Production, Construction and Property: an Economic Viewpoint - Coursework Example

PRODUCTION, CONSTRUCTION AND PROPERTY: AN ECONOMIC VIEWPOINT Introduction Production is a of study in microeconomics as well as modern industrial organisation. It encompasses many aspects such as goods and services and many industries. Some economists go to the extent of including distribution and selling as part of production because such activities add value to the product reaching the consumers. Because the concept of production extends to construction for residential, non-residential and public works projects, this paper will attempt to provide that link and to highlight the importance of the construction and real estate property sectors in meeting the demand of users and consumers for housing and other structures. Production in economics The products and services that people enjoy everyday are produced in an economy that consists of thousands of firms. Some companies are big and employ thousands of workers while others are small, owned by single person or family employing few workers. In a free economy, all production decisions are based on what quantity and quality of goods the market is willing to buy at certain prices. Producers are willing to supply the goods or services when prices are high; buyers prefer to buy good quality at low or reasonable prices. Theoretically, an equilibrium is reached when supply meets demand in a free market. Production is described in economics and in the science of industrial organisation as the process of converting resources as inputs into products or services as outputs for the purpose of distribution and sale to buyers, users, or consumers. Companies purchase their raw materials from suppliers and transform them into finished products, in the process incurring the costs of labor, utilities, depreciation of fixed assets, and other requirements.. They may produce a single product or several products. Some are labor intensive and others capital intensive and relying heavily on automation technology. Some companies also focus on high quality whereas others emphasise low cost so that their products can reach more consumers. (Jackson 2001) All firms in an economy produce goods and services in order to earn a profit. The amount received by a firm for the sale of its outputs is called total revenue. The amount it pays for the inputs (raw materials, labor, equipment, rent, etc.) is its total cost. What remains after deducting the cost of inputs from total revenue is called profit. a. Factors of production Production and productivity can be understood only in the context of the mix of the given resources controlled by an organisation. Economists identify the factors of production as land, labor, capital, entrepreneurship, and technology. Mankiw (2001) classifies these factors into physical capital (the stock of equipment and structures), human capital (knowledge and skills of workers including managers), natural resources (land, rivers, minerals and other products provided by nature), and technological knowledge (common and proprietary knowledge used in business). Any productive enterprise, including real estate development and construction activity, utilises all the factors of production in various proportions in order to create its finished product. b. Production function. The production function is the relationship between the quantity of inputs used to make a good and the quantity of output of that good. It follows that when the inputs (labor, raw materials, etc.) are varied, the output will also change, which describes what is termed as marginal product. Efficiency-conscious companies strive always to increase or at least maintain productivity. Productivity is measured by the ratio of output to input (See Krajewski et al 2007). Where the percentage increase in output exceeds the percentage increase inputs, productivity is indicated. When the inputs do not result in a proportionate or higher output increments, we have a characteristic called diminishing marginal product - a situation whereby the marginal product of an input declines as the quantity of input increases (Mankiw 2001). c. Various measures of costs. In economics, costs are regarded as opportunity costs, whether explicit or implicit. Explicit costs are those that are actually incurred by the firm in producing goods, and implicit opportunity costs refer to the cost of giving up something to obtain some item. The opportunity foregone when a company builds houses is what it gives up when it could have engaged in retail business. The opportunity cost of financing housing construction is the income foregone had the capital been invested in a savings account. Accountants only recognise explicit costs. Costs can be segregated into fixed costs and variable costs. Costs that do not vary with the quantity of output produced - such as utilities, staff salaries, depreciation - are fixed costs. Raw materials and salaries of workers are variable costs. Economists and management analysts use these two classes of cost in order to arrive at the break-even point volume of goods that mark the production level beyond which profit can be made. Cost averages (i.e., averages of total cost, fixed costs, and variable costs) and rising marginal costs are also computed to find that quantity of output beyond which further increase in production would not be profitable. The optimal level of output is that where the marginal cost curve crosses the average total cost curve at its lowest point. d. Economies of scale as efficiency measure. In the long run the