Theories and Models of Economics in the Construction Industry - Term Paper Example

THEORIES AND MODELS OF ECONOMICS IN THE CONSTRUCTION INDUSTRY INTRODUCTION Economic theories are usually divided into two types of analysis: microeconomics and macroeconomics. Microeconomics focuses on individual decision making by both individuals and firms. On the other hand, macroeconomics is the study of phenomena encompassing the entire economy resulting from group decision making in entire markets. Modern economic theory also blends together microeconomics and macroeconomics, using microeconomic analysis as the basis for macroeconomics. According to Myers (2004), “the study of any specific industry involves both microeconomic and macroeconomic approaches”, especially for a multiproduct industry with national and international significance. Such a sectoral, intermediate approach is known as mesoeconomics. Therefore, to gain a comprehensive understanding of construction activity, the three perspectives that need to be included are: a broad macro overview of the economy, a specific sectoral study of the construction industry, and a detailed micro-analysis of the individual markets in which the construction firms operate. Thesis Statement: The purpose of this paper is to discuss the statement that successful construction industry participants must possess a good understanding of theories and models of economics. DISCUSSION The construction sector is composed of the value-added activity of firms that construct buildings and infrastructure; and include on-site activities pertaining to infrastructure; housing; public non-residential construction such as facilities and institutions; private industrial construction such as factories, private commercial such as shops, and the extensive area of repair and maintenance which constitutes nearly 50 percent of the total annual activity. In the production of any economic goods or services, as in the construction industry, there is a requirement for using scarce resources such as “land, labour, capital and entrepreneurship” (Myers 2004, p.17). Construction comprises of a diverse range of markets, with a large number of comparatively small enterprises. The exchange of information between buyers and sellers about factors such as price, quality and quantity takes place in a market. “Economic models are simplified representations of the real world that we use to understand, explain and predict economic phenomena” (Myers 2004, p.13). A set of assumptions are at the basis of every economic theory or model. To what extent the assumptions make the theories effective is more important than the extent to which the assumptions are realistic. The Fairclough Report (2002, p.34) has recommended the construction industry to use economic theories based on improving “sustainability, competitiveness, productivity and value to clients”. Economic models attempt to identify the relationships between the key variables and they simplify the processes in the sector. The theories have practical applications though they may appear abstract. They help to explain the central issues being studied, though they may not analyse every detail of the real world aspect. Economic models provide starting points, reference points and frameworks to determine how construction in a particular project deviates from or reflects the model. Additionally, economic theories support continual validity testing and guide further progress in construction. The Theory of Procurement Contracts Procurement in the construction industry has a significant place in the study of economics. A greater emphasis is found to be on procurement in the public sector because of its immense importance to the economy. Both governmental as well as private sector transactions are governed by procurement contracts in several industries including building construction. “Modern economic theories of procurement use mechanism design to model the procurement problem as one of ex ante asymmetric information coupled with moral hazard” (Bajari and Tadelis 2001, p.387). This means that the seller has information about production costs that the buyer does not have. The buyer screens the seller by offering a list of possible contracts from which the seller selects a particular contract, thus making known his private information. This is the normative way explaining how the project should be addressed, under the assumption that ex ante asymmetric information is the major concern. On the other hand, in descriptive engineering and construction management, menus of contracts are not used. Instead, most contracts are variants of simple fixed-price (FP) and cost-plus (C+) contracts. In the fixed-price contracts the buyer offers the seller a prespecified price for completing the project. However, cost-plus contracts do not specify a price, but reimburse the costs to the contractor along with a stipulated fee. The researcher found no evidence on either the contractor or the buyer having private information at the onset of a procurement project. However, both share uncertainty about essential “design changes that occur after the contract is signed and production begins” (Bajari and Tadelis 2001, p.388), such as changes in regulatory requirements. It is clear that procurement problem is fundamentally one of ex post adaptations rather than ex ante screening. Mechanisms that are important in solving the adverse- selection problem include “competitive bidding, reputation, and bonding companies that insure the buyer against default by the contractor” (Bajari and Tadelis 2001, p.388). The authors determine the economic forces that influence the choice of procurement contracts, which is based on two specific questions: If restricting focus to FP and C+ contracts, when should each type of contract be used, and secondly what explains the widespread use of these two simple contracts. The model has a novel approach, since it treats both choice of incentives and of design or contractual incompleteness as endogenous variables in the procurement problem.”The empirical regularities in which these contracting components appear to move together, are consistent with the complexity of the project being procured” (Bajari and Tadelis 2001, p.388). Moreover, the model has concepts similar to Transaction Cost Economics (Williamson 1975, 1985) which states that low incentives are good to accommodate ex post adaptations and this is the reason for commending cost-plus (C+) contracting. But these advantages make it more costly. With the use of C+ contracts, “the cost-reducing incentives disappear, but the process of