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Dr. Wilton W.T. Fok E-mail: wtfok@eee.hku.hk Office: CYC Building Room 703

The University of Hong Kong Department of Electrical and Electronic Engineering ELEC15 Engineering Economics & Finance Day 1 Session 1: Introduction. Dr. Wilton W.T. Fok E-mail: wtfok@eee.hku.hk Office: CYC Building Room 703. ELEC15 Engineering Economics & Finance.

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Dr. Wilton W.T. Fok E-mail: wtfok@eee.hku.hk Office: CYC Building Room 703

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  1. The University of Hong KongDepartment of Electrical and Electronic EngineeringELEC15 Engineering Economics & FinanceDay 1Session 1: Introduction Dr. Wilton W.T. Fok E-mail: wtfok@eee.hku.hk Office: CYC Building Room 703

  2. ELEC15 Engineering Economics & Finance

  3. 1. Key Principles of Economics Principle of opportunity cost; marginal principle; principle of diminishing return; spillover principle; reality principle. 2. Macroeconomics Circular flow; money and resource; production and consumption; role of government; gross domestic product; consumer price index, unemployment rate. 3. Microeconomics Effects of markets on prices; demand & supply curve; elasticity; Game theory 4. Financial Management Importance of financial management; calculation of opportunity cost; present value; Payback, Internal Rate of Return 5. Principles of Accounting Management Functions Accounting information; assets, liabilities, and owner’s equity; income and expenses; double entry; balance sheets; profit and loss account; cash flow statement; adjustments, accounting ratios; financial analysis Syllabus

  4. Session 1: Introduction to Key Principles of Economics

  5. 1.1 What’s Economics? • Definitions from Books: • L. J. Gitman • Economics is the study of how a society uses scarce resources to produce and distribute goods and services. • K. E. Case • Economics is the study of how individuals and societies choose to use the scarce resources that nature and previous generations have provided. • R. W. Griffin • An Economic System is • A nation’s system for allocating resources among citizens. • Assumes resources are scarce thus requiring allocation.

  6. 1.1 What’s Economics? • Economics is a study of choices made by people who are faced with scarcity. • Economics provides a structure for: • Investment decision making • Risk analysis, • Pricing theory • Supply and demand relationships, • Comparative return analysis • Monetary policy • Currency policy • Investment decision • ….many other important issues.

  7. 1.2. Basic Classifications of Economic Studies • Both areas offer valuable outlook on the economy. • After learning some fundamental concepts in Macro-economics and Micro-economics, we shall see how economists solve problems, by viewing Key Principles of Economics. Macroeconomics The big picture. Study of the operation of the economy as a whole. It looks at aggregate data. Microeconomics “A small-scale study”. Focuses on individual entities of the economy, such as households and firms. Focuses more at the policy and regulatory levels. focuses at the firm level

  8. 1.3. Key Principles of Economics • The Principle of Opportunity Cost • The Marginal Principle • The Principle of Diminishing Return • The Spillover Principle • The Reality Principle (Extracted from O’Sullivan: Economics Principles and Tools 3rd ed. Chapter 2 pp 23-36, Prentice Hall)

  9. 1.3.1 The Principle of Opportunity Cost • An Opportunity Cost is • something what you sacrifice to get it. • the cost incurred by the loss of potential gains from other alternatives when one action is taken, that is, that consideration of costs must include consideration of other forgone opportunities. • A focus on opportunity cost rather than measures of accounting cost is a central characteristic of economic reasoning. • E.g. when considering the potential profit from one investment, the calculation of costs should include income that would have otherwise been received (such as income from a bank deposit).

  10. 1.3.1 The Principle of Opportunity Cost Example 1 • The HK Government decides to build their headquarters in the vacant land it owns in Admiralty, the opportunity cost is the value of the benefits forgone of some other things which might have been done with the land, instead of just the construction cost (HK$5 Billion) • In building the headquarter, HK has forgone the opportunity to build a sports center or a library, or the ability to sell the land to gain government incomes, since those uses tend to be mutually exclusive.

