Construction Workers

Construction Industry Economics and Policy

A BLOG ABOUT THE STRUCTURE AND PERFORMANCE OF THE BUILDING AND CONSTRUCTION INDUSTRY

Updated: Feb 10




Purpose

  • This paper argues a market is created by the main contractor as they go through the subcontracting process, and introduces the idea that procurement of subcontractors for a project creates an identifiable, though temporary, market for goods and services.

  • The extent of market power held, gained or lost by participants as the procurement process goes through the stages of pre-bid, tender, final bid and negotiation, or some variation of those stages, is an important factor


A Project Market?

  • A market is “any arrangement in which the interaction of buyers and sellers determines the price and quantity of goods and services exchanged”.

  • A client is the buyer of a bundle of goods and services from the contractor/s bidding or negotiating for the project, and their interaction on the scope (quantity) and price of the project is resolved when the agreement or contract is exchanged. This could be called a micro-market.


Characteristics

  • The characteristics of markets are the number of buyers and sellers, the distinctiveness and substitutability of products, forms of competition, barriers to entry and concentration ratio, and the information and mobility of customers.

  • These market characteristics do not, however, carry over to industries with extensive subcontracting, such as building and construction, for three reasons.


Bargaining Power

  • There is only one buyer, and in such a market with a single buyer it is possible to gain market power through bargaining with potential suppliers.

  • The economic treatment of bargaining power uses the concept of outside options available to buyers and sellers, or the the best option that either the seller or buyer can achieve if they walk away from the negotiations. These walk-away options are the minimum negotiated outcome that the respective parties will accept.


Relational Exchange

  • Subcontractors are typically not engaged in a single transaction, as in pure market-based trades of instant exchange and settlement.

  • The relationship between a large corporation and its subcontractors is typically more durable and intensive than a market relationship.

  • Instead of using the market, the firm will rely on a trusted supplier, especially when their relationship involves shared knowledge and learning


Hybrids

  • There are ‘hybrid’ concepts such as the ‘quasifirm’

  • As developed by Eccles (1981: 339-40) for the construction industry where “relations between the general contractor and his subcontractors are stable and continuous over fairly long periods of time and only infrequently established through competitive bidding. This type of ‘quasi-integration’ results in what I call the ‘quasifirm’.”

  • It can be argued this concept of the quasifirm largely makes the concept of relational exchange redundant.


Temporary Markets

  • A different approach to long-term or continuous relationships is taken here, by arguing for the idea that a project creates an identifiable, though small and temporary, micro-market for the goods and services supplied by subcontractors.

  • While there may be relational aspects to the organization of production/projects between firms, the legal distinction between firms, markets and other arrangements remains real, and the legal status of the firm has not been undermined.

  • Conceptual boundaries are not contractual boundaries, and this distinction should not be ignored.


Monopsony Power

  • A market with single buyer is known as a monopsony (the opposite of a monopoly with a single seller).

  • The treatment of buyer power in economics is concerned with how downstream firms can affect the terms of trade with upstream suppliers.

  • A buyer has monopsony power if they can reduce the price paid below competitive levels by withholding demand.


Implications

  • Two questions that emerge from the range of factors discussed are:

1. How might a head contractor exercise their market power when dealing with

subcontractors?


2. What would be the implications of this market power for allocative and dynamic

efficiency in building and construction projects?



Market Power

  • In a first-price sealed-bid auction where the number of bidders is unknown and bidders are risk averse, the expected revenue to the seller is greater if the actual number of bidders is concealed.

  • Game theory suggests a risk-seeking subcontractor will be more likely to win work, at lower margins, if a contractor does not reveal the number of subcontract bids they receive.


Marginal Cost

  • This suggests contractors might be more focused on extracting as much surplus from subcontractors as possible, and they can do this through the bidding system used to award contracts.

  • If the subcontractor, or supplier, has no or little direct competition that firm will be able to negotiate favorable terms.

  • However, if subcontracts are put out to tender and the number of bidders is unknown, the winning bid will typically be below the market price, and also below marginal cost.


Conclusion

  • The use or abuse of market power is the core issue, and the standard approach to it is analysis of relative prices, typically using the Lerner Index to look for evidence of price manipulation in monopolistic or oligopolistic markets.

