Economics of Construction Industry - Case Study Example

Economics of construction industry Introduction How the wheels of a particular industry turn can best be understood by examining the economic forces that govern the industry. The best way to understand the workings of construction industry thus would be to follow the gradual development of economic thought and how it applied to construction industry. In the early years of nineteenth century, Adam Smith, the self styled champion of free markets and minimal governmental intervention, felt construction industry being a part of the overall economic scenario would automatically reach an equilibrium given the complete flexibility of price mechanism. Later on, Karl Marx introduced his ideas of exploitation of labor by capital and concluded that the huge constructions that the economy witnessed were all the result of labor that were unjustly and unethically denied the fruits of their efforts which were usurped by capitalists. With progress of time, came the Great Depression and the development of a radically new approach to macroeconomics by John Maynard Keynes. Faced with gloomy prospects of an ever deepening economic depression where the roaring economy of United States that was confident that good times will last forever suddenly faced a scary scenario where jobs vanished and with it the much vaunted purchasing power of populace, Keynes had to think of an way out of that desperate situation. He realized that increasing aggregate demand was the only way out and chose construction industry as the most convenient vehicle of autonomous investment to undertaken by the US government. He prescribed large doses of investment by the government in construction industry that would, through multiplier effect, generate substantial aggregate demand and consequent rise in general price level that would be sufficient to motivate producers to undertake induced investment. Once this process gets started the upward moving price-wage spiral would pull the entire economy out of the depths of depression. Impact of construction industry on the entire economy Construction industry is seldom characterized by cutting edge innovations. Any new technique implemented by a builder is quickly replicated by competitors and generally all firms in the industry have access to similar technology. Thus it is an industry that experiences intense competition among equally formidable rivals. It is also an industry where production cycle is possibly the longest and with huge potential for employment requiring substantial levels of continuous investment to keep the industry healthy, construction industry becomes one of the benchmarks for judging the overall health of an economy. Construction industry in Australia accounted for 5.5% of its GDP and employed 8% of workforce during 1999-2000 (Industry Information Unit, Business Competitiveness Division, Department of Industry, Science and Resources 2001). Thus there is no doubt that Australian construction industry is a major player in the economy of the country. One witnesses in Dubai the huge impact construction industry has had on the entire economy. The global recession after the slump in US markets together with the international debt repayment lapse on the part of Dubai had put sudden brakes on the burgeoning construction industry that was rapidly converting the laid back sleepy oasis of Dubai into an international destination bristling with gleaming skyscrapers and all the amenities an international metropolis can offer. Dubai had become a much sought after destination in world map as construction wielded its magic wand over the arid expanse. But, all this came to a screeching halt as funds suddenly dried up and world started wondering whether Dubai had indeed stretched its resources beyond limits of tolerance. With construction work at a near standstill, jobs vanished and expatriate workers left the country causing a slump in hotel and other associated industries. The economy witnessed an unprecedented slump of sorts and had to wait till fellow emirates came forward with their help and a temporary moratorium of debt repayment obligations were put in place. But, once the first impact of the crisis was absorbed, it dawned on the authorities that the best way out of this morass was to continue construction, especially those that were in a semi-finished stage as substantial investments had already been made and no returns could be expected until they were completed. So, after some restructuring in the spheres of ownership, management and planning of construction companies along with some strategic mergers construction work has restarted. Though there is at present an oversupply of built up accommodation and consequent suppression of rental and real estate prices, as the construction activity has begun, the multiplier effect of investments in this sector is bound to pull out the economy from the dreary depths it is now in (Martin 2010). Cyclical nature of construction industry Though all industries are most certainly impacted by business cycles, construction industry is characterized by booms and busts like no other industry in an economy. It has been observed that prior to an expected economic boom; construction industry experiences a spike in activities as the entire gears up its productive capacity in anticipation of such a boom. Almost as an extension of this, even before a downswing has set in, in anticipation of difficult times, the first signs of tightening of belt is witnessed in construction industry and it experiences a slump as investment in this sector dries up much before it does so in other sectors. To clearly understand the cyclical nature one must appreciate that demand in construction industry is essentially of a derived nature depending very much on investment and market demand for consumer and other durable goods. Moreover, investment in construction industry is almost totally dependent on availability of cheap home loans from banks and other financial institutions. So, movements of credit markets have a huge impact on investment levels in this industry. The other aspect that needs attention is the nature of output in this industry. Homes, offices and buildings are generally built with an idea that they would last a lifetime. The long life of such capital investments automatically creates the scope of periodic maintenance resulting in cash flows in the sector say, once in every five years. However, as the boom sets in, most construction companies start feeling that good times will last forever and are seldom prepared to withstand the scenario where major capital inflow would be in the form of maintenance jobs rather than new constructions. This industry is a typical example where hectic construction during boom periods creates a situation of excess supply that pushes down rentals and sale prices of real estates, thus preventing the start of another boom. This is accentuated by the durability of output (at least 25 years on an average) that delays creation of new demand from old consumers (Mathews 1959). The situation is even more acute in case of construction of high-rise buildings. Such construction projects are extremely sensitive to changes in interest rates. Substantial portion of required finance is obtained on interest rates that are subject to periodic review to correctly mirror current market rates. If interest rates increase at a higher rate than the increase in rental rates or market price of real estate (as it almost always happens during periods of boom when demand for investment pushes up the rate of interest) and if the builders