BKF4143 - PROCESS ENGINEERING ECONOMICS

Chap. 1.0 - Basic

Engineering Economics

Hj. M Noor Nawi

FAKULTI KEJURUTERAAN KIMIA & SUMBER ASLI,
UNIVERSITI MALAYSIA PAHANG, KUANTAN.
Earth provides
enough to satisfy
every mans
NEEDS, but not
even one mans
GREED
Mohandas Karamchand Gandhi
(2 Oct 1869 30 Jan 1948)
 Why study Engineering
Economics?
* To understand the society

* To understand global affairs

* To be an informed citizen

* Learn a way of economist thinking

* Opportunity cost
* Marginalism and sunk costs
* Efficient markets
* Revenue against Cost
* Corporate Finance
June 2015
The Global Economy in Transition
Developing countries face a series of tough challenges in 2015, including the
looming prospect of higher borrowing costs in a new era of low prices for oil
and other key commodities.
This will result in a fourth consecutive year of disappointing economic
growth this year, says the World Bank Groups latest 2015 Global Economic
Prospects report, released on June 10.
Developing countries are now projected to grow by 4.4 percent this year,
with a likely rise to 5.2 percent in 2016, and 5.4 percent in 2017.
KLCI PARES LOSS, BUT STRUGGLES TO BREACH 1,600 LEVEL
SEPTEMBER 7, 2015 : 1:08 PM MYT

KUALA LUMPUR (Sept 7): The FBM KLCI pared some of its losses, but
clawing back above the psychological 1,600-point level seemed ways off at the
midday break today, as regional markets sagged.

At 12.30pm, the local index was down 0.56% or 8.86 points at 1,580.30. It
had earlier fallen to its intra-morning low of 1,567.91.
Exchange Rates 7 September 2015
Rates from the Interbank Foreign Exchange Market in Kuala Lumpur. Rates at 1130 are
the best rates offered by selected commercial banks.

Date USD GBP EUR JPY100 CHF AUD CAD SGD HKD100
1/9/15 4.1560 6.3998 4.6834 3.4400 4.3226 2.9643 3.1626 2.9512 53.6258
2/9/15 4.2190 6.4622 4.7571 3.5074 4.3843 2.9672 3.1899 2.9863 54.4384
3/9/15 4.2285 6.4675 4.7454 3.5091 4.3615 2.9682 3.1887 2.9858 54.5609
4/9/15 4.2605 6.4894 4.7392 3.5683 4.3841 2.9696 3.2233 3.0038 54.9703
7/9/15 4.3045 6.5394 4.7978 3.6036 4.4285 2.9832 3.2448 3.0212 55.5401
BASIC OUTLINES:
1. Fundamentals of Economics
2. The Concept of Supply and Demand
3. Banking and Financial Institutions
4. Financial Markets
5. Monetary System
1.1 Fundamentals of Economics

*ECONOMICS is social science that studies how

individuals, governments, firms, and nations
make optimal choices on allocating scarce
resources to satisfy their unlimited wants.