adaptation is far smoother because the reimbursement process is simple, well defined, and leaves little room for haggling” (Bajari and Tadelis 2001, p.404). This model is useful for procurement in both public and private sectors. C+ contracts rather than fixed price (FP) are preferred for more complex construction projects. Theory of Competition in the Market Place According to traditional economic theory, inter-company competition seeking opportunities for profit works as “an efficient allocator of resources in a decentralized economy” (Suzumura 1995, p.1). The role of competition in the market place pertains to the first and fundamental theorem of welfare economics which considers that a perfectly competitive welfare economy gets a Pareto-efficient resource allocation as long as the existence of a competitive equilibrium is essential. A state of perfect competition in the market place is a state in which the number of competitors is very large, whereby no single competitor would be able to influence market prices on its own. This led to the belief that strengthening inter-firm competition by increasing the number of competing firms would lead to economic welfare. Contrastingly, a second conventional concept exists pertaining to competition in the market place and economic welfare. This is supported by a large group of people outside the academic circles, who are in business and those who are related to developing industrial policy.This concept believes that doing too much is as bad as not doing enough, and it applies to market competition also. For competition to work as an efficient allocator of resources, “it should be kept under deliberate public control” (Suzumara 1995, p.1). This approach perceives competition as a necessary evil at best, and is capable of serving a socially useful role, but only when under the control of dependable public policy authorities. This relates to the concept of excessive competition, and is considered to be self-contradictory by supporters of the first type of competion in the market place. However, it is a true fact that competition in the process of weeding out the losers from the winners, possibly creates friction and waste. Such a process of “constructive deconstruction” (Suzumara 1995, p.1), with fierce competition eliminating firms operating below the expected standards, is necessary for overall benefit of the industry and the buyers and sellers. This motivates firms to innovate new techniques for competitive survival and distinction in their field, as in the construction industry. Further, excessive competition may result in information regarding demand, technology and resources being widely dispersed, and resources may fail to be made available. Additionally, governmental action towards avoiding the social costs by keeping excessive competition under appropriate control, might result in unnecessary delay in adjustment, which however may be unavoidable. If the economic analysis which forms a part of welfare economics is able to find a proper meaning in an esoteric expression such as excessive competition, and identifies the dysfunctions of a competitive mechanism arising from excessive competition, the concept of excessive competition cannot be considered wrong. Consequently, public policy interventions to control excessive competition cannot have legitimacy. Hence, taking these factors into consideration in studying the role of excessive competition, Suzumara (1995, p.226) states that though uncontrolled competition may be exceedingly wasteful, “handcuffed competition may also be wasteful by suppressing spontaneous development which only free-market competition can nourish”. As a result, it is unclear which of the two evils should be promoted. According to Prasad and Fox (1996) the five competitive forces that ultimately influence the profit potential in an industry such as that of construction, are as follows: Threat of new entrants, bargaining power of buyers, threat of substitute products or services, bargaining power of suppliers, and rivalry among existing firms. For optimal results, traditional barriers between client and contracting firm should be removed. Minimizing the adversarial approach between the chief contracting firm and the subcontractors, “the philosophy of project partnering” (Prasad and Fox 1996, p.179) and promoting the strategic alliance concept particularly in the building construction industry, are all essential models to be followed for optimal results. Contracting firms should implement competitive arrangements with the idea of creating and improving competitive advantage in the construction industy. Theories on Construction Price Analysis and Construction Pricing According to Skitmore et al (2006, p.773) neo-classical microeconomic theory provides an appropriate analytical tool for construction price determination. Further, full-cost pricing is the “most commonly accepted pricing policy of construction firms”. It is a paradox that both are mutually exclusive theories, and only one of them, if any, can be correct. The authors examined both the statements given above, on neo-classical microeconomic theory and on full-cost pricing. Evidence from research indicates that the first statement on neo-classical microeconomic theory should be selected among the two. However, it is essential to note that the differences in the two theories can be clearly observed only in disequilibrium. On the other hand, in equilibrium, from a practical perspective, the difference between the two theories appears to be insubstantial. Additionally, the inherently uncertain nature of the construction industry makes the overall task of estimating costs and prices difficult to carry out. Hence, though Skitmore et al (2006) support neoclassical economic theory as the most suitable for construction price analysis, they state that it cannot be applied for the practice of pricing which is more highly related to the marketing discipline than economics. Free Market Model According to the free market theory of Adam Smith, the political economist, construction firms produce commodities in the free market, and competition among firms to be a low cost producer serves as a great leveller. “Smithian principles can explain much about the workings of the modern construction market” states Finkel (1997, p.21). Construction serves as a part of the free market enterprise system in that it is the sector creating wealth in the form of finished construction products. Karl Marx describes the unified framework through which the accumulation of wealth is achieved. There is a circuit of capital in which