  11. 1.3.1 The Principle of Opportunity Cost • The total opportunity costs of such an action can never be known with certainty (and are sometimes called "hidden costs" or "hidden losses", what has been prevented from being produced cannot be seen or known). • Even the possibility of inaction is a lost opportunity Opportunity Cost = Costs saved from not doing this + Benefits from doing that

  12. 1.3.1 The Principle of Opportunity Cost • Example: The Opportunity Cost of a U Degree The opportunity cost of a U degree = Direct costs, including tuition and books + Opportunity cost of time (the salary you could have earned) But also…we should also count the difference of total incomes (until we retire) comparing our career opportunities for having a degree and without a degree

  13. 1.3.2 The Marginal Principle • Marginal cost is the change in total cost that arises when the quantity produced changes by one unit • Marginal cost (MC) function = Derivative of the total cost (TC) function with respect to quantity (Q). Total Cost (TC) = Fixed Cost (FC) + Variable Cost (VC) • As fixed costs do not vary with production quantity  d FC/dQ=0 • Note: • Marginal cost is not related to fixed costs. This can be compared with average total cost or ATC, which is the total cost divided by the number of units produced and does include fixed costs.

  14. 1.3.2 The Marginal Principle • Marginal cost equals the change in total (or variable) cost that comes with each additional unit produced. • Example 1.1 • Suppose the total cost of making 1 shoe is $30 and the total cost of making 2 shoes is $40. • Marginal cost of producing the second shoe is $40 - $30 = $10. $30 $40

  15. 1.3.2 The Marginal Principle • Marginal cost at each level of production includes any additional costs required to produce the next unit. • If we need a building a new factory for producing an additional unit, the marginal cost should the cost of the new factory. • It is a general principle of economics that a producer should always produce (and sell) the last unit if the marginal cost is less than the market price. Marginal Cost for a production In the graph: Pt A- MC drops due to economy of scales Pt B- drop rate reduce due to Diminishing Return Pt C- Production capacity full. Cost of a new building increase the MC a lot. Pt D – MC drops due to further economy of scales C A B D Qty Current Capacity full

  16. 1.3.2 The Marginal Principle • How to decide go or no-go by considering the marginal benefits and marginal cost? • Increase the level of an activity if its marginal benefit exceeds its marginal cost • Reduce the level of an activity if its marginal cost exceeds its marginal benefit. • If possible, pick the level at which the activity’s marginal profit greater than or equal to its marginal cost.

  17. 1.3.3. The Principle of Diminishing Return • Suppose that output is produced with two or more inputs (say factory size and labor), and we increase one input while holding the others constant. Eventually output will begin to increase at a decreasing rate • Diminishing marginal returns states that a firm's short run marginal cost curve will eventually increase. • Conversely, producing one more unit of output costs more and more in variable inputs. This concept is also known as the law of increasing relative cost, or law of increasing opportunity cost. Output C D B A Input

  18. 1.3.3. The Principle of Diminishing Return • Example 1.2 • Suppose that 1kg of seed applied to a fixed size area produces 1 ton of crop. • Farmer might expect that 1 additional Kg of seed would produce 1 additional ton of output. • However, if there are diminishing marginal returns, that additional Kg will produce less than one additional ton of crop • (on the same land, during the same growing season, and with nothing else but the amount of seeds planted changing). • E.g. the 2nd Kg seed may only produce ½ ton of extra output. • Diminishing marginal returns also implies that a 3rd kilogram of seed will produce an additional crop that is even less than ½ ton of additional output. Perhaps only ¼ ton only. Output (Ton) 2.00 1.75 1.50 1.25 1.00 0.75 0.50 0.25 0.00 C 1 2 3 Input (Kg)

  19. 1.3.3. The Principle of Diminishing Return • Example 1.2 (Con’t) • In this case, the difference in the investment of seed in these 3 scenarios is 1kg — “Marginal investment in seed is 1 kg" • And the difference in output is: • 1 ton for the 1st kg • ½ ton for the 2nd kg and • ¼ ton for the 3rd kg . •  , the marginal output (Marginal return) will fall as the total amount of seed planted rises. The marginal product = Extra amount of output (or Marginal return) Extra amount of Input