discover that the sum of marginal interest cost and cost of ongoing construction would exceed expected marginal revenue, construction work is stopped immediately even if it is yet to completed. This happens when the rest of the economy is still enjoying a boom period (Gerald 1997). As construction industry moves through its own cycles of booms and busts, it still must be remembered that these booms and busts are inextricably intertwined with business cycles in the economy as a whole. Business Cycles The Business Cycle Source: (SparkNotes LLC 2009) Right through the last five decades, policy makers in United States sought to enact laws that aimed at stabilizing prices and maintaining steady rate of growth. Way back in 1946, US Congress passed the Employment Act that mandated that Federal Government should lay down economic policies that encouraged economic growth while maintaining price stability. In 1978, US Congress passed the Full Employment and Balanced Growth Act that reiterated the Federal responsibilities already espoused by the earlier act of 1946. Policy makers were mandated with the responsibility of steering the economy in such a manner that full employment was ensured without the possible pitfall of inflation. Robert Lucas had published a slim book in 1987 that effectively challenged US government’s preoccupation with maintaining growth and stability and its efforts in neutralizing business cycles which are a natural phenomenon in an unregulated free market economy (Lucas 1987). Lucas tried to calculate the cost of business cycles by assuming people generally view an economic downturn in terms of the sacrifice they would have to make in the consumption levels. So, consumption, according to Lucas had two components – one that steadily increases with time and the other part that fluctuates with business cycles in an economy. Thus, the cost of business cycles can be correctly evaluated by measuring the changes in the variable part of the consumption function over a period of time. After a series of complicated mathematical calculations using data that had empirical authenticity, Lucas arrived at the conclusion that an average consumer would have missed out on just 0.008% of their lifetime consumption had they resided in an uncontrolled economy. Therefore, according to Lucas, the perceived loss of the economy during a downturn is more or less made up during an upswing and averages out during the lifetime of an individual consumer. Alvarez and Jermann tried to measure the cost of business cycles calculated indirectly from prices of several types of assets, including expected dividends from financial assets. They concluded that consumers, though acutely averse to any sort of fluctuations in the trend value of consumption, would not be that perturbed by cyclical fluctuations and calculated that a consumer would be losing at the most 0.3% of lifetime consumption if they opted for an uncontrolled economy (Alvarez and Jermann 2000). However, the biggest pitfall in using average data is that it ignores individual situations. It might very well be that the average consumer will not mind living in an uncontrolled economy but there could be individuals that suffer enormously during periods of economic downturn and no amount of assurance that it would be made up during the lifetime would help in easing their current travails (Barlevy 2005). When viewed from the perspective of construction industry, this entire debate as to whether government should play a monitoring role in smoothening out business cycles takes on a very interesting hue. Construction industry, as already discussed earlier, experiences an upswing even before any other sector in the economy has started enjoying it. Assuming a scenario where the economy is not controlled through government intervention, the construction workers would start enjoying higher wages before workforce employed in any other sector can. However, even when the boom period is still in force in other sectors of the economy, construction workers will start feeling the pinch as soon as marginal interest costs increase beyond the tolerance limit. So, they are either rendered unemployed or are forced to accept lower wages as the construction sector enters into one of its busts. The risks of an average employer in construction industry do not end here. As wages are pro-cyclical by definition, when a period of upswing recurs, these unemployed workers would surely be reemployed, but at lower wage rates than earlier and their wages would remain low for quite some time. If we stop our argument at this stage, surely it would be a clarion call in support of stabilization policies for government, but one must also remember that much as construction industry workers would have stable jobs if business cycles are smoothened, they would also lose the opportunity of earning high wages during periods of boom. So, it is essentially a question of how far the construction industry workers are willing to take the risk that determines whether one would root for stabilization or support a free market economy where equilibrium is attained through wage price flexibility. Conclusion Construction industry has certain peculiarities that are seldom found in other sectors. Here innovation does not accord any competitive edge to the innovator as such innovations are almost instantaneously replicated by competitors. This industry is a significant employer in every economy yet it requires massive capital investments to function steadily. It produces durable outputs which buyers purchase with an idea that they would last a lifetime and this very nature of outputs generate trade cycles in this industry where periodic bouts of frenzied activity are followed by long periods of slumps as overproduction reduces market price of its output and discourages further investment. Though there has been a raging debate among economists regarding the efficacy and justification of government intervention to eliminate business cycles, construction industry and especially those who work in this industry would gain substantially if such efforts by government are continued. References Alvarez, Fernando, and Urban Jermann. Using asset prices to measure the cost of business cycles. Working Paper, Chicago: University of Chicago, 2000. Barlevy, Gadi. "The Cost of Business Cycles and the Benefits of Stabilization." Economic Perspectives, Volume 29, Issue 1, 2005: 32-39. Gerald, Finkel. The Economics of Construction Industry. Armonk, New York: M. E. Sharpe, 1997. Industry Information Unit, Business Competitiveness Division, Department of Industry, Science and Resources. "The construction industrys linkages with the economy ." Australian Bureau of Statistics. 2001. http://www.yprl.vic.gov.au/cdroms/yearbook2002/cd/wcd00003/wcd0035f.htm (accessed November 20, 2010). Lucas, Robert. Models of Business Cycles. Oxford: Basil Blackwell, 1987. Martin, David. "The Impact of the Construction Industry on Dubai’s Economy." Buzzle.com: Intelligent Life on the Web. May 28, 2010. http://www.buzzle.com/articles/the-impact-of-the-construction-industry-on-dubais-economy.html (accessed November 20, 2010). Mathews, Robert Charles Oliver. The Business Cycle. Chicago: Chicago University Press, 1959. SparkNotes LLC. "Overview of Macroeconomics: Economic Growth." sparknotes. 2009. http://www.google.co.in/imgres?imgurl=http://img.sparknotes.com/figures/2/27494f43f8520c29bb39130541e7bb44/Business_Cycle.jpg&imgrefurl=http://sparkcharts.sparknotes.com/economics/macroeconomics/section4.php&h=233&w=320&sz=19&tbnid=CJrXhAEPsTZuJM:&tbnh=86 (accessed November 20, 2010). Read More