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Contents

Section 1 Economy and the Industry

Section 2 Influences

Section 3 Supply, Demand and Price in Construction

Section 4 Finance
                                                        
 

Description:  This unit introduces the elements of economics within the Construction Industry and the constraints that they exert.

Author:  Gates MacBain Associates


Section 1  Economy and the Industry


The success of the construction industry is closely connected to the economy of the country.  If the country is doing well then the construction industry is likely to have more work.  The reason for this is that if the economy is doing well more disposal income exists within the population, individuals are more likely to buy goods, thus companies will produce more. In order to do that they may need a new or larger factory and/or offices. People will also feel more confident about their future and more likely to move to a new home. This results in more activity for banks, building societies and finance companies and also for the shops providing the goods which people need. Also people are more likely to spend on luxury goods and services if they are confident about the future all of which provides additional work for the construction industry. 

It will be seen therefore, that the demand for industrial and commercial buildings is derived from demand for the goods or services that a firm produces, as the firm needs the buildings in order to be able to meet the demand for their product or service. 

If the cost of buildings increase this increase must be added on to the capital cost. This will result in an increase in the cost of the product. Conversely, if building costs fall there is a reduction in the cost of the final product.  

It is essential, therefore, that you understand the economy and the factors which affect it. You will be looking at economics in greater detail in another module although we will look at some of the basic principles in order that you are aware of its’ importance and the effect it has on the industry.  




Section 2  Influences




Aims and Objectives

At the end of this section you should be able to:  
  • Outline the importance of the relationship of Fiscal and Monitory Policy to the Construction Industry.

The industry is influenced by a number of factors both by the market and by the government, let’s starts by looking at the influence that the government can have on the industry.  


Fiscal Policy 

Fiscal policy involves the Government changing the levels of Taxation and Government spending. Government influences the level of economic activity. It aims to reduce the rate of inflation and stabilise economic growth, avoiding the boom and bust economic cycle which has been a significant part of the construction industry.  

In managing public expenditure and raising the money to pay for it, the government has to decide on:  
  • The Forms of Taxation
  • The Volume of Spending
  • Monetary Policy
  • Market Considerations

The Forms of Taxation  

Taxation can have an influence on spending and working behaviour, and the distribution of income in society. A balance is normally made between direct (income tax) and indirect (VAT). The government also needs to consider that too much tax can create tax exiles who then take away a large source of income from the country. This can also cause multinational companies to relocate elsewhere.   


The Volume of Spending   

The Government must decide not only on the amount of spending, but also the division between current (salaries, textbooks) and capital items (roads, hospitals). It is easier to cut capital spending where a project can be shelved than sack workers.  To find out more about Fiscal Policy select ‘Guidance on Economics’ from the Website box and select Fiscal Policy; though while you are on the site have a look at some of the other options available.  


Monetary Policy 

Strictly speaking the UK Monetary Policy is set by the Bank of England and they are independent in setting interest rates, they are answerable to the Government in maintaining inflation within a target rate, which is to keep inflation within a target of 2% +/-1  

Monetary Policy involves using interest rates to influence the levels of consumer spending and Aggregate Demand. It is the attempt to influence the level of economic activity and income by changing the availability and cost of money.   

More information is available on the ‘Guidance on Economics’ from the Website box and select Monitory Policy. 


Market Considerations 

The type of economy in the UK is a market economy, in this resources is allocated by the price mechanism. The decision as to the type and amount of goods to produce and their price are decided by firms or individuals, not a central planning authority like the Government. Resources are in private ownership, this is known as 'free enterprise'.   

The main factor which influences supply, demand and price is the motive for profit.  A firm will only produce items if people want to buy the items it produces and it can sell them at a price sufficient to make a reasonable profit.   

You can find out more about market considerations by reading the appropriate chapter in the book ‘Economics’ shown below, although we will need to understand the relationship between supply, demand and price which we will look at in the next section.




Websites



Publications

  • Manser, J, (2002),  Economics a foundation course for the built environment, London: Spons



Self-Assessment Task

  • Discuss ways that the current economic situation within the country can affect the level of work within the construction industry.
  • Differentiate between Fiscal and Monitory policy.





Section 3  Supply, Demand and Price in Construction




Aims and Objectives

At the end of this section you should be able to: 
  • State the relationship between Supply, Demand and Price as it affects the Construction Industry.

  

Demand

An item or service will only be produced if there is a demand for it and if a producer can make a profit by producing it. 

Demand refers to a desire, or want backed by the ability and willingness to pay an appropriate price for the satisfaction of that desire or want.


Factors which affect Demand

  • Market Considerations.   Looks at whether the population is growing or declining in given areas. It will consider their disposable income, the state of the economy, wages, taxation, employment and the availability of finance. It will also consider the reasons for purchasing.
  • Company and Product Considerations. This will depend on the company's and products reputation; it will also consider how well it advertises.
  • Demand for other Products. This will consider at the competition and their price, quality, perceived value and aesthetic appeal. It will also consider whether we buy a new house, a second hand one or rent property.

Supply

Supply may be demand driven or price driven. 

The greater the demand the more items the producer will want to be supply as they will be able to make profit on each item sold, the more items supplied the greater the profit. Consequently production will increase.  If however, manufactures are unable to sell items, such as the speculatively built houses, they will reduce production.

If the demand exceeds supply the price is likely to increase, when the economy is doing well and there are more buyers for houses than houses for sale then the price will increase. The more the price of an item rises the more items the producer will want to supply. Higher prices increase profits so firms will increase output and new firms will begin to produce the product.