firms average total cost curve is flatter than it short-run cost curve. When such cost curve declines as output increases, there is a condition called economies of scale, whereby each increase in inputs yields a greater increase in outputs. When the long-run average total curve remains flat over rising output levels, there is a condition called constant returns to scale. The situation changes when the average total cost begins to rise as it gives rise to diseconomies of scale (See Mankiw 2001). Carlton and Perloff (1994) identify the smallest output that a firm can produce such that its long-run average total cost is minimised as that level of output which can be useful in judging how many firms can operate in a market. Beyond this point -- the minimum efficient scale (MES) -- a cost disadvantage can be incurred. Empirically it has been determined by Stigler (1968, cited in Carlton and Perloff 1994) that the very smallest and the very largest plants are inefficient because their shares of industry output declined over time. e. Economies of scope. When it is cheaper to produce two products together rather than separately, an economy of scope can result. (Baumol et al 1982, cited in Carlton and Perloff 1994). It would be economical, for example, to produce both mutton and wool within the same facility than elsewhere. The use of economies of scope must however be balanced against the efficiency gains from specialisation. Construction and property Construction is defined lexically as the art, trade, or work of building; the structure that results from such activity. Etymologically, it is derived from Latin constructionem, from pp. stem of construere "pile up together, build," from com- "together" + struere "to pile up." (construction. Dictionary.com). According to McKenzie and Betts (2001), real estate construction consists of three main categories: residential, non-residential, and public construction. Residential construction consists of single-family dwellings, condominiums, and multi-family apartments. Residential construction activity rises when people are employed, mortgage credit is available at low or reasonable interest rates, and personal incomes in general are high. Non-residential construction includes industrial plants, retail and office buildings, institutional structures such schools, libraries, and hospitals. It is tied to the business cycle: During periods of prosperity, non-residential construction is active; but during an economic downturn or slack, it can decline or remain stagnant. Public construction has to do with the building of streets, highways, ports, bridges, sewerage systems, and other publicly financed infrastructures. Public construction is not influenced in the same way as residential and non-residential construction. During a recession, for example, the government may increase public spending to put more money into the economy and thus stimulate consumer spending, based on Keynesian theory. Public spending can also increase during an election year, when incumbents are trying to convince voters that they deserve reelection. a. Home building economic characteristics As a large part of construction concerns home building, a description of the home building industry is in order. One of its characteristics is that it is comprised of many small independent builders and a few hundred large companies. The small outfits cannot gain economies of scale that large companies normally realise. Secondly, it is relatively easy to enter the industry because some projects are small scale and do not require large capital. Thirdly, replacement demand for homes is low because of their long physical and economic life. Fourthly, the industry is sensitive or vulnerable to government actions or policies, through taxation, interest rates, and environmental controls. Finally, the homebuilding industry is much affected by mortgage credit terms, because borrowings are often needed to finance home purchases. b. Feasibility study steps A real estate project demands managerial ability to plan, coordinate, and control the the factors of production, which we recall as consisting of land, labor, capital, entrepreneurship and technology. The developers, contractors, and architects are the main actors in converting these factors into a successful real estate project. A feasibility study has to be conducted to analyze the market, assess government requirements, determine sources of financing, and make profit projections. Market analysis. An in-depth market study will determine whether demand for the proposed project exists. For a specific location, how is demand configured in terms of quantity and price levels? Answers have to be found also about timeliness, specific features, competitors and heir likely moves, current and future supply in the community, among others. Government requirements. Government permits have to be secured, and government regulations met, such as those affecting zoning, building codes, utility requirements, reports, and so on. An estimate of time needed to secure government approvals is crucial as delays and penalties could cause losses to be incurred. Required infrastructures and common utilities as well as impact fees -- in terms of providing facilities as a park or school -- have to be estimated in advance. Financing. Gearing is fairly common in real estate property development, and developers and investors rely heavily on outside financing for their projects. They need funds for land acquisition and construction from both traditional lenders (banks, insurance companies, mortgage