*Economics is the social science that analyzes

the production, distribution, and consumption of
goods and services. (wikipedia, 2011)
 Scarcity
*SCARCITY is the basic economic problem
that arises because people have
unlimited wants but resources are
limited. Because of scarcity, various
economic decisions must be made to
allocate resources efficiently.
 Marginalism
*In economics, marginal means extra,
additional or a change in.
*Marginal Benefit (MB)
*Refers to what people are willing to give up in
order to obtain one more unit of a good
*Marginal Cost (MC)
*Refers to the value of what is given up in order
to produce the additional unit.
 1.2 The Concept of Supply and
Demand
* Supply and demand is perhaps one of the
most fundamental concepts of economics and it is the
backbone of a market economy.
* Demand refers to how much (quantity) of a product or
service is desired by buyers. The quantity demanded is the
amount of a product people are willing to buy at a certain
price; the relationship between price and quantity
demanded is known as the demand relationship.
* Supply represents how much the market can offer. The
quantity supplied refers to the amount of a certain good
producers are willing to supply when receiving a certain
price.
* The correlation between price and how much of a good or
service is supplied to the market is known as the supply
relationship.
* Price, therefore, is a reflection of supply and demand.
 Supply and Demand
*The Law of Demand
*The law of demand
states that, if all other
factors remain equal,
the higher the price of
a good, the less people
will demand that good.
In other words, the
higher the price, the
lower the quantity
demanded.
 Supply and Demand
*The Law of Supply
*the law of supply
demonstrates the
quantities that will
be sold at a certain
price.
*the higher the
price, the higher
the quantity
supplied.
Read
 Supply and Demand
*How supply and demand affect
price????
 Supply and Demand
* Equilibrium
* When supply and demand are
equal (i.e. when the supply
function and demand
function intersect) the
economy is said to be at
equilibrium.
* At this point, the allocation
of goods is at its most
efficient because the amount
of goods being supplied is
exactly the same as the
amount of goods being
demanded.
 Supply and Demand
*Disequilibrium (Excess
supply)
* If the price is set too high,
excess supply will be created
within the economy and there
will be allocative inefficiency.

*Disequilibrium (Excess
demand)
* Excess demand is created
when price is set below the
equilibrium price. Because
the price is so low, too many
consumers want the good
while producers are not
making enough of it.
Chapter 1.3 Banking and Financial
Institutions
Function of Banking and Financial Institutions

Central Bank

Malaysia Financial Sector

 Function of Banking and Financial
Institutions
Financial Intermediation
*Helps get funds from savers to investors
through bond/equity/foreign exchange
markets
Banks and Money Supply
*Crucial role in creation of money
Financial Innovation
 Central Bank
* The entity responsible for overseeing the monetary system for a nation (or
group of nations). Central banks have a wide range of responsibilities,
from overseeing monetary policy to implementing specific goals such as
currency stability, low inflation and full employment. Central banks also
generally issue currency, function as the bank of the government, regulate the
credit system, oversee commercial banks, manage exchange reserves and act
as a lender of last resort.
* E.g. The Federal Reserve Bank (USA), ECB(European Central Bank), Bank
Negara Malaysia.
 OBJECTIVES OF
BANK NEGARA MALAYSIA

The objectives of Bank Negara Malaysia are:

To promote monetary stability and a sound
nancial structure
To act as a banker and nancial adviser to
the Government
To issue currency and keep reserves
safeguarding the value of the currency
To inuence the credit situation to the
advantage of the country
Malaysia Financial Sector

* Commercial Banks (Affin Bank, AM Bank, Maybank, CIMB, Public Bank

etc)
* Islamic Banks (BIMB, CIMB Islamic, Affin Islamic, AM Islamic, Maybank
Islamic, Al-Rajhi, Kuwait Finance House etc)
* Development Finance Institution (Bank Pertanian, Bank Pembangunan
Malaysia, Bank Kerjasama Rakyat, SME Bank etc)
* Investment Banks (Affin Investment Bank, ECM Libra, Hwang DBS,
Kenanga Investment, MIDF Amanah Investment)
* Insurance (General Insurance, Life Insurance, Takaful)
* Intermediaries Operator (Money brokers, Insurance Brokers, Insurance
and Takaful Brokers, Loss Adjuster, Financial Advisers)
 1.4 Financial Markets
What is Financial Markets?
Any marketplace where buyers and sellers participate in
the trade of assets such as equities, bonds, currencies and
derivatives. Financial markets are defined by having
transparent pricing, basic regulations on trading, costs and
fees and market forces determining the prices of securities
that trade.
Channel funds from savers to investors, thereby
Promoting economic efficiency
Affect personal wealth and behavior of business firms
Major Financial Markets

