Energy economics

1. S. K. Singh, Ph. D.
Centre for Energy Studies, IIT Delhi

2. Course Outcome
Student will able to learn about:
• The fundamentals of economic principles and their
applications in the broad field of supply and demand of
energy
• How to tackle the problems related to energy
economics
• The need for Engineering Economy in the field of
engineering
• Understand the basic Engineering Economy
• Determine the role of Engineering Economy in decision
making.

3. Course Contents
Chapter 1- Energy economics:
Basic concepts
 Energy data
 Energy cost
Energy balance
Relevance of economic and financial viability evaluation of
renewable energy technologies, and
Basics of engineering economics
Chapter 2- Energy accounting framework:
Economic theory of demand
Production and cost market structure
National energy map of India, and
Energy subsidy – National and international perspectives

4. Cont.…
Chapter 3- Concepts of economic attributes:
Calculation of unit cost of power generation from different
sources with examples
Different models and methods
 Social cost – benefit analysis of renewable energy technologies
Financial feasibility evaluation of renewable energy
technologies
Technology dissemination models
Volume and learning effects on costs of renewable energy
systems
Dynamics of fuel substitution by renewable energy systems
and quantification of benefits
Chapter 4- Application of econometrics:
Input and output optimization
Energy planning and forecasting - different methods
 Economic approach to environmental protection and
management,

5. Chapter 5- Financial incentives:
Fiscal, financial and other incentives for promotion of
renewable energy systems and their effect on financial and
economic viability
Electricity tariff types
Financing of renewable energy systems
Carbon finance potential of renewable energy technologies
and impact of other incentives
Software for financial evaluation of renewable energy systems
Case studies on financial and economic feasibility evaluation
of renewable energy projects
Cont.…

6. Energy
• It is a ability to do work or to produce heat
• Normally heat could be derived by burning a fuel—i.e. a
substance that contains internal energy which upon
burning generates heat, or through other means—such as
by capturing the sun’s rays, or from the rocks below the
earth’s surface (IEA 2004)
• Similarly, the ability to do work may represent the
capability (or potential) of doing work (known as
potential energy as in stored water in a dam) or its
manifestation in terms of conversion to motive power
(known as kinetic energy as in the case of wind or tidal
waves)

7. Contd…
• Energy can be captured and harnessed from very
diverse sources that can be found in various physical
states, and with varying degrees of ease or difficulty of
capturing their potential energies
• Initially the mankind relied on solar energy and the
energy of flowing water or air
• With the discovery of the fire-making process, the use of
biomass began. The use of coal and subsequently oil and
natural gas began quite recently—a few hundred years
ago

8. Contd…
• According to the physical sciences, two basic laws of
thermodynamics govern energy flows
 The first law of thermodynamics is a statement of material
balance—a mass or energy can neither be created nor
destroyed—it can only be transformed. This indicates the
overall balance of energy at all times
The second law of thermodynamics on the other hand
introduces the concept of quality of energy. It suggests that
any conversion involves generation of low grade energy that
cannot be used for useful work and this cannot be eliminated
altogether. This imposes physical restriction on the use of
energy

9. Alternative Classifications of Energy
1. Primary and Secondary Forms of Energy
2. Renewable and Non-Renewable Forms of Energy
3. Commercial and Non-Commercial Energies
4. Conventional and Non-Conventional Energies
•Based on the above classification, it is possible to
group all forms of energy in two basic
dimensions: Renewability as one dimension and
Conventionality as the other

10. Primary and Secondary Forms of Energy
• Primary energy is used to designate an energy source
that is extracted from a stock of natural resources or
captured from a flow of resources and that has not
undergone any transformation or conversion other
than separation and cleaning (IEA 2004)
• Examples include coal, crude oil, natural gas, solar
power, nuclear power, etc.
• Secondary energy on the other hand refers to any
energy that is obtained from a primary energy source
employing a transformation or conversion process
• Thus oil products or electricity are secondary energies
as these require refining or electric generators to
produce them
• Both electricity and heat can be obtained as primary
and secondary energies

11. Renewable and Non-Renewable Forms of Energy
• Non-renewable source of energy is one where the
primary energy comes from a finite stock of resources.
• Drawing down one unit of the stock leaves lesser units
for future consumption in this case.
• For example, coal or crude oil comes from a finite
physical stock that was formed under the earth’s crust
in the geological past and hence these are non-
renewable energies
• On the other hand, if any primary energy is obtained
from a constantly available flow of energy, the energy is
known as renewable energy. Solar energy, wind, and
the like are renewable energies

12. Commercial and Non-Commercial Energies
• Commercial energies are those that are traded wholly or
almost entirely in the market place and therefore would
command a market price. Examples include coal, oil, gas
and electricity.
• Non-commercial energies are those which do not pass
through the market place and accordingly, do not have a
market price. Common examples include energies collected
by people for their own use
• But when a non-commercial energy enters the market, by
the above definition, the fuel becomes a commercial form of
energy.
• The boundary could change over time and depending on
the location. For example, earlier fuel-wood was just
collected and not sold in the market. It was hence a non-
commercial form of energy.