a sum of money is exchanged for labour power and capital leading to production resulting in commodities sold in the market. Free market exists when private individuals are allowed to obtain resources, to organize those resources and to sell those products in any way they wish to. The government or other producers cannot obstruct or restrict those in business from seeking profit by purchasing inputs and selling outputs (Myers 2004). All the members of the economy are free to choose, including workers who can enter the line of work they are best suited for. However, in a free market system, it is the consumer who holds the ultimate power and decides which products will survive. Secondly, prices signal the value of individual resources and act guidelines for both consumers and producers. Combining Industrial Organisation Economics with Supply Chain Concepts for the Construction Industry Construction and mainstream management supply chain is organized around four concepts: distribution, production, strategic procurement management and industrial organization economics. There is a need to develop an industrial organization economic supply chain model for construction. Combining together the supply chain concept with the industrial organization model “as a methodology for understanding firm conduct and industry structure and performance is an important contribution to both construction supply chain and construction economic theory” state London and Kenley (2001, p.777). Industrial organization methodology deals with the performance of business enterprises and the effects of market structures on market conduct including pricing policy, restrictive practices and innovation, and how firms are organized, owned and managed. The significant elements of market structure in these models refer to the nature of the demand based on buyer concentration, number and size of buyers; existing distribution of power among rivals; firms concentration, number and size of sellers, entry/ exit barriers; government intervention; and the physical structuring of relationships in terms of horizontal and vertical integration. The role of the industrial organization model is to give substance to the traditional neoclassical abstract concepts of market types (London and Kenley 2001). The industrial organization model of Ellram (1991) from a single organization’s perspective to manage the supply chain is as follows. The various types of competitive relationships that firms undertake include transaction, short term contract, long term contract, joint venture, equity interest to acquisitoin. These involve increasing commitment on the part of the firms. The key conditions under which supply chain management relationships are attractive from an industrial organization perspective need to be taken into account. It was found that supply chain management is simply a different way of competing in the market that falls between transactional type relationships and acquisition, and takes up different economic organizational forms. Other theories of economics in the construction industry include demand and supply, costs of the construction firm, types of market structure, and division of labour. CONCLUSION This paper has highlighted theories and models of economics in the construction industry. The models include approaches based on a broad macro overview of the economy, a specific study of the construction industry, as well as a detailed micro-analysis of the individual markets in which construction firms operate. It was found that successful construction industry participants are required to have a comprehensive understanding of the theories and models of economics. The economic theories of the construction industry that were investigated were: procurement contracts, competition in the market place, construction price analysis and construction pricing, free market, and combining industrial organization economics with that of supply chain. Significantly, the study of the economics aspect of construction were found to have some limitations such as: generalizations and models cannot be applied to several processes in the construction industry. This is because it has complex processes and unwarranted assumptions regarding what is possible due to the large variety of interests and parties involved in the projects. Further, economic analysis is only one of the disciplines in the construction process as a whole. Myers (2004) reiterates these views, adding that there also is a perceptible lack of vision about the role of construction in society and how it could better serve its clients. To overcome these limitations, it is essential that future research should focus on simplifying the processes, thus enabling meaningful assumptions leading to the development of relevant models. Similarly, further studies are required on improving the construction industry to provide better service to clients, followed by the development of appropriate models. REFERENCES Bajari, P. and Tadelis, S. (2001). Incentives versus transaction costs: A theory of procurement contracts. RAND Journal of Economics, 32 (3): pp.387-407. Ellram, L. (1991). Supply chain management: The industrial organisational perspective. International Journal of Physical Distribution and Logistics Management, 21 (1): pp. 13-22. Fabozzi, F.J. (2009). Institutional investment management: Equity and bond portfolio strategies and applications. New Jersey: John Wiley and Sons. Fairclough, J. (2002). Rethinking construction innovation and research: A review of government R & D policies and practices. London: Department of Trade and Industry. Finkel, G. (1997). The economics of the construction industry. The United States of America: M.E. Sharpe Publishers. London, K.A. and Kenley, R. (2001). An industrial organization economic supply chain approach for the construction industry: A review. Construction Management and Economics, 19: pp.777-788. Myers, D. (2004). Construction economics: A new approach. London: Taylor & Francis. Prasad, B. and Fox, M. (1996). Advances in concurrent engineering: CE96 proceedings. London: CRC Press. Skitmore, M., Runeson, G. and Chang, X. (2006). Construction price formation: Full- cost pricing or neoclassical microeconomic theory? Construction Management and Economics, 24 (7): pp.773-783. Suzumara, K. (1995). Competition, commitment and welfare. The United Kingdom: Oxford University Press. Williamson, O.E. (1975). Markets and hierarchies, analysis and anti-trust implications. New York: Free Press. Williamson, O.E. (1985). The economic institutions of capitalism. New York: Free Press. Read More