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Contents

Section 1 Introduction

Section 2 Resources and Production

Section 3 Demand

Section 4 Supply

Section 5 Price Mechanism

Section 6 Property Finance and Investment                                   

 

Description:  This unit introduces the principles of economics as it appertains to the development of projects within the Construction industry.

Author:  Gates MacBain Associates


Section 1 Introduction

The principles of economics need to be understood by all managers, as economic factors will play a major part in the majority of business decisions. Economics is the social science concerned with the production and consumption of goods and services, and the analysis of the commercial activities of society. In this unit we will look at the principles of economics which you will need to be aware of. 

When a product is developed resources are required to make it, and the same applies with the provision of services. The process of production requires the allocation of resources to that process. Resources which are used for one purpose cannot simultaneously be used for another. For example, if a piece of timber is used to make a table it cannot also be used to make a chair. If a development site is used for an office block it can not be used for a supermarket. However, at some time in the future the office block may be demolished to make way for a supermarket.  

The study of economics looks at the allocation of resources between the competing alternative uses, each of which has costs involved with their production. If resources are used for one product or venture then the value of the alternative uses are lost at that particular time - this is known as Opportunity Cost.  As resources are limited, choices have to be made between these alternative uses. Finance also has an opportunity cost in that if money is invested in a project it is expected to bring a certain return. This money cannot also be invested in another project, which may result in a lost opportunity.   

Costs may be assessed in a number of ways, though the main one is in financial terms. This looks at the amount of money that can be made or the amount that will be required.




Section 2  Resources and Production




Aims and Objectives

At the end of this section you should be able to:
  • Explain the type of resources that are required in order to produce a construction project.

In order to produce items a number of resources will be required.  The organisation of these resources to produce a product is known as production. 

Production is the sequence of operations whereby certain items or materials are input into a process, at the end of which products emerge as output.  


Resources  

In order to produce commodities a number of resources or factors of production are required, these are: 
  • Land
  • Labour
  • Capital
  • Entrepreneurial Function

Land 

This is the natural resources used in the production process and includes: 
  • Land farmland, woodland, storage areas
  • Water water courses, lakes, the sea
  • Natural resources minerals, fuels, chemicals.  This would include fish and timber.

The type of land resources will dictate, to a certain extent, the type of industry and society that exists.  Consider the tropical rain forest of South America, Oil resources of the Middle East and fertile land of North America.  A farming region will have a low population, an industrial region a high population. 


Labour 

Labour as a factor of production means not only those who produce products i.e. a bricklayer, but also those who provide a service i.e. the architect. A number of demographic factors need to be taken into account when considering labour, these are: 
  • Effects of migration
  • Age distribution the average age of the UK population is increasing
  • Policies on retirement
  • Geographical distribution of the work force
  • Sex structure of population suitability and willingness to do certain jobs
  • Skills surpluses and shortages
  • Unemployment levels

Capital 

This, in economics, does not just mean money; it also means the raw materials, plant, machinery or any other commodity which helps to produce further goods or services. 

Capital would include, in the construction process, all materials, equipment, site huts and office furniture.  It would also include the factory premises used to i.e. make bricks.  


Entrepreneurial Function 

This is the risk taking and organising element of production and would include the following: 
  • Discovery, recognition and development of profit making opportunities
  • Providing or acquiring funds for an enterprise
  • Organising the other factors in order to make a profit
  • Supervision of production

Use of Resources  

Scarce resources need to be allocated between competing alternative uses.  As production takes place, the goods created known as economic goods use the resources.  The resources have costs associated with them: These may be: 
  • Financial costs these involve the money spent obtaining the resources and converting them into a product.
  • Opportunity costs this means the resources allocated to one use cannot simultaneously be used for something else, i.e. a piece of land used for the construction of an office block cannot be used at the same time for housing.  This can be changed later when the office block is demolished and the land used for something else.  Opportunity cost is therefore concerned with the loss of the value of the next best use at any particular time. Opportunity costs are important when the government considers how to share its taxation revenue between defence, education, health and other competing uses. 