13. • Now in many urban (and even in rural) areas, fuel-wood is
sold in the market and hence it has become a commercial
energy. At other places, it is still collected and hence a
noncommercial form of energy. This creates overlaps in
coverage
• Another term which is commonly used is Modern and
Traditional energies
• Modern energies are those which are obtained from some
extraction and/or transformation processes and require
modern technologies to use them.
• Traditional energies are those which are obtained using
traditional simple methods and can be used without modern
gadgets.
• Often modern fuels are commercial energies and traditional
energies are non-commercial. But this definition does not
prevent traditional energies to be commercial either
• Thus if a traditional energy is sold in the market it can still
remain traditional

14. Conventional and Non-Conventional Energies
• This classification is based on the technologies used
to capture or harness energy sources.
• Conventional energies are those which are obtained
through commonly used technologies
• Non-conventional energies are those obtained using
new and novel technologies or sources
• Once again the definition is quite ambiguous as
conventions are subject to change over time, allowing
non-conventional forms of energies to become quite
conventional at a different point in time

15. Energy Classifications
Conventionality
Renewability
Renewable
Non-
renewable
Commercial Large scale hydro
Geothermal
Nuclear
Fossil fuels
Other nuclear
Traditional /non-
commercial
Animal residues
Crop residues
Windmills and watermills
Fuelwood (sustainable)
Unsustainable
fuelwood
New and novel Solar
Mini and micro hydro
Tidal and wave
Ocean thermal
Oil from oil
sands oil from
coal or gas
Source Codoni et al. (1985) and Siddayao (1986)

16. Energy Economics: An Introduction
• Energy issues have been analysed from an economic
perspective for more than a century now
BUT
• Energy economics did not develop as a specialised branch
until the first oil shock in the 1970s (Edwards 2003).
• The dramatic increase in oil prices in the 1973–1974
highlighted the importance of energy in economic
development of countries.
• Researchers, academics and policymakers have taken a
keen interest in energy studies and today energy economics
has emerged as a recognised branch on its own.

17. Energy Economics: In 80’s, 90’s & Now
• Further the scope of the work expanded in the 1980s
• Environmental concerns of energy use and economic
development became a major concern and the
environmental dimension dominated the policy debate
• This brought a major shift in the focus of energy studies
as well- the issue of local, regional and global
environmental effects of energy use became an integral
part of the analysis
• In the 1990s, liberalisation of energy markets and
restructuring swept through the entire world although
climate change and other global and local environmental
issues also continued

18. Contd…
• These changes brought new issues and challenges to the
limelight and by the end of the decade, it became evident
that unless the fundamental design is not well thought
through, reforms cannot succeed
• In recent years, the focus has shifted to high oil prices,
energy scarcity and the debate over state intervention as
opposed to market-led energy supply
• This swing of the pendulum in the policy debate is
attributed to the concerns about security of supply in a
carbon-constrained world

19. Energy Economics
• Energy economics or more precisely the economics of
energy is a branch of applied economics where economic
principles and tools are applied to ‘‘ask the right
questions’’ and to analyze them logically and
systematically to develop a well-informed understanding
of the issues
• Energy economics studies energy resources and energy
commodities, and includes:
 forces motivating firms and consumers to supply, convert,
transport, use energy resources, and to dispose of residuals;
market structures and regulatory structures; distributional and
environmental consequences; economically efficient use

20. Complexity in Energy Sector
• The constituent industries tend to be highly technical in
nature, requiring some understanding of the underlying
processes and techniques for a good grasp of the economic
issues
• Energy being an ingredient for any economic activity, its
availability or lack of it affects the society and consequently,
there are greater societal concerns and influences affecting
the sector
• The sector is influenced by interactions at different levels
(international, regional, national and even local), most of
which go beyond the subject of one discipline
• Analyses of energy problems have attracted inter-
disciplinary interests and researchers from various fields
The energy sector is complex because of a number of
factors:

21. Key Role Of Energy in Economic Activities
• Economy arises because of the mutual interdependence
between economic activities and energy
• These interrelations influence
the demand for energy, possibilities of substitution
within the energy and with other resources (capital, land,
labour and material),
supply of energy and other goods and services,
investment decisions, and
the macro-economic variables of a country (economic
output, balance of payment situations, foreign trade,
inflation, interest rate, etc.)