  20. 1.3.3. The Principle of Diminishing Return • A consequence of diminishing marginal returns is that as total investment increases, the total return on investmentas a proportion of the total investment (the average product or return) also decreases. • E.g. Beyond the point of diminishing returns – output will increase at a decreasing rate. Output (Ton) 2.00 1.75 1.50 1.25 1.00 0.75 0.50 0.25 0.00 C • In this example: • The return from investing the first kilogram is 1 t/kg. • The total return when 2 kg of seed are invested is 1.5/2 = 0.75 t/kg, • The total return when 3 kg are invested is 1.75/3 = 0.58 t/kg. 1 2 3 Input (Kg)

  21. 1.3.4. The Spillover Principle • For some goods, the costs of producing or consuming the good are not confined to the producer and/or consumer of the good • So called “Negative externality” • Examples of Spillover Costs • 1. Air pollution • 2. Water pollution

  22. 1.3.4. The Spillover Principle • For some goods, the benefits of producing or consuming the good are not confined to the producer and/or consumer of the good • So-called “Positive externality”. • Examples of Spillover Benefits • 1. A flood-control dam benefits everyone in the area regardless of who pays for it. • 2. If scientists discover a new way to treat a common disease, everyone suffering from the disease will benefit. • 3. If Engineer discover a new clean energy, everyone will benefit.

  23. Session 2: Macroeconomics

  24. 2.1. Introduction to Macroeconomics • Macroeconomics deals with the performance, structure, and behavior of a national economy as a whole. • Macroeconomists study aggregated indicators such as: • GDP, • Interest rate • Currency rate • Unemployment rates, and • Price indexes • Purchase index…etc • to better understand how the economy functions.

  25. 2.1. Introduction to Macroeconomics • Macroeconomists develop models that explain the relationship between such factors as: • National income, • Output, • Consumption, • Unemployment, • Inflation, • Savings, • Investment, • International trade and • International finance

  26. 2.1. Introduction to Macroeconomics • There are 2 areas of research in macroeconomics: • To understand the causes and consequences of short-run fluctuations in national income (the business cycle), and • To understand the determinants of long-run economic growth (increases in national income).

  27. 2.2. Circular flow of economic activities • In a market economy, individual firms and households control production and allocation by creating combinations of supply and demand. • The economy is interacted by millions of households and millions of firms in a circular flow. • A circular flow of economic activities is illustrated as follow:- Modified from R. W. Griffin “Business” Figure 1-1 p9 Prentice Hall

  28. 2.2. Circular flow of economic activities • A market is a mechanism for exchange between the buyers and sellers of a particular good or service. • We can find 2 markets in the circular flow diagram. • Input Market: • - firms buy resources from households. • Output Market • - firms supply goods and services in response to household demands. supply goods buy resources

  29. 2.2. Circular flow of economic activities • Firms: • Supply products in output markets • Demand resources in input markets • Households: • Demand products in output markets • Supply resources in input markets • Also save their incomes as reservation Supply products Demand products Circular flow is bi-directional Bank Saving Supply resources Demand resources

  30. 2.2. Circular flow of economic activities • From the circular flow diagram, it can be visualized that a good economy requires a good “flow rate” of resources and money. • If flow rate is too high, we may have an overheated economy. • If flow rate is low, we may have recession. An optimal circulation flow is important for a healthy economy

  31. 2.3. Money multiplying effect • The importance of a “good flow rate” can be explained by the money multiplying effect • Example 2.1 • If a firm paid $100 to a worker as salary, he saved 20% to his bank and spent the balance for buying goods from a Shop A. • The shop-owner saved 20% and spend the balanced to pay salary to his employee. • The employee again saved 20% to buy services from another Shop B. • What’s the total values created in the circular flow? Expenses Income 80% 20% saved

  32. 2.3. Money multiplying effect • Example 2.1 (Con’t) • Total values created = =$100+80+64+51.2 = $295.2 $100 $80 $64 $51.2 Firm Worker Shop A Employee Shop B Saving: $20 $16 $12.8 (Saving = 20% of income) The total money flow is almost 3 times ($295.2) than the initial value ($100)