Websites



Publications

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



Self-Assessment Task

  • List each of the types of resources required in the production of a construction project and show examples of each explaining why each is needed.





Section 3  Demand




Aims and Objectives

At the end of this section you should be able to: 
  • Explain the factors which affect demand
  • Outline the reasons for shifts in the demand curve
  • Explain elasticity of demand


In a market economy an item or service will only be produced if there is a demand for it and if a producer can make a profit by making and selling 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 

There are a number of factors which affect demand. These are: 
  • Market Considerations.   This will consider if the population is growing or declining in given areas. It will look at disposable income, the state of the economy, wages or salaries, taxation, employment and the availability of finance. It will also consider the reasons for purchasing the goods or services.
  • Company and Product Considerations. This considers the company's and product's reputation and how well it advertises.
  • Demand for other Products. This will look at the competition there is in terms of price, quality, perceived value and aesthetic appeal.

Demand is linked to price in that:                 

If the price increases, the quantity demanded falls                
If the price decreases, the quantity demanded rises. 

This means that if the price of an item rises, fewer people will want to buy it, conversely, if the price is reduced there will be a greater demand for the item.   


Demand is linked to price in that:         

As price increases, quantity demanded falls        
As price decreases, quantity demanded rises. 

This can be shown by a demand curve, which shows the consumer behaviour in a single market.   

 
Demand Curve 

The curve is constructed from the individual demand curves for all consumers in the market. The gradient of the curves fall, which falls from left to right, depends on the elasticity of demand.  

The downward slope of the curve confirms that consumers demand more of the item as the price falls. 

In the graph shown it can be seen that at a price of £15 their is a requirement for 30,000 items. If the price falls to £5 there will be a requirement for 40,000 items. An increase in price to £15 will reduce the demand to 20,000. 


Demand_Curve
Demand Curve

The movement along the demand curve is due solely to price changes in the  product and is referred to as changes in quantity demanded. The demand curve itself does not change position on the graph.  


Shifts in the Demand Curve 

Demand can change for reasons other than change in price. This will cause a shift in the demand curve. Here the demand curve will move to either the right (causing an increase in demand D2) or to the left (resulting in a decrease in demand D3).   



Shifts in the Demand Curve


Reasons for a Shift in the Demand Curve 
  • Taste or fashion.  Health related information can affect life styles, also clothing, mountain bikes.
  • Price of substitutes.  Most items have close substitutes. An increase in the price of one item is likely to increase the demand for its substitute. The demand curve shifts to the right even though its price has not altered. (Shortage of plastic due to oil crises)
  • Jointly demanded products (vehicle & petrol, hardware & software)
  • Income.  For demand to be effective it must be backed by money. If real disposable incomes are increased the consumer can afford to pay more for the item.
  • Population.  Changes in population, age and geographical situation influences demand, e.g. ageing population increases demand for sheltered housing and healthcare. 
  • Innovation  New goods effect the demand for current products e.g. CDs replacing vinyl LP's.

Elasticity of Demand 

Elasticity of demand is the degree of responsiveness of the movement of   demand due to movement in price. Demand is said to be elastic when a relatively small variation in price produces a marked variation in the amount demanded. 

The price elasticity of demand for a product measures the responsiveness  of the quantity demanded to a change in its price. The more elastic the product (slight changes in price causing proportionally greater changes in demand) the more final products will need to be produced. 

Elasticity of demand may be: 
  • Inelastic.  In this case there is a smaller proportionate change in the quantity demanded than in the proportionate change in price. The price may be increased by a large proportion though demand stays much the same.
  • Elastic.  Here there is a larger proportionate  change in the quantity demanded than proportionate change in price. A small increase in price will mean a large reduction in the demand for the product.

