Power
Purchasing Power Parity
• If the exchange rates are right, the
same product would cost the same
everywhere in a standard currency
• The US$ is normally used as the
standard
• Purchasing Power looks at what a
product costs in US$ terms in different
countries
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$,
Guyana is the cheapest place to buy a KFC chicken
sandwich in the region
• The most expensive is Cayman Islands with
Barbados not far behind and both are more
expensive than the USA i.e. their currencies are overvalued compared with the US$.
• 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 specific 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
often 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.
• These 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 (just like rent)
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 and is a measure of their
‘marginal propensity to consume’
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
all 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