If few people want to buy houses there will be a glut on the market and the price will fall in order to make them more attractive to purchasers. 

If we look at it from the contracting point of view if there are few people wanting work done, contractors will reduce their price for the work in order to try to be more competitive and hence gain some of the work that is available.

From this you will see the link between supply, demand and the final factor; Price.


Price

A price is a means of assessing value and/or making comparisons of value.  The method of pricing will depend on the product and the demand for the product.

Pricing must take into account not only the number of variables but also that they are continually changing.


Market Price

The market, or equilibrium, price is established when demand equals supply.

If consumers demand 20,000 units and the producer supplies 40,000 a surplus is created which will cause the price to fall. This will then lead to an increased demand which will reduce the supply establishing an equilibrium (state of rest) price.

If the price were set below the equilibrium price, shortages would result due to demand exceeding supply. This would encourage firms to increase prices and supply until equilibrium was restored. 


Methods of Pricing 
  • Competition Based.  This is based on the going rate, what competitors are charging. Prices may then be set in line with, above or below.
  • Cost Based.  This is the cost of producing the item with a percentage for profit added on.
  • Demand Based.  The greater the demand and smaller the supply, the more you can charge. You need to be able to assess demand and know what the market will stand.
In housing it can be a combination of all three methods.

To obtain a greater understanding of these principals you should read the appropriate chapters in ’Economics’ book shown below.




Publications

  • Gatepain, R & Jones, IE, (1996) Management for the Professions, RIA publishing: Lincoln (Chapter 2)
  • Manser, J, (2002),  Economics a foundation course for the built environment, London: Spons (Chapter 3)



Self-Assessment Task

  • Explain the relationship of supply, demand and price with regard to the selection of the components for the provision of windows for a renovation contract.





Section 5  Finance




Aims and Objectives

At the end of this section you should be able to: 
  • State the types of finance and their sources.


We have seen previously how the availability of finance can affect the economy and the Construction Industry.  If interest rates are high  it makes the cost of borrowing high and can prevent people from being able to afford to purchase items, particularly houses where a rise of 1% in the mortgage rate can significantly increase the monthly repayments. 

Finance can be classed as short term, medium term or long term. The use for which the finance is required will determine which type of finance is obtained. 

Short term finance is normally accepted as being up to 1 Year. In the Construction Industry this will be required for the development of the project and is therefore known as development finance. Short term finance taken as an overdraft is repayable on demand. 

Medium term finance refers to loans of between 1 - 5 years. This type of finance can be required due to the developer wanting to retain the project for investment, although not wanting to finance long term until the project was let and the increased rental increments had been achieved.  

Long term finance refers to financing which is taken over a period in excess of 5 years and will include a mortgage. 

(It should be noted that a number of sources define these periods in differing lengths of time i.e. short term can be up to 3 years, medium 3 - 10 years, long term over 10 years)  

Finance may be obtained either through borrowing (Debt Finance) or through the sale of shares in the company or by an institution obtaining an equitable interest in a project (Equity Finance).  


Debt Finance
 
Debt finance is in fact borrowing. The borrower guarantees to repay the money after or over a definite period. The amount that the borrower pays for the money is expressed in fixed terms. Debt finance is normally provided by the banks, although there is an increasing use of capital market instruments.   

A large proportion of debt finance is provided at local level by the clearing banks for small and medium sized projects. 

If the bank believes that the project is likely to be a success they may be prepared to lend the developer between 65 - 70% of the value of the project although this will depend on the economy at the time and on the current monitory policy.  

Banks, which frequently deal in finance for property development may participate in the project by lending up to 100% of the development costs. This is an equity participation loan which we will look at later. In such a situation the bank would receive either a share of the profits of the completed project or an extra fee. 

The bank is likely to require some form of security for the amount of the borrowing in order to cover itself in the event of the developer defaulting.  


Sources of Finance

Short term Finance  
Overdrafts 
Short-term Loans 
Creditors
Hire Purchase 
Factoring and Invoice Discounting  

Medium term Finance
Loans
Leasing 
Debentures 
Realisation of Assets  

Long term Financing 
Mortgage loans 
Sale and Leaseback 
Retention of Profits   


Equity Finance
 
In Equity finance there is a financial interest in a venture on the part of the investor. The return to the investor depends entirely on the profits made by the project. The return may be through an increase in the value or from an income derived from the venture.  

Pension Funds and Insurance Companies are traditionally the main investors in property and are the main suppliers of this type of finance.  

The amount of money that these institutions are prepared to lend for property investment itself has an affect on the property market. The more money that the institutions make available for property investment, the greater the demand there will be for property to invest in. This will result in an increase in the price that a purchaser is prepared to pay and can contribute to the increase in property prices. 

The amount of cash which is available from the institutions also depends on the performance of equities and gilts (the other types of investments for institutions) and the amount of property in the institutions portfolios. 

Institutions may provide 100% of the development finance and commit themselves to purchase the completed project. 

Speculative developments must not however, be finance-led, but should be tenant-led and produced only if there is a market for that type of development. Over supply of a type of development ( e.g. office accommodation ) will result in the failure of the project.  



Publications

  • Gatepain, R & Jones, IE, (1996) Management for the Professions, RIA Publishing: Lincoln (Chapter 13)
  • Manser, J, (2002),  Economics a foundation course for the built environment, London: Spons (Chapter 19)



Self-Assessment Task

  • State the two types of finance that are available to finance construction projects and where they can be obtained from.




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