Price elasticity is influenced by: 
  • Availability of substitutes.  Where a product has a close substitute, (e.g. timber or uPVC windows), demand tends to be elastic as it is easy for the consumer to switch between the two. If substitutes do not exist there is less competition and demand is therefore more inelastic.
  • Percentage of spending on the product.  Cheaper products have inelastic demands because increases in price have little effect on consumer spending. Higher cost items involve the consumer looking for alternatives. Consumer durable goods have price elastic demands as consumers will go without the item.
  • Addiction.  In the case of tobacco or alcohol the consumer does not make price rational decisions, therefore, price movements have little effect which makes the price inelastic.

The elasticity of a product will have an effect on the total revenue it brings in should there be fluctuation in the price. This is particularly important with regard to the governments decisions on taxation, for example petrol, or alcohol (the fall in sales is lower than the rise in income generated from the price or tax increase).   


Effect of Elasticity of Demand on Industrial and Commercial Buildings 

The demand for industrial and commercial buildings is derived from demand for the goods or services that the 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 would be a reduction in the cost of the final product. This may mean more sales and consequently more production capacity being required, which can mean more buildings. 

The more elastic the product (slight changes in price causing proportionally greater changes in demand) the more final products will need to be produced. Price elasticity depends on: 

1.   The proportion of the cost of the final product which is made up of the cost of the buildings. The cost of the product will to a certain extent depend on the cost of the buildings. The relationship of building costs and the cost of the product significantly affect the price of the product, if there are changes in the cost of the buildings. This means that if a large proportion of building costs are in the final product and building costs rise, the cost of the final product will rise which may mean a fall in demand. 

2.    Flexibility of the production process. It may be possible to alter the capacity for production of the existing buildings by rearranging or installing new, smaller machinery. In such cases demand for buildings will be fairly elastic and a rise in the price of buildings will significantly reduce the demand for buildings. Alternatively, expansion may require new buildings in order to meet with current technology or legislation, demand here is less elastic.   
   



Websites



Publications

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



Self-Assessment Task

  • Explain why there can be a fluctuation in the demand for a product and the effect that elasticity will have on the demand for a product. 





Section 4  Supply




Aims and Objectives

At the end of this section you should be able to: 
  • Explain the factors which affect supply
  • Outline the reasons for shifts in the supply curve
  • Explain elasticity of supply


Supply may be price driven or demand driven. The more the price of an item rises the more items the producer will want to supply as this will mean that the supplier will increase profits. Therefore:         

If the price increases, the quantity supplied rises        
If the price decreases, the quantity supplied falls.  


Shifts in the Supply Curve 

The supply curve will shift due to: 
  • Change in production costs. This will affect the firm's profit margins and supply levels. New machinery can reduce time of production and labour costs increasing productivity.
  • Competition.  This should lead to increased efficiency in use of resources and higher output at given cost levels resulting in increased production and supply.
  • Other products.  Where production produces a number of products, e.g. petrol and oils, an increase in the production of one product will result in the increase in supply of all jointly produced products.
  • Government policies.  The levels of taxation affect total costs and thus supply levels. Changes in the law may require new methods of production or increased costs i.e. clean air legislation.  Government can impose subsidies or quotas in order to influence prices.


Elasticity of Supply 

Elasticity of supply is determined mainly by the ease with which producers can change their level of production. The construction of an office block requires investment months or even years ahead of actual production. This makes it difficult to alter production which means that they are inelastic. Products which can be stopped or changed at short notice are elastic in supply. 

Supply may be price driven or demand driven. The more the price of an item rises the more items the producer will want to supply. Therefore:         

As price increases, quantity supplied rises        
As price decreases, quantity supplied falls. 

Higher prices increase profits so firms will increase output and new firms will begin to produce the product. 

The supply curve is therefore, opposite to that of the demand curve.



Websites



Publications

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



Self-Assessment Task

  • Explain why there can be a fluctuation in the supply of a product and the effect that elasticity will have on the supply of that product. 