Bond Market

Stock Market

Foreign Exchange
Market
 Bond Market
*Bonds are an example of a debt contract.
*A debt contract is simply a promise to repay an
amount in the future in exchange for funds now.
*A bond is a kind of a debt contract that is
marketable, that is it can be bought and sold in a
market.
*For example, to raise funds, Proton Holdings might
sell a bond, which is a promise to repay the money
plus interest some time in the future.
 Stock Market
*Stock represents share/ownership in the company so
that stockholders can vote on who manages the
company.
*Owner of stocks may buy or sell their share in the stock
market (e.g. London Stock Exchange, KLSE)
*Firms/company may raise their fund through Initial
Public Offerings (IPO)
*Stock Price volatility
*Stock Price Bubbles
*Technology bubble in 1990s?
 Foreign Exchange Market
*It is the activity of funds transfer from one
country to another
*There are a variety of different currencies in the
world: dollars (US), Yen (Japan), Euros (13 nations
of the European Community) among many others.
*The value of currencies differs from one another
and subject to international trade.
*The market where currencies are exchanged is
called the foreign exchange market.
 Classification of Financial
Markets
1. Primary Market
* New security issues sold to initial buyers (often behind closed doors)
* Investment banks typically underwrite securities (i.e. guarantees a price
for the security and then sells it to the public)
2. Secondary Market
* Securities previously issued are bought and sold. E.g.: NASDAQ, Futures,
Options, Foreign Exchange
* Exchanges
* Trades conducted in central locations (e.g., New York Stock Exchange, NYSE;
London Stock Exchange, LSE)
* Over-the Counter Markets
* Dealers at different locations buy and sell
 Methods of Raising Private
Sector Funds
Debt Markets
* Short-term (maturity < 1 year): Money Market
* Intermediate-term (1year < maturity < 10 years)
* Long-term (maturity > 10 years)
Equity Markets
* Common stocks: claims to share in assets and net income
* No maturity date; periodic payments known as dividends
Capital Market
* Intermediate + Long Term Debt + Equity
* Examples: Bonds, mortgages
 Financial Market Instruments

What are the kinds of securities traded in financial markets?

Money Market Instruments
* Because of short term to maturity, debt instruments traded in the money
market do not have much fluctuation in their prices, and hence are the
least risky
Capital Market Instruments
* Debt and equity instruments with maturities greater than a year;these
have much greater fluctuations in their prices (compared to money market
instruments) and as such are considered more risky
 Examples: Money Market
Instruments
Treasury Bills
* Issued by US govt, with 1, 3, and 6 month maturities.
* Pay a set amount at maturity, and have no interest payments;
effectively pay interest by selling at a discount.
Negotiable Bank Certificates of Deposit
* CDs are debt instruments sold by banks to depositors that pays
an annual interest of a given amount, and pays back the
original purchase price at maturity
Commercial Paper
* Short term debt instrument issued by large banks and well
known corporations (e.g. Microsoft, GM).
 Examples: Money Market
Instruments
Repurchase Agreements
*Reposes are effectively short term loans (usually
with a maturity of less than 2 weeks) for which T-
bills serve as collateral. The most important
lenders in this market are usually large
corporations.
Federal (Fed) Funds
*These are typically overnight loans of reserves
between banks, of their deposits at the Federal
Reserve.
 Examples: Capital Market
Stocks
Instruments
* These are equity claims on net income and assets of a corporation.
* Issue of new stocks in any given year is typically quite small, although the
total value of stocks exceed that of any other type of security in the
capital markets.
Mortgages
* Mortgage market is the largest debt market in the US
* Residential mortgages are approximately 4 times the amount of
commercial and farm combined.
Corporate Bonds
* Long term bonds issued by corporations with very strong credit ratings.
* Typical corporate bond sends the holder an interest payment twice a year
and pays off the face value when the bond matures.
* Some convertible corporate bonds allows the holder to convert them
into a specified number of shares of stock at any time up to the maturity
date.
 Examples: Capital Market
Instruments
Government Securities
* These are long term debt instruments issued by the Treasury to
finance the governments deficits.
Government Agency Securities
* Issued by various agencies such as Ginnie Mae, the Federal Farm
Credit Bank, etc, to finance such items as mortgages, farm loans
or power generating equipment.
* Many of the securities are guaranteed by the federal government.
State and Local bonds
* Also called municipal bonds, which are long term debt instruments
issued by the state and local governments to finance expenditures
on roads, schools, and other programs.
* Interest payments from these bonds are exempt from federal
income tax and generally from the state taxes issuing the bond.
Consumer and Bank loans
 Some Basic Definitions
1. Debt Instrument:
Contractual agreement by borrower to pay holder
of the instrument a fixed dollar amount at regular
intervals (principal + interest), until a specified
date
*Example: Car loan
2. The maturity of a debt instrument is the number of
years (term) until the instrument expires
3. Liquidity
The degree to which an asset or security can be
bought or sold in the market without affecting the
asset's price. Liquidity is characterized by a high
level of trading activity. Assets that can be easily
bought or sold, are known as liquid assets.
*Some Basic Definitions (Cont.)
4. Volatility
* Volatility refers to the amount of uncertainty or risk about the
size of changes in a security's value.
* A higher volatility means that a security's value can potentially
be spread out over a larger range of values. This means that
the price of the security can change dramatically over a short
time period in either direction.
* A lower volatility means that a security's value does not
fluctuate dramatically, but changes in value at a steady pace
over a period of time.
* Commonly, the higher the volatility, the riskier the security.
 1.5 - Monetary System
Understanding Money
Money Exchange Rate
Modern Monetary system
 Understanding Money
*Money is a token that is widely accepted as
a medium of exchange. The token can be
tangible like a coin or note, or intangible
like a bank deposit.
Understanding Money