  33. 2.3. Money multiplying effect • E.g.2.2: What if saving increased? • If a firm paid $100 to a worker as salary, he saved 50% to his bank and spent the balance for buying goods from a Shop A. • The shop-owner saved 50% and spend the balanced to pay salary to his employee. • The employee again saved 50% to buy services from another Shop B. • What’s the total values created in the circular flow? Expenses Income 50% 50% saved

  34. 2.3. Money multiplying effect • Example 2.2 (Con’t) • Total values created = =$100+50+25+12.5 = $187.50 $100 $50 $25 $12.5 Firm Worker Shop A Employee Shop B Saving: $50 $25 $12.5 (Saving = 50% of income) The total money flow is less than 2 times ($187.50) than the initial value ($100)

  35. 2.3. Money multiplying effect • The effect: • When saving increase, flow rate in the circular flow drop. • Resulted in a reduction in total flow values • Lead to recession Saving  Flow rate  Total circular flow values   Recession

  36. 12.0 10.0 8.0 6.0 4.0 2.0 0.0 0 0.2 0.4 0.6 0.8 1 2.3. Money multiplying effect • Example 2.3: Money multiplying effect (an endless loop?) • If the average saving to spending ratio in an economy is 30:70. What is the overall multiplying effect to the circular flow?  1+0.7+(0.7)2+(0.7)3+….. +(0.7)n n =a/(1-r) = 1/ (1-0.7) = 3.33 times a/(1-r) Spending ratio

  37. Example 2.4: Impact of imposing GST When a government impose a Goods and Services Tax (GST), e.g. GST= 10% Values in the circular flow will be extracted out 2.3. Money multiplying effect $100 $80 $56 $44.8 Firm Worker Shop A Employee Shop B Saving: $20 $16 $11.2 (Saving = 20% of income) 10%GST: $4.48 10%GST: $8 GST If the government does not spend the collected GST, values in the circular flow will decreased

  38. 2.4 Roles of the Government • Government is also an important player in the economy of a society.

  39. 2.4 Roles of the Government • The role of the government is important: • There are resources controlled by the government; • E.g. control the money supplies, currency rate, interest rate • Firms may not be willing or do not have the capacity to produce particular goods; or to produce goods for particular segments; • E.g. Education services, public health services, water supplies • The government is a buffer in the circular flow. Its decisions may adjust the circular flow • When economy is good, it reserves resources • When economy is poor, it releases resources/ increase investment/ infrastructure developments

  40. Question? • What which organs in human body has a similar function as the role of Government in the context of circular flow of economic activities?

  41. 2.5. Adjusting the flow by the Interest Rate • What is interest and interest rate? • Interest is a fee paid on borrowed capital • Can be thought of as "rent on money". • Borrower enjoys the benefit of the use of the assets ahead of the effort required to obtain them, • Lender enjoys the benefit of the fee (Interest) paid by the borrower for using the asset. • The percentage of the principal (loan amount) paid as a fee (the interest), over a certain period of time, is called the interest rate. %

  42. Case Study 2.1: Let’s watch a news on interest rate cut • http://www.youtube.com/watch?v=zNpLbzpWmuE • 19 Sep 2007, CNS reports on the consequences of the US Federal interest rate cut, specifically in the housing, credit, and crude oil markets. (CBSNews.com)

  43. 2.5. Adjusting the flow by the Interest Rate • Case Study 1: Consequence of US Federal interest rate cut on Stock, housing, credit, and crude oil markets • Interest rate drop by 0.5% resulted in: • Stock market: DOW index rose to 13739.39 (+335.97) • Housing market: Property price increase because: • Mortgage repayment (Interest rate sensitive) reduced • More easy to get credit  encourage people to buy properties • Oil market: rose to US$82 (Record high!) because rate drop simulate the oil demand

