What do we mean by “Economic E
- What do we mean by “Economic Equivalence?” Support your viewwith a simple example if applicable.
- Why do we need to establish an economic equivalence?
- How do we establish an economic equivalence?
Answer:
Economic equivalence exists betweencash flows that have the same economic effect and could thereforebe traded for one another. Economic equivalence is a combinationof interest rate and time value ofmoney to determine the different amounts of money at differentpoints in time that are equal in economic value.
Even though the amounts and timingof the cash flows may differ, the appropriate interest rate makesthem equal.
You borrowed $5,000 from a bank andyou have to pay it back in 5 years. There are many ways the debtcan be repaid, given interest rate is 8%
Plan 1: At end of each year pay$1,000 principal plus interest due.
Plan 2: Pay interest due at end ofeach year and principal at end of five years.
Plan 3: Pay in five end-of-yearpayments ($1,252).
Plan 4: Pay principal and interestin one payment at end of five years. All these plans are equivalentin the sense that the sum of all outgoing cash flows at time 0 is$5,000.
Economic equivalence is usedcommonly in engineering to compare alternatives. In engineeringeconomy, two things are said to be equivalent if they have the sameeffect. Unlike most individuals involved with personal finances,corporate and government decision makers using engineeringeconomics might not be so much concerned with the timing of aproject’s cash flows as with the profitability of the project.
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