  • However, there is a much smaller literature on monopsony power and even less on market power in the context of auctions.

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Public Policy and a BES Satellite Account


The building and construction industry links to other industries in a variety of ways, and an earlier post suggested measuring the extent of the built environment sector in a satellite account is the best representation of the dense network of firms involved in the creation of the built environment. The data required to measure the contribution to GDP and share of the economy of the built environment sector is available, but scattered across separate industry data collections. This understates the macroeconomic importance of the built environment sector and the role it plays in improving the performance of cities.

Because building and construction is so diverse it is hard to get an overview of the industry. With a vast variety of projects in all possible locations made out of materials ranging from primitive to rustic to ultra-sophisticated the industry, particularly on a global scale, is so broad that some system of classification and categorization is necessary. With the development of the Standard Industrial Classification the industry has come to be defined by the data collected by national statistical agencies, but the role of the industry is much wider and deeper than the statistics show.

The typical view of the industry called ‘construction’, is an industry made up of three sectors, residential building, non-residential building and engineering construction. Because statistical data on activity and work done is presented in this form, most of the discussion and reporting of the industry also follows this pattern. This is not a bad thing, but is not truly reflective of an industry as diverse and wide-ranging as building and construction. Industry output statistics represent the industry as a set of functional projects, like detached housing or retail and railways or hospitals, despite the fact that many buildings are mixed use. Also, there are many other ways of classifying and categorizing building and construction projects.


The idea that the construction industry as measured in the national accounts or using the standard industrial classification of industries, is only one part of the creation and maintenance of the built environment and the range of industries that encompasses is not new. David Turin in the 1960s and the Bartlett International Summer School series in the 1980s advocated looking at the sector that produces the built environment in broad and integrative terms. The industry’s extensive linkages with other sectors, measured through the industry’s high multiplier effects gives the industry an important macroeconomic role. Through those linkages the impact of construction activities on other parts of the economy is much greater than their direct contribution.


The Built Environment Sector
















The term that arguably best encompasses the extraordinarily large number and range of participants in the creation and maintenance of the built environment, from suppliers to end users, is the built environment sector (BES). Research suggests adding the contributions to economic activity and output from other industries like manufacturing, materials and technical services is about the same as the direct contribution from construction. For example, in most OECD countries construction is between 5 and ten per cent of GDP, so the BES would be between ten and twenty per cent across those countries.


Measuring the BES would help public policy and macroeconomic management for two reasons. Firstly, the macroeconomic contribution of the BES to aggregate demand and employment is large, and possibly the largest in many countries. It is also one of the most volatile components of the economy, with annual rates of growth or contraction greater, and often much greater, than changes in GDP, making the BES a key driver of the business cycle. A satellite account collects those characteristics and thus provides data on trends in activity and output that have a significant effect on the national economy. Perhaps more importantly, changes in the composition of output of the BES would be a leading indicator of future demand as current new work completes, reflecting changes in the early stage project preparation activities required for future work. Through industry linkages and lags, such slowdowns or pickups in project preparation can be strongly procyclical, exacerbating the peaks and troughs of the business cycle. Because of the number of small firms found across the BES, the employment consequences of changes in activity levels are also significant.

Secondly, measuring the BES provides a way to measure the effectiveness of discretionary fiscal policy, when that involves changes in expenditures on building and construction. Discretionary fiscal policy, as a response to the business cycle, is an increase in public spending to counteract a downturn in the business cycle or a recession, typically targeting public investment in both social and economic infrastructure. Tracking the impact of such expenditures through the economy is difficult but would show up in a BES satellite account. This would also allow a finer-grained analysis of the employment effects of different types of projects and programs.


In this context, it is worth noting city policies involve significant infrastructure spending, and is often their main focus. However, it is the associated induced development around the new infrastructure that drives longer-term growth. A satellite account would capture all that activity over time, thus giving a measure of the effectiveness of city policies in promoting urban growth and development. It may be that regional or city-scale satellite accounts would be most useful for urban planning and management.