22. Contd…
• Also, the national level institutions (including the rules
and organisations like government, judiciary, etc.) both
influence and get influenced by these interactions
• The energy sector uses inputs from various other
sectors (industry, transport, households, etc.) and is
also a key input for most of the sectors

23. Energy Data
• Information/data is crucial for any decision-making: be
it development planning decisions or business decisions
or decisions by individual consumers
• Reliable and quality information facilitates decision-
making and improves the decision-making process
• Any decision-making process requires analysis of the
past and present status of the sector (or sub-sector or
specific area of concern) and a vision about the future
• This implies that a large amount of both historical and
projected data would be required related to the specific
components and subsystems of the energy sector

24. The information/data requirement would vary by
stakeholders, broadly the common requirement would
included:
1. Energy use by various economic activities;
2. Energy production, transformation and delivery to
various users,
3. Technical and operating statistics of the plants and
installations;
4. Financial and cost information, and
5. Macro-economic and other social information.

25. Data availability, Data Collection and
Reporting
• At the national level, some countries produce good
information
• In Asia, Nepal, Thailand, Sri Lanka and Philippines have
reliable time series data on traditional energy data
• Most other countries have had several studies or
surveys on TEs but do not have a consistent time series
data
• At the international level, United Nations, Food and
Agricultural Organisation, International Energy Agency
(IEA) and World Bank are active in data collection and
reporting

26. • In late 1990s, traditional energies came to focus once
again in the debate over sustainable energy development
• The workshop on Biomass energy organized by IEA in
1997 attempted to understand the role, level and
sustainability of biomass use for energy purposes in
non-OECD countries
• IEA has since started to play an important role in
collecting and reporting data on Tes
• At the national level, generally data on consumption of
TEs is available from special purpose surveys. These
surveys can be specifically for TEs or as part of overall
energy survey

27. • The scope and coverage of surveys to be conducted
depends on the objectives of the survey in question
• To assess the level and pattern of TE consumption, a
large-scale extensive survey at the national/regional
level would be required
• On the other hand, rural level surveys would be required
if the objective is to assess the possibility of
improvements in the existing use-patterns and
introduction of new technologies

28. The information/data required may be categorized as follows
(Codoni et al. 1985):
Energy Pricing:
• Despite the liberalization of energy markets, energy
pricing continues to be a very sensitive and contentious
issue because of social and political implications.
• Regulators and price-setting agencies require
considerable information to make correct pricing
decisions. This includes: consumption of fuels by various
consumers, consumption pattern by income groups,
rural–urban divide in consumption and supply, cost of
supply to various consumers, impact of price revision on
consumers, etc.

29. Energy investment:
• Energy investment decisions have high visibility because
of their size. Investment decisions require an
understanding of the evolution of demand, pricing
policies, business environment, viability of alternative
options, and various types of impacts. Historical and
forecast data are required for such exercises.
Energy research and development (R&D):
• Decisions on R&D require information on resources of
various kinds of fuels, cost of production and conversion,
evolution of demand for various kinds of fuels, costs and
benefits of investment in R&D activities, etc.

30. System management:
• Decisions on energy system management would normally
be taken by the operators themselves but quite often
there would be some regulatory or governmental
supervision/involvement
• The requirement is significantly high in the case of
electricity where supply and demand balancing has to be
ensured every moment
• The information required includes supply and demand
positions, system availability, technical constraints, etc.
Contingency plan:
• Any system should remain prepared to deal with a
number of contingencies

31. •Complete or partial system failure, supply failure
due to technical or other problems, erratic change in
demand, etc.
• Preparation of a contingency plan would require
information on geography of energy supply, distribution
and consumption, technical features of the system,
knowledge of social and economic impacts of energy
disruption, etc.
Long-term planning:
• This involves developing a view of the possible future
evolution of energy demand and the possibilities of
fulfilling that demand in various ways

32. • This requires a proper understanding of the followings:
current consumption activities and consumption
pattern,
possible changes in the activities in terms of efficiency
and structure,
possible supply alternatives, possible technological
changes, etc.

33. Common Energy Data Issues
• A number of conceptual, technical problems and data-
related issues are confronted while dealing with energy
data (Codoni et al. 1985; Siddayao 1986; IEA 1998; Ailawadi and Bhattacharyya 2002)
Data availability:
• Often multiple agencies collect and publish data.
Collection and reporting involves some time lag and
delayed publication of information is quite common
• Delays reduce usefulness of the information and its
value
• Data on energy use is often sketchy and inadequate.
Even in cases where a network is used for supply,
reliable information on consumer category-wise usage
is not available

34. Contd..
• Manual systems for recording and storing information
coupled with managerial incompetence are responsible
for such poor state of affairs
Data quality:
• There is doubt about the quality of information whenever
data is available. This is because in absence correct sales
and consumption information, estimates are used and their
basis is often questionable
• Besides, consistency problems also arise in data and
arithmetic errors, internal inconsistency, logical errors, etc.
are not uncommon. For example, in the case of natural gas,
production may be reported on gross (i.e. including gas
vented, flared and re-injected) or net basis
Boundary problem:
• This is generally encountered while using data from a
number of sources, especially from different countries