  44. 2.5. Adjusting the flow by the Interest Rate • How interest rate affect the economy? • When the interest rate is increased, then • 1. borrowing cost by firms is increased • 2. borrowing cost by households is increased • 3. saving incentive is enhanced • 4. opportunity cost is raised • 5. flow of money in circular flow is slowed down • 6. less investment and less spending • 7. economy is cooled down • 8. double coincidence of wants is fewer • 9. inflation is controlled or depressed • 10. (wages in downward trend) • 11. (unemployment rate increases) • 12. (currency more likely to appreciate)

  45. 2.5. Adjusting the flow by the Interest Rate • When we raise the interest rate (R), more saving is expected: Interest rate  Saving  Flow rate  Total circular flow values  • Just similar to a circuit flow! Resistance   Current flow  R Supplies ~ Loading

  46. 2.6. Recession and Interest Rate • Case Study 2.1: Japan cuts interest rate • Read the article from BBC News • http://news.bbc.co.uk/1/hi/business/1161890.stm

  47. 2.6. Recession and Interest Rate Japan cuts interest rate Source: BBC News http://news.bbc.co.uk/1/hi/business/1161890.stm Friday, 9 February, 2001, 12:12 GMT • The discount rate is cut for the first time in six years. The Bank of Japan has decided to cut its largely symbolic discount interest rate to 0.35% from 0.5%. However, Japan's key interest rate, called the overnight call rate, has been kept at 0.25%. The Bank of Japan (BoJ), led by governor Masaru Hayami, has not cut the discount rate since September 1995. • The move to reduce the discount rate has been interpreted by some economists as an attempt by the central bank, which is independent, to increase pressure on the government to tackle the country's economic problems. In the past Mr Hayami has said that the government should take responsibility for kick-starting the economy through structural reform. Financial markets also see the cut as a sign that the bank is prepared to ease monetary policy further if the economy continues to deteriorate.

  48. 2.6. Recession and Interest Rate • Robin Bew, chief economist at the Economist Intelligence Unit, says the rate cut will have "almost no macro impact on the economy" because the size of the cut is relatively insignificant. "The BoJ is acknowledging that the economy is weak, but is unwilling to cut the overnight rate and so ease pressure for reform on the banking sector," he added. The discount rate is the rate at which commercial banks borrow from the central bank. • It is rarely used and is not as important as the overnight call rate, which governs the rate at which commercial banks lend to each other. The BoJ also announced on Friday that it plans to increase the ease with which commercial banks can borrow on the discount rate. But with the discount rate 0.1% higher than the interbank rate, it is unlikely that many banks would make use of it.

  49. 2.6. Recession and Interest Rate • Fears of a recession • The interest-rate cut comes days after the Japanese government revised down figures for the country's gross domestic product, which now show that the economy shrank by 0.6% for July to September. The government had previously released a preliminary estimate of a 0.2% growth rate. The Bank of Japan is unwilling to ease pressure for reform on the banking sector • The revised figures have revived fears that Japan's depressed economy may even fall into recession, if it contracts in the next quarter as well. In August, the BoJ made the controversial move of increasing the overnight call rate to 0.25%. Previously, the BoJ had kept the interest rate close to zero to stimulate growth in the economy. • Mr Bew believes the BoJ wishes keep the key rate at 0.25% to maintain pressure on private-sector banks to sort out bad loans on their books. While the overnight call rate was closer to 0%, the banks were able to cover their bad loans at very little cost. Publicly, the BoJ has resisted calls to lower the overnight rate, arguing that deflationary pressures in the economy reflect technological change rather than weak demand.

  50. 2.6. Recession and Interest Rate • Annual growth forecasts • The Economist Intelligence Unit forecasts that the Japanese economy will only grow at 0.4% in 2001, compared to its estimate of 1.6% for 2000. Mr Bew says these figures may even be revised downwards in light of the recent economic figures. A recent report by a UK think tank, the National Institute for Economic and Social Research (NIESR), also predicts that the Japanese will be slow. "The economy will be hit by a sharp decline in recovery the contribution of net exports to growth as world trade slows down," stated the report. The NIESR also said that domestic demand will not "pick up the baton" because business confidence has stalled and consumer spending remains subdued. After the interest rate announcement, the euro recovered from five-week lows to rise above 107.4 yen, while the dollar strengthened to highs above 117 yen.

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