A satellite account for the building and construction industry would also reflect changes in the range of activities and types of firms that contribute to the built environment. In the broad view of the industry, and in a satellite account, more of these activities would be included, and the role and development of the sector better understood.


Groak, S. 1992. The Idea of Building. London: E. & F.N. Spon.
Turin, D. A 1969. The Construction Industry: Its Economic Significance and Its Role in Development, UNIDO, New York.

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Updated: Feb 10




Construction Scenarios: AI and Technological Opportunity


In one of those interesting accidents of timing, reports from the two leading management consultancies on the future of construction were released within days of each other. These are briefly summarised below. Also, some quotes from interviews with people on new technology and their projects, with some comments and observations to close.


From management consultants McKinsey comes the latest in their series of reports on technology and construction, this one titled Artificial Intelligence: Construction Technology’s Next Frontier, the first major publication specifically on the industry-wide implications of AI that I know of. This is one of a series of recent papers on AI, automation and infrastructure.

The World Economic Forum and the Boston Consulting Group released their Shaping the Future of Construction report in 2016, with some interesting examples of frontier firms. They have published a scenario analysis as the second, final step in their Future of Construction project, which has involved people from industry and researchers from a wide range of organizations. The three Future Scenarios they describe make technological context central to the future form of the industry.


As an adjunct to these two reports, the views and comments by the managers in their interviews in Infrastructure Intelligence’s Toward Digital Transformation provide a nice counterpoint to the somewhat stilted language found in management consultese. All three were published simulaneously and contain a lot of boilerplate about change management, agility, recruitment and talent management but, despite the importance of organizational structure and the development of skills if you want to compete for the future, this is not discussed here.

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McKinsey identifies five AI-powered applications, and use cases that have already arrived in other industries, that can be applied to construction. This is a practical approach that seems to target major contractors, and is a different approach to previous reports that could have been primarily intended for public sector clients. McKinsey has been seriously developing their infrastructure practice for some years now, positioning themselves for the global infrastructure boom they forecast over the next few decades. The five industry applications are:


Transportation route optimization algorithms for project planning optimization;

Pharmaceutical outcomes prediction for constructability issues;

Retail supply chain optimization for materials and inventory management;

Robotics for modular or prefabrication construction and 3-D printing;

Healthcare image recognition for risk and safety management.


Each of these has a short discussion with some nice examples of crossover potential. They are all plausible extensions of current technology, and in robotics, 3-D printing and drones leading construction firms are already well advanced. Using AI for optimization is obvious, but it is just as likely construction contractors will be using logistics firms to manage transport and inventory as they are to invest in the hardware and software development needed. The question is whether this makes a convincing case for using AI in construction, or whether these are the pathways into construction for AI, or the only ones.

McKinsey also looks at some machine learning algorithms that are more relevant to contractors, and briefly assesses their potential engineering and construction applications. Despite their extensive reporting on BIM elsewhere there is no discussion of the potential use of AI in design and engineering, or in restructuring processes. They do have a good, generic framework for types of machine learning, and they suggest algorithms will be useful for:


Refining quality control and claims management

Increasing talent retention and development

Boosting project monitoring and risk management

Constant design optimization


And then there’s this:

industry insiders need to look beyond sector borders to understand where incumbents are becoming more vulnerable and to identify white space for growth. Both owners and E&C firms can explore nontraditional partnerships with organizations outside the industry to pool advanced R&D efforts that have multiple applications across industries.


Not coincidentally, McKinsey might be able to arrange introductions and facilitate ‘exploration’ and, like many McKinsey papers, this one reads a bit like a catalogue. However, where the previous reports in this series have emphasised industry problems, using consolidated industry data from their client base, this one is full of solutions. While some of these may be solutions looking for problems there are, nonetheless, many acute observations in this paper on the range of possibilities AI will offer in the near future. They have put out a stream of reports on AI over the last few years.


