Engineering Economics Blog

Economic equivalence is a fundamental concept upon which engineering economy computations are based. Before we delve into the economic aspects, think of the many types of equivalency we may utilize daily by transferring from one scale to another. Some example transfers between scales are as follows:

Often equivalency involves two or more scales. Consider the equivalency of a   speed  of 110 kilometers per hour (kph) into miles per minute using conversions between distance and time scales with three-decimal accuracy.



Four scales—time in minutes, time in hours, length in miles, and length in kilometers are combined to develop these equivalent statements on speed. Note that throughout these statements, the fundamental relations of 1 mile 1.609 kilometers and 1 hour 60 minutes are applied. If a fundamental relation changes, the entire equivalency is in error.

Now  we  consider  economic  equivalency.  
  

Economic equivalence  is a combination of   interest rate  and   time value of money  to determine the different amounts of money at different points in time that are equal in economic value.  

As an illustration, if the interest rate is 6% per year, $100 today (present time) is equivalent to $106 one year from today.     


If someone offered you a gift of $100 today or $106 one year from today, it would make no difference which offer you accepted from an economic perspective. In either case you have $106 one year from today. However, the two sums of money are equivalent to each other   only  when the interest rate is 6% per year. At a higher or lower interest rate, $100 today is not equivalent to $106
one year from today.

In addition to future equivalence, we can apply the same logic to determine equivalence for previous years. A total of $100 now is equivalent to $100 /1.06 = $94.34 one year ago at an interest rate of 6% per year. From these illustrations, we can state the following: $94.34 last year, $100 now, and $106 one year from now are equivalent at an interest rate of 6% per year.

The fact that these sums are equivalent can be verifi ed by computing the two interest rates for 1-year interest periods.

and


The cash fl ow diagram in  Figure 1–10  indicates the amount of interest needed each year to make these three different amounts equivalent at 6% per year.

Figure 1–10 Equivalence of money at 6% per year interest.

EXAMPLE 1.12 - Economic Equivalence

EXAMPLE 1.13 - Economic Equivalence