Commodity Money
Money using valuable
commodity as token
(such as gold)

Money
Fiat Money
Representative Money Intrinsically worthless,
Physical tokens (coins, inconvertible token
certificate etc) that can be
reliably exchanged for a endowed with special
fixed quantity of a status by the
commodity such as gold government to make
them viable as money
 Money Exchange Rate
* Exchange Rate
* Exchange rates are quoted as foreign currency per unit of
domestic currency or domestic currency per unit of foreign
currency.
* How much can be exchanged for one euro? 102/1
* How much can be exchanged for one yen? 0.0098/1
* Exchange rate allow us to denominate the cost or price of a
good or service in a common currency.
* How much does a Honda cost? 3,000,000
* Or, 3,000,000 x 0.0098/1 = 29,400
 Money Exchange Rate
*Purchasing Power Parity Theory
*A method of calculating exchange rates that
attempts to value currencies at rates such
that each currency will buy an equal basket
of goods.
*Creates a balance in trade. When a country
has an inflation, its currency depreciates.
 Money Exchange Rate

Import Export
demand demand

Tariffs and
Other Productivity
quotas
factors
affecting
exchange
rates
 Modern Monetary System
* In the 19th and early 20th centuries gold played a key role in
international monetary transactions.
* The gold standard was used to back currencies; the
international value of currency was determined by its fixed
relationship to gold.
* 19th Century Gold Standard
1 oz of gold = $20 = 4
1 = $5

* Liberty Gold Dollar (1849-1854)

 Modern Monetary System
* Bretton Woods Agreement 1944
* Established a system of fixed exchange rates.
 Modern Monetary System

* 1960s inflation hit US resulted in

President Nixon Closes the Gold
Window in year 1971
* Nixon refuses to honor agreement
signaling the beginning of the end
of fixed exchange rates.
 Modern Monetary System
*The Effect of Exchange Rate Interventions
*Central Banks enters into forex market to
influence value of currency. Tendency of
competition to keep value high.
*Central Banks enter into forex market and
then conducts open market operation to keep
money supply constant.
*The speculative activities of world currencies
 Asian Financial Crisis
* In 1997 speculative short-selling of the Malaysian currency
* The value of the ringgit dropped from MYR 2.50 per USD to
MYR 4.80 per USD.
* Bank Negara imposed capital controls and pegged the
Malaysian ringgit at USD 3.80.
* The fixed exchange rate was abandoned on July 21, 2005.
* The Ringgit was made into floating system but to be traded
with strict permission from Bank Negara.