This is a short paper and light on detail. If McKinsey has a more interesting story to tell on pathways for AI into construction it might look something like the scenarios depicted in the WEF/BCG paper. They use the term Infrastructure and Urban Development Industry (IU) to describe what I call the Built Environment Sector:


The scenarios depict three extreme yet plausible versions of the future. In Building in a virtual world, virtual reality touches all aspects of life, and intelligent systems and robots run the construction industry. In Factories run the world, a corporate-dominated society uses prefabrication and modularization to create cost-efficient structures. In A green reboot, a world addressing scarce natural resources and climate change rebuilds using eco-friendly construction methods and sustainable materials. It is important to keep in mind that the scenarios are not predictions of the future. Rather, they demonstrate a broad spectrum of possible futures. In the real future, the IU industry will most probably include elements of all three.


Each scenario is used to extrapolate implications for the industry, identifying potential winners from technological transformation, and the range of examples and ideas shows the value of such a widespread collaboration between industry, government and academia. The WEF does not say how far into the future they are looking, although it seems a fair bet that it is a lot further than McKinsey.


Building in a virtual world

Interconnected intelligent systems and robots run IU

Software players will gain power

New businesses will emerge around data and services


Factories run the world

The entire IU value chain adopts prefabrication, lean processes and mass customization

Suppliers benefit the most from the transition

New business opportunities through integrated system offerings and logistics requirements


A green reboot

Innovative technologies, new materials and sensor-based surveillance ensure low environmental impacts

Players with deep knowledge of materials and local brownfield portfolios thrive

New business opportunities around environmental-focused services and material recycling


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What to make of all this? Scenarios can be useful thought experiments, but by their nature are limited because the futures they depict are typically extensions of the present. Tomorrow will be like today, only more so. And saying AI will be important in the near future is not particularly insightful, although for some construction managers may be necessary. Some, however, are already working with digital-twin projects and restructuring around technological opportunity, as the quotes from Infrastructure Intelligence’s Digital Transformation interviews below indicate:


London’s Crossrail and Malaysia’s Mass Rapid Transit Corporation are two examples that show how “visionary transportation owners and supply chains are embracing digital technology”, ”moving beyond 3D modelling and 2D deliverables to enable handover of digital as-built information to operations.” Steve Cockerell – Bentley Systems


“BIM Wednesdays, where each Wednesday we got together in a location or had people Skype call in and view models on smartboards. This meant that when we got to the point of submission we had collectively resolved all the issues”. Mert Yesugey – Mott MacDonald


“Not knowing where to start is something we hear often. Just being so overwhelmed with all the technology that’s available and all the workflow processes. The lessons that we’ve learned are you must start small with tangible pilots and attack one part of the workflow at a time, implement technology, create a feedback loop and be able to measure what’s working and what’s not.” Sasha Reed – Blackbeam


David Waboso of Network Rail on procurement based on whole of asset life and outcome based contracts, focusing on in-service performance and outputs. An example is Resonate’s “Luminate” digital train management system, “a novel form of contracting that needs only a small upfront investment and is based a shared benefits agreement whereby the supplier will be rewarded if the new system delivers performance improvements and a corresponding reduction in delay compensation payments.”


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So where is the industry at in regard to technology take-up, now that there is widespread recognition of the reality of a digital future? Will construction industry development over the next decades absorb the impacts of new technology and be gradual, changing industry practice over time without significantly affecting industry structure or dynamics? Given the entanglement of economic, social, political, and legal factors in the construction technological system this might be the case, however there are good reasons to think this may be wrong. Machine learning, AI, automation and robotics are an interconnected set of technologies that are evolving quickly, enabled by expanding connectivity and the massively scaleable hardware available today.


If we think of the structure of the industry as a pyramid, there is a broad base of tradesmen and small firms at the bottom, followed by a deep layer of medium sized firms, and a small top section with a few large firms. Those large firms and some of their clients are clearly on the technological frontier, and their investment in capability and capacity should deliver significant increases in efficiency and productivity, and probably scale. Some medium-size firms are also making these investments, and also have access to technologies like algorithmic optimisation, platform-based project management, robotic, VR and AR applications and so on. The WEF/BCG Shaping the Future of Construction report, which is now nearly two years old, included many snapshots of what a range of firms at the frontier were doing, and some are in the table below. These sort of examples are missing from McKinsey’s high level analysis, and reflect the diversity of the industry beyond McKinsey’s potential client base.


Shaping the Future: Technology, materials and tools in 2016




























Based on these examples, the level of technology use in construction