Section 5  Price Mechanism




Aims and Objectives

At the end of this section you should be able to:
  • Explain the methods of pricing strategies


A price is a means of assessing value and/or making comparisons of value. Like money price has no value in itself but it is a means of measuring value. Therefore, the market, or equilibrium, price is established when demand equals supply. 

If consumers demand 100,000 units and the producer supplies 200,000 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. 

If prices are fixed,  as is the case through decisions made by the European Community, surpluses may occur (e.g.'wine lakes' and 'butter mountains'). Conversely, shortages may result in rationing and the demand for goods on the 'black market'.  


Methods of Pricing 

The method of pricing will depend on the product itself and the demand for it. Pricing must take into account not only the number of variables but also that they are continually changing. The methods include: 
  • Competition Based.  This is based on the going rate, what competitors are charging. Prices may then be set in line with, above or below this.
  • Cost Based.  This is the cost of producing  the item with a percentage added on for profit.
  • Demand Based.  The greater the demand and smaller the supply, the more that can be charged. There is a need to be able to assess demand and know what price the market will stand.
With some commodities like housing, it can be a combination of all three methods.   


Pricing Strategies 

As well as the methods of pricing, there are a number of strategies which can be adopted, these include: 
  • Market Penetration.  Low prices are set to penetrate or corner the market. This policy is only valid if the market is very price sensitive, or if production costs fall with increased volume.
It is important to consider supply capacity or 2nd hand items may sell for more than the new. This was in the case of the Jaguar XJ12 motor car. On its launch, demand was far greater than supply, which meant that some people who had reserved a vehicle early could buy an XJ12 and then immediately sell it on at a profit.

  • Short term Profit Maximisation.  If you make as much profit as possible when there is no competition, prices will fall back later when other firms start supplying similar items.
  • Product Line Pricing.  The use of a 'loss leader' in retailing to bring people in to buy high profit goods. This is used in supermarkets when certain items are sold very cheap as people will normally do the rest of their shopping when they buy the cheap items. For example, in 1996 the price of a tin of baked beans was reduced by some British supermarkets to 3 pence. 
  • Variable Pricing.  Different prices set for different times, for example, holidays are cheaper off season, or off peak priced electricity. This encourages people to buy in a period when trade is quiet.
 
Changes in Price 

This can affect: 
  • Volume of sales.  If the price is reduced the volume of sales can increase.
  • Marginal Costs.  The more items that are made, the more there are to distribute the standing costs between. For instance if the standing costs (costs which must be paid regardless of the number of items produced, like rent, rates, staff wages) are £1,000 a week and the factory makes 1,000 items per week then £1 must be added to each item to cover these standing costs. However, if 2,000 items are made this would reduce the amount to £0.50 per item.
  • Customers perception of value. The customer is more likely to pay more for an item if they perceive that they are getting a superior product (e.g. Rolex watches or BMW cars).
  • Competitors reaction. If one manufacturer reduces their prices it is possible that other manufacturers producing the same type of item will reduce theirs as well. This may lead to 'price wars'.
Reductions in price can have a negative effect as well as a positive one. 

If prices fall people may think:
  • The product is faulty or inferior.
  • The company has financial difficulties.
  •  Further reductions may take place.
Prices will fall if there is:
  • Excess capacity.
  • Falling share of the market.
  • Aggressive selling.
Prices will rise if there is:
  • Strong demand.
  • Inflation.
  • Lack of competition.
Reduction in price can be disguised by given discounts or including extras  (e.g free insurance with new cars or 0% interest rates), though a discount is usually a payment for a service, for example, a cash 'award' if goods are purchased within a certain time. Alternatively special offers dressed as promotional offers can be used.  

Many people believe that higher price means higher quality: "You only get what you pay for", many successful organisations price for this very fact.  



Websites



Publications

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



Self-Assessment Task

  • Discuss the options that a speculative house builder will need to consider when deciding on the price of houses to be constructed on a new development.




Section 6  Property Finance and Investment




Aims and Objectives

At the end of this section you should be able to:
  • Explain the different types of finance and the situations in which they may be used.