35. • Countries use different conventions about energy
classifications and consumer categorization. The
boundary problem arises due to:
1. Exclusion of or inclusion of traditional fuels;
2. Different terminologies used for the same product
3. Different user sectors identified for different data (e.g.
electricity end use sectors may be different from that for
petroleum products);
4. Accounting for differences in energy efficiencies,
efficiencies of energy delivering equipment, etc.
Common measurement unit:
• Aggregating energy sources of different characteristics is a
difficulty faced in energy data. The problem is how to
aggregate energy forms of different qualities in a way that
will allow appropriate cross country comparisons

36. • In order to present the variety of units on a comparable basis,
a common denominator for all fuels is required.
• Traditionally, the common denominator is their energy or heat
content, expressed in Joules, Btu or kWh. Units like tons of coal
or oil, or barrels equivalent are derivatives of the heat content
Conversion factors:
• This is related to common measurement unit
• Once a choice is made about the common denominator, the
next question comes is how precise does the conversion factor
need to be and how much will the overall picture change if one
factor is used rather than the other
• The quality of certain products such as coal varies significantly
from one country to another and also from one extraction site
to another

37. • This necessitates a specific factor for each country and
often for each time period as the domination of different
extraction sites vary from year to year
• For other products, the variation may not be significant
and a common factor may be used
To resolve these issues, a number of initiatives have been
taken:
For oil statistics, the Joint Oil Data Initiative (JODI) has
created a platform for interaction of various stakeholders
Similarly, the UN Statistical Commission and UN Statistics
Division are working on the challenges facing the energy
statistics
 The UN organisations are working towards revising the
older manuals and recommendations for international
energy statistics

38. Energy Costs
• The total annual cost of the energy system is given as
• Annual Cost (AC) =
Annual Maintenance operational cost (AMC) + First
Annual Cost (FAC) – Annual Salvage Value (ASV) – Tax
Savings (TS)
Where FAC can be measured as,
FAC=CC * CRF
Where:
CC, CRF are capital cost and capital recovery factors of the system respectively.

39. •Capital recovery factor can be calculated as
Where: n is the system's whole lifetime.
• A portion of the first annual cost should be taken from the
Annual Maintenance Cost (AMC). This expense, however, is
not anticipated to be high.
•ASV can be found as,
ASV=S * SFF
Where S, represents a system's salvage value which can be taken as a
percentage of the system's original cost.
𝐂𝐑𝐅 =
𝟏 𝟏 + 𝐢 𝐧
𝟏 + 𝐢 𝐧 − 𝟏

40. • SFF (sinking fund factor) can be measured as:
• Based on the results obtained, it is possible to make a
choice on the viability
Renewable energy savings = conventional energy cost –
renewable energy cost
SFF =
i
1 + i n − 1

41. Costs Of Renewable Energy Deployment
•Costs accruing on plant level and for the plant
owner
•Expressed using the levelised cost of electricity
(LCOE) metric
Generation
Cost
•Direct and indirect costs and benefits of RE-
deployment
•Additional costs/benefits of a RE-based system
in comparison to a system based on conventional
technologies
System Cost
•Comprising gross and net effects in an
economy
•Measured at a macro-economic level
Macro-
economic cost

42. Costs and Benefits of RET Deployment

43. Relevance Of Economic And Financial Viability
Evaluation of Renewable Energy Technologies
• Relevance of economic and financial viability
evaluation of RET depends upon two factor, i.e., cost of
the system and return/benefit from the system
Cost of the systems:
• Land lease cost
• Installation cost
• Electrical equipment cost
• Cost of additional reserve requirement
• Component life maintaining cost
• Operating cost

44. Benefits of the system
• Capacity benefit
• Carbon credit benefit
• Fuel saving benefit
• Social empowerment benefit in remote area
• With proper design, multi function land utilization
• Project evaluation is a systematic and objective
assessment of an ongoing or completed project
• Aim to determine the relevance and level of
achievement of project objectives, development
effectiveness, efficiency, impact and sustainability
• Evaluations also feed lessons learned into the
decision-making process of the project stakeholders,
including donors and national partners

45. Project evaluation methods and
sustainability

46. • Most of the renewable energy project are less
economical viable, because of high investment and
risk associated with the project
• But still most of the government interested to
increase the share of renewable energy
• Overall Cost Benefit analysis of renewable energy
show that they are acceptable
• Main benefit of renewable energy :
it is clean form of energy and
socially acceptable and help government to make
a dream true to provide electricity to village