companies, etc) and non-traditional lenders (pension funds, trusts, and the like). If it can be demonstrated that the project has good market potential and if credit conditions are not tight, the chances of obtaining loans improve. If credit is tight because of the banking crisis similar to what is being experienced today, housing construction projects, no matter how financially viable, have to be shelved for the time being. Potential profitability. After having found all of the above to be feasible, the last hurdle is the profit potential. Measures of profitability such as the accounting rate of return and the discounted cash flow rate of return are applied. If the return to the investors exceed a certain hurdle rate, then the project can be given the go-ahead. c. Steps in the construction process. The first step is the planning process, which has been described above as the feasibility study steps. The other steps are land procurement, land preparation, construction, market distribution, and property management. Land procurement may be simple one of buying the lot, or it could involve purchasing and putting together several parcels, a process which can be difficult. Land preparation refers to land clearing and installation of offsite improvements such as streets, gutters, and utilities. Construction is next in sequence, and it usually is done in phases. A systematic method of scheduling such as PERT/CPM can help anticipate bottlenecks and problems, and thus avoid costly delays and losses. The market distribution stage can start even before construction, by pre-selling, and can extend beyond construction completion, but title is transferred only when it is ready for occupancy. The property management phase refers to the maintenance and servicing of the property after construction is finished. d. Learning from the past. Overbuilding can occur, particularly in the case of non-residential real estate. In the 1980s the United States experienced a supply glut because usually no adequate market studies were prepared, and builders based their investments on unjustified optimism. The government cooperated through its laxity in regulating banks and and savings and loans associations which provided easy credit, through income tax incentives, etc. The Asian Financial Crisis in 1997 was also caused by over-optimistic developers in Thailand and banks that gave them liberal credit. The backlash affected other countries in Asia. The importance of a good feasibility study cannot be over-emphasised. e. Finding the "right" property. Practitioners in the real estate industry have been obsessed with how to make the right decisions about property investing. Clearly, the rational approach is always best. McKenzie and Betts (2001) identify the following sequence of steps in arriving at the right decision regarding an improved property: 1) determine finance availability for the acquisition of a parcel of land, 2) analyze national trends, 3) analyze regional trends, 4) analyze local trends, 5) analyze neighborhood trends, and 6) analyze the individual property (involving appraisal analysis and investment analysis). For unimproved property, the steps vary slightly. When focusing on a specific property, real estate professionals are widely in agreement that location is the most important factor. Phil & Kirstie give advice on how to find the right property (here a bargain house) and enumerate the following tips for these times: 1. Work out your priorities and compromises and stick to them. 2. Consider all types of properties 3. Watch the property listings for properties that have been on the market for some time 4. Dont be afraid of doing fix-up work to add value to the house you purchase 5. Buy a property at auction. Conclusion The production process is a very important stage in creating value for consumers in any economy. The process of creating and adding value entails the assumption of risk on the part of investors. In the construction and real estate property industry in particular, the risks are highlighted by the fact that today the world is facing an economic crisis wherein housing credit was a major cause. The repercussions have been far-reaching and has affected the property industry, which today is experiencing a major slump that is not expected to bounce back until 2011 or even beyond. We believe that the crisis that is affecting the property sector worldwide can be solved both through government efforts and initiatives and the responsiveness of the market to whatever stimulus is provided. For real estate property professionals, opportunities can still be found provided one exercises resourcefulness and diligence. Bibliography Carlton, JM & Perloff, JM, 1994, Modern industrial organisation, 2nd edn., HarperCollins College Publishers, New York construction. Dictionary.com. Online Etymology Dictionary. Douglas Harper, Historian, viewed January 27, 2010 http://dictionary.reference.com/browse/construction Jackson, S & Sawyers, R 2001, Managerial accounting, Harcourt, New York Krajewski, L, Ritzman, L & Malhotra, M 2007, Operations management: Processes and value chain, 8th edn., Pearson Prentice Hall, New York Mankiw, NG 1998, Principles of economics, The Dryden Press, Orlando, FL McKenzie, DJ & Betts, RM 2001, Essentials of real estate economics, 4th edn., South-Western Publishing/ Thompson Learning, Mason, OH Phil & Kirstie 2007, Top 5 steps to bagging a bargain house, viewed 26 January 2010 http://www.channel4.com/4homes/on-tv/relocation-relocation/phil-kirstie-s-top-5-tips-to-bagging-a-bargain-house-09-01-07_p_6.html Read More