Financing a Project 

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 and is not related to the financial success of the project. The likely return, from the investor's point of view, is predictable and reasonably secure. 

Debt funding is normally provided by the banks, although there is an increasing use of capital market instruments.  Such instruments are beyond the scope of this book. 

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.  

The amount that the bank would expect the developer to put into the project would depend on the level of risk. A project which is pre-sold or pre-let presents less risk than a speculative project. It is normal, however, for the developer to contribute 10 - 20% of the total anticipated costs for the project. 

The developer would be expected to contribute any additional finance over and above the agreed amount of the loan should it be required. 

In a project to be developed which, on completion, would be valued at £1m, the development costs could, for instance, amount to £800,000. The bank would be willing to advance 70% of the value of the completed project, which would be £700,000, this would require the developer to inject £100,000. 

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: This will be dealt with later. In such a situation the bank would receive either a share of the profits of the completed project or an extra fee. 

For large projects the finance can be syndicated between a number of banks. 

It is normal for a development to produce a profit of around 20% on costs, although a lesser profit may be acceptable it should not fall below 15% as additional development costs would erode the profit to an unacceptable amount.  


Bank Security 

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. 

The form of security is likely to be a floating charge over the site and the development. However, since the introduction of the Insolvency Act 1986, the bank will probably want to take a floating charge over the borrowing company. If this is the case, it may be advisable for the developer to form a subsidiary company for the development which is to be financed. 

If the completed project is to be retained the bank may require an authority from the developer which would, in the event of the developer defaulting, allow the bank to collect the rents from the tenants. The bank would hold the signed authority, though would not date it. In the event of the developer defaulting the authority could be dated and activated.  


Bank Fees 

A number of fees will be charged by the bank. This will be to cover the cost of arranging and managing the loan. A commitment fee will also be charged on the amount of the loan which remains unused, this will be charged at periodic times over the life of the loan. A fee would also be payable if the developer does not take up the loan after it has been arranged or if it is paid prior to the life of the agreement.  


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.   

If the developer provides some of the finance, the institutions may purchase the completed project, once it is let, at a lower yield. This would give the developer a higher investment value and a larger profit margin.     


Investment Appraisal   

It should be borne in mind that the property market is cyclical in nature. At times, Property as a medium for investment, performs well and can out-perform inflation. While at other times rental growth can under-perform inflation while capital values can actually fall. Property investment has, therefore, an income and a capital element.   

Something which must be considered by an investor is that property is not a liquid asset. It can take a number of months to transfer the ownership of property. Even if agreed, a sale is uncertain until contracts are exchanged. The ability to convert it to cash is dependant on the demand for the property. This will be affected by the state of the economy at the time which will have an affect on the property market.     


Investors Assessment Criteria   

In assessing whether to lend for a development a bank will consider not only the project itself but also the potential borrower.  The bank will look at the cash flow of the scheme and its viability both from an economic and from a marketable point of view.   

The bank will want to know about the balance sheet of the borrower and its past trading records. It will consider the qualifications and experience of the principals, the commitments which already exist and the strength of its guarantees. Not only are these factors crucial in determining whether the bank is prepared to advance the money but also the rate of interest which it is likely to charge.   

Institutions will assess the risk involved in a project as they have to consider the likely profit from the investment for their policyholders. As they have to account for the performance of their investments, they tend to lean towards certainty. However, they may adopt risk as a means of obtaining a greater return.   

Institutions tend to prefer prime sites as these are more marketable, even though these may bring a lower initial yield. The portfolio will, however, probably cover a spread of different types of property in order to spread the risk.



Websites



Publications

  • Manser, J, (2002),  Economics a foundation course for the built environment, London: Spons
  • Fellows, R, Langford, (2002), Construction Management in Practice 2nd Ed, Oxford: Blackwell



Self-Assessment Task

  • Discuss the options available for a property developer to finance the development of an office building.
  • State the factors which would be relevant in deciding on the method.




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