47. Energy Balance
Energy balances provide a great deal of information
about the energy situation of a country.
They are also a source of consistent information that
could be used to analyse the supply and demand
situations of a country and with appropriate care, can
be used for international comparisons
• Energy balance can be organized in three sections
(supply, transformation and consumptions), it is
possible to gain insight in these areas, depending on
the need and purpose of the analysis
• For example, the primary energy requirement
indicates the total energy requirement of the country
to meet final demand and transformation needs in
the economy

48. Contd…
• The trend of primary energy requirement of a country
shows how the internal aggregate demand has changed
over time
• Similarly, the transformation section of the energy
balance provides information on energy conversion
efficiency and how the technical efficiency of aggregate
conversion has changed over the study period
• Final consumption data can be used to analyse the
evolution of final energy demand of the country by fuel
type and by sector of use
• Such analyses provide better understanding of the
demand pattern of each sector and energy source
• In addition to any descriptive analysis using trends or
growth rates, further insights can be obtained by
analyzing various ratios

49. • IAEA (2005) has compiled a large set of useful ratios that
could be examined and analysed. A few of these ratios are
discussed below:
1) Energy supply mix:
• As primary energy supply comes from various types of
energies, it is important to know the contribution of each
type and its evolution over time
• The share of each energy source in primary consumption
(i.e. the ratio coal, oil, gas or electricity supply in the total)
characterises the energy supply mix of a country. This
share shows the diversity of the supply mix (or lack of it)
in a country
• It is normally considered that a diversified energy mix is
better and preferable compared to a highly concentrated
mix

50. 2) Self-reliance in supply:
• As the supply can come from local production or imports,
independence of a country in terms of supply is
considered an important characteristic of the supply
system
• The rate of energy independence (or self-reliance) is the
ratio of indigenous production to total primary energy
requirement
• For importers, self-reliance would be less than 100%
while for exporters, the value would be more than 100%
• This analysis can be done at a more disaggregated level
by considering the self-reliance in respect of each type of
energy

51. 3) Share of renewable energies in supply:
• Where the energy balance covers the renewable energies,
this could be examined to see the role of alternative
energies in the supply mix
4) Efficiency of electricity generation:
• The Overall efficiency of power generation can be
determined from the ratio of electricity output to energy
input for electricity generation
• Where input and output values are available by energy
type, efficiency can be determined by fuel type as well
• This indicator can reflect how the electricity conversion is
evolving in the country and whether there is any
improvement in this important area

52. 5) Power generation mix:
• The power generation mix of a country can be obtained
from the share of electricity production by type of fuel.
• The higher the concentration of power generation
technology, the more vulnerable a country could be in
terms of supply risk
6) Refining efficiency:
• This is determined from the ratio of output of refineries
to refinery throughput
• This indicator could be easily compared internationally to
see how the refineries are performing in a country
7) Overall energy transformation efficiency:
• This is determined as the ratio of final energy
consumption to primary energy requirement. This shows
how much of energy is lost in the conversion process
• “Lower the loss, more efficient the system is”

53. 8) Per capita consumption of primary energy and
final energy:
• These two indicators are frequently used in cross
country comparisons
• The ratio of primary (or Final) energy consumption to
population in a country gives the per capita
consumption
• Generally per capita consumption of energy is higher
in developed countries than in developing countries
and this index is often used as a rough measure of
prosperity
• Similarly, per capita electricity (or other fuel
consumption) could be used to see the level of
electricity (or fuel) use in a country

54. 9) Energy intensity:
• Energy intensity is the ratio of energy consumption to
output of economic activities. This indicator is used to
analyse the importance of energy to economic growth
• When energy intensity is determined on a national basis
using GDP, it is termed as GDP intensity
• GDP intensity can be defined in a number of ways: using
primary energy consumption or final energy
consumption, using national GDP value or GDP
expressed in an international currency or in purchasing
power parity
• Accordingly, the intensity would vary and one has to be
careful in using intensity values for cross-country
comparisons

55. The Overall Energy Balance (OEB) constructed on this
basis can then be used for the analysis of changes in the
level and mix of energy sources used for particular
purposes before and after transformation
 It can also be used for the study of changes in the use of
pattern of different fuels, for the examination of the extent
of or scope for substitution between fuels at different
stages of the flow from primary supplies to final energy
uses, and as a source for the generation of time series
tables

56. What is Economics ?
A social science of how limited
resources are used to satisfy
unlimited human wants
What is Engineering ?
Engineering is the application of
scientific, economic, social, and
practical knowledge, in order to
design, build, and maintain
structures, machines, devices,
systems, and materials 56
Engineering
Economics
Engineering
Economics
Basics of Engineering Economics

57. Concept of Engineering Economy
• Engineering Economics is all about making decisions
• It deals with the concepts and techniques of analysis
useful in evaluating the worth of systems, products,
and services in relation to their costs
• Engineering Economics assesses the appropriateness
of a given project, estimates its value, and justifies it
from an engineering standpoint
• It is defined as “A set of principles , concepts,
techniques and methods by which alternatives within
a project can be compared and evaluated for the best
monetary return”

58. Engineering Economy
 It is used to answer many different questions
 Which engineering projects are worthwhile?
• Has the mining or petroleum engineer shown that
the mineral or oil deposits is worth developing?
 Which engineering projects should have a
higher priority?
• Has the industrial engineer shown which factory
improvement projects should be funded with the
available dollars?
 How should the engineering project be
designed?
• Has civil or mechanical engineer chosen the best

59. Engineering Economics: Origins
• The development of EI methodology is relatively recent
• A pioneer in the field was Arthur Wellington, a civil
engineer, who at the end of 19th century addressed the
role of economic analysis in engineering projects
• This early work was followed by other contributions in
which the emphasis was put on techniques that
depended on financial mathematics
• In 1930, Eugene Grant published a textbook which
was a milestone in the development of engineering
economy as we know it today (economic point of view
of engineering)
• In 1942 Woods and DeGarmo wrote a book, later
titled Engineering Economy

60. Resources
All gifts of nature, such as: water, air, minerals,
sunshine, plant and tree growth, as well as the land
itself which is applied to the production process.
The efforts, skills, and knowledge of
people which are applied to the
production process.
LAND OR NATURAL
RESOURCES
LABOUR
Real Capital (Physical Capital)
Tools, buildings, machinery things which have been
produced which are used in further production
Financial Capital
Assets and money which are used in the production
process
Human Capital
Education and training applied to labor in the
production process.
CAPITAL

61. Why Do Engineers Need to Learn About
Economics?
• Ages ago, the most significant barriers to engineers were
technological. The things that engineers wanted to do, they
simply did not yet know how to do, or hadn't yet developed
the tools to do
• There are certainly many more challenges like this which
face present-day engineers
 Natural resources (from which we must build things)
are becoming more scarce and more expensive
 Negative side-effects of engineering innovations
(such as air pollution from automobiles)

62. Why Do Engineers Need to Learn About
Economics?
• Engineers must decide if the benefits of a project
exceed its costs, and must make this comparison in a
unified framework
• The framework within which to make this comparison
is the field of engineering economics, which strives to
answer exactly these questions, and perhaps more

63. Principles of Engineering Economy
1. Develop the Alternatives
• Creativity and innovation are essential to the process
• The alternatives need to be identified and then defined for
subsequent analysis
• Consider the status quo, but do not focus on it(i.e., doing
nothing)
2. Focus on the Differences
• Only the differences among alternatives are relevant to
comparison and decision
3. Use a Consistent Viewpoint (perspective)
4. Use a Common Unit of Measure
• Use it for enumerating as many possible outcomes as
possible, since it simplifies the analysis of alternatives

64. Contd…
5. Consider All Relevant Criteria
• Consider both those that can be measured in
monetary terms and “non-monetary” criteria
6. Make Uncertainty Explicit
7. Revisit Your Decisions: compare initial projected
outcomes with actual results achieved

65. How Engineering is composed of
physical and economic components
65
Engineering
Assessing the worth of these
products in economic terms
Produce products and
services depending on
physical Laws
Physical
Environment
Economic
Environment
Physical Efficiency = System
Output/System Input
Economic Efficiency = System
Worth/System Cost

66. Engineering Economic Analysis
Procedure
1. Problem recognition, definition, and evaluation
2. Development of the feasible alternatives
• Searching for potential alternatives
• Screening them to select a smaller group of feasible
alternatives
3. Development of the cash flows for each alternative (or
of prospective outcomes)
4. Selection of a criterion ( or criteria)
5. Analysis and comparison of the alternatives
6. Selection of the preferred alternative
7. Performance monitoring and post-evaluation results:
helps to do better analysis and improves the operations in
organization

67. Simpler Procedure For Formulating
Engineering Economic Decisions
 Four essential steps in formulaing engineering
economic decisions are:
1. Creative step: find an opening through a barrier of
economic and physical limitations
2. Definition step: define all factors associated with
each alternative originated in creative step
3. Conversion step: define all factors associated with
each alternative originated in creative step
4. Decision step

68.  Creative Step
• The creative step consists of finding an opening
through a barrier of economic and physical
limitations (ex. aluminum discovery or mining)
• We explore, investigate and research aiming at
finding new opportunitites
• Many successful ideas are simply new combinations
of known facts
 Definition Step
• In the definition step, we define the alternatives
originated or selected for comparison
• Choice is always between alternatives, but we also
need to choose which alternatives to consider

69. • Is it better to spend more time defining more
possible alternatives or to take the decision fast
considering only few?
 Conversion Step
• In order to be able to compare the alternatives we
need to convert them to a common measure
• We express each alternative in terms of cash flows at
specified date in the future, and state also those
considerations that cannot be reduced to money
terms

70.  Decision Step
• Having done all the abovementioned, we need to
decide what to choose
• Consider multiple criteria
• Cancel out identical factors and stress the attention
on differences
• When facts are missing use judgement
• Making the decision

71. Basic Concepts
• Cash flow
• Interest Rate and Time value of
money
• Equivalence technique

72. Cash Flow
• Engineering projects generally have economic
consequences that occur over an extended period
of time
– For example, if an expensive piece of machinery is installed
in a plant were brought on credit, the simple process of
paying for it may take several years
– The resulting favorable consequences may last as long
as the equipment performs its useful function
• Each project is described as cash receipts or
disbursements (expenses) at different points in
time

73. Categories of Cash Flows
• The expenses and receipts due to engineering
projects usually fall into one of the following
categories:
– First cost: expense to build or to buy and install
– Operations and maintenance (O&M): annual
expense, such as electricity, labor, and minor
repairs
– Salvage value: receipt at project termination for
sale or transfer of the equipment (can be a
salvage cost)
– Revenues: annual receipts due to sale of products
or services
– Overhaul: major capital expenditure that occurs
during the asset’s life

74. Cash Flow diagrams
• The costs and benefits of engineering projects over
time are summarized on a cash flow diagram (CFD)
• Specifically, CFD illustrates the size, sign, and timing
of individual cash flows, and forms the basis for
engineering economic analysis
• A CFD is created by first drawing a segmented time-
based horizontal line, divided into appropriate time
unit.
• Each time when there is a cash flow, a vertical arrow
is added pointing down for costs and up for
revenues or benefits
• The cost flows are drawn to relative scale

75. Drawing a Cash Flow Diagram
• In a cash flow diagram (CFD) the end of period t is the
same as the beginning of period (t+1)
• Beginning of period cash flows are: rent, lease, and
insurance payments, and
• End-of-period cash flows are: O&M, salvages, revenues,
overhauls
• The choice of time 0, is arbitrary. It can be when a
project is analyzed, when funding is approved, or
when construction begins
• One person’s cash outflow (represented as a
negative value) is another person’s cash inflow
(represented as a positive value)

76. AnExample of Cash Flow Diagram
Question: A man borrowed 1,000 from a bank at 8%
interest. Two end-of-year payments: at the end of the first
year, he will repay half of the 1000 principal plus the
interest that is due. At the end of the second year, he will
repay the remaining half plus the interest for the second
year.
End of year Cash flow
0 +1000
1 -580 (-500 - 80)
2 -540 (-500 - 40)
Cash flow for this problem is:

77. Cash Flow Diagram
1,000
0
1 2
580
540

78. Time Value of Money
Time value of money deals with changes in the value of money
over some period of time (due to investment opportunities,
uncertainty, etc.)
This is a key concept in engineering economics!
• The time value of money centers around the idea of an
interest rate (if projecting into the future):
• Or, equivalently, a discount rate (if rolling back to the
present)
• Money has value
– Money can be leased or rented and the payment is called
interest
– If you put 100 in a bank at 9% interest for one time
period you will receive back your original 100 plus 9

79. Compound Interest
• Interest that is computed on the original unpaid debt
and the unpaid interest
• Compound interest is most commonly used in
practice
• Total interest earned = In = P (1+i)n - P
Where,
P – present sum of money, i – interest rate
n – number of periods (years)
I2 = 100 x (1+.09)2 - 100 = 18.81

80. Future Value of a Loan with
Compound Interest
• Amount of money due at the end of a loan
F = P(1+i)1(1+i)2…..(1+i)n or F = P (1 + i)n
Where,
• F = future value and P = present value
• Referring to previous slide, i = 9%, P = 100 and say n=
no. of days
Determine the value of F.
F = 100 (1 + .09)2 = 118.81

81. Notation for Calculating a
Future Value
• Formula:
F=P(1+i)n
is the single payment compound amount factor
• Functional notation:
F=P(F/P,i,n) F=5000(F/P, 6%,10)
• F =P(F/P) which is dimensionally correct

82. Notation for Calculating a
Present Value
• P=F(1/(1+i))n=F(1+i)-n
is the single payment present worth factor
• Functional notation:
P=F(P/F,i,n) P=5000(P/F, 6%,10)
• Interpretation of (P/F, i, n): a present sum P, given a
future sum, F, n interest periods hence at an interest
rate i per interest period

83. Spreadsheet Function
P = PV(i,N,A,F,Type)
F = FV(i,N,A,P,Type)
i = RATE(N,A,P,F, Type, guess)
Where,
i = interest rate,
N = number of interest periods,
A = uniform amount,
P = present sum of money,
F = future sum of money,
Type = 0 means end-of-period cash payments,
Type = 1 means beginning-of-period payments, guess is a
guess value of the interest rate

84. Equivalence
• Relative attractiveness of different alternatives can
be judged by using the technique of equivalence
• We use comparable equivalent values of alternatives
to judge the relative attractiveness of the given
alternatives
• Equivalence is dependent on interest rate
• Compound Interest formulas can be used to
facilitate equivalence computations

85. Technique of Equivalence
•Determine a single equivalent value at a point in time
for plan 1
•Determine a single equivalent value at a point in time
for plan 2
Both at the same interest rate and at the same time point
•Judge the relative attractiveness of the two alternatives
from the comparable equivalent values.

86. Engineering Economic Analysis
Calculation
• Generally involves compound interest formulas
(factors)
• Compound interest formulas (factors) can be
evaluated by using one of the three methods
– Interest factor tables
– Calculator
– Spreadsheet

87. Given the choice of these two
plans, which would you choose?
Year Plan 1 Plan 2
0 5,000
1 1,000
2 1,000
3 1,000
4 1,000
5 1,000
Total 5,000 5,000
To make a choice the cash flows must be altered so a comparison
may be made.

88. Resolving Cash Flows to
Equivalent Present Values
• P = 1,000(P/A,10%,5)
• P = 1,000(3.791) = 3,791
• P = 5,000
• Alternative 2 is better than
alternative 1 since
alternative 2 has a greater
present value

89. AnExample of Future Value
• Example: If 500 were deposited in a bank savings
account, how much would be in the account three years
hence if the bank paid 6% interest compounded
annually?
Given P = 500, i = 6%, n = 3,
use F = FV(6%,3,500,0) = -595.91
Note that the spreadsheet gives a negative number to
find equivalent of P. If we find P using F = -595.91, we
get P = 500.

90. An Example of Present Value
• Example: If you wished to have 800 in a savings
account at the end of four years, and 5% interest we
paid annually, how much should you put into the
savings account?
Given: n = 4, F = 800, i = 5%, P = ?
P = PV(5%,4,,800,0) = -658.16
You should use P = 658.16

91. Economic Analysis Methods
• Three commonly used economic analysis methods
are
 Present Worth Analysis
 Annual Worth Analysis
 Rate of Return Analysis

92. Present Worth Analysis
• Steps to do present worth analysis for selecting a
single alternative (investment) from among multiple
alternatives
– Step 1: Select a desired value of the return on
investment (i)
– Step 2: Using the compound interest formulas bring
all benefits and costs to present worth for each
alternative
– Step 3: Select the alternative with the largest net
present worth (Present worth of benefits – Present
worth of costs)

93. Cost and Benefit Estimates
• Present and future benefits (income) and costs need
to be estimated to determine the attractiveness
(worthiness) of a new product investment
alternative

94. Annual costs and Income for a
Product
• Annual product total cost is the sum of :
 annual material, labor, and overhead (salaries,
taxes, marketing expenses, office costs, and
related costs), annual operating costs (power,
maintenance, repairs, space costs, and related
expenses), and annual first cost minus the annual
salvage value
• Annual income generated through the sales of a
product = number of units sold annuallyxunit price

95. Rate of Return Analysis
• Single alternative case
• In this method all revenues and costs of the alternative
are reduced to a single percentage number
• This percentage number can be compared to other
investment returns and interest rates inside and outside
the organization
• Steps to determine rate of return for a single stand-alone
investment
– Step 1: Take the dollar amounts to the same point in time
using the compound interest formulas
– Step 2: Equate the sum of the revenues to the sum of the
costs at that point in time and solve for i

96. Rate of Return Analysis
• An initial investment of 500 is being considered. The
revenues from this investment are 300 at the end of the
first year, 300 at the end of the second, and 200 at the end
of the third.
If the desired return on investment is 15%, is the
project acceptable?
In this example we will take benefits and costs to the
present time and their present values are then equated:

97. Rate of Return Analysis
• 500 = 300(P/F, i, n=1) + 300(P/F, i, n=2) + 200(P/F, i, n=3)
Now solve for i using trial and error method
• Try 10%: 500 = ?
272 + 247 + 156 = 669(not equal)
• Try 20%: 500 = ?
250 + 208 + 116 = 574 (not equal)
• Try 30%: 500 = ?
231 + 178 + 91 = 500 (equal) » i = 30%
• The desired return on investment is 15%, the project
returns 30%, so it should be implemented

98.  References
1. IEA (2004) Energy statistics manual, International Energy Agency, Paris
http://www.iea.org/textbase/nppdf/free/2005/statistics_manual.pdf,
2. Codoni R, Park HC, Ramani KV (eds) (1985) Integrated energy planning: a manual. Asian and
Pacific Development Centre, Kuala Lumpur.
3. Siddayao CM (1986) Energy demand and economic growth: measurement and conceptual issues
in policy analysis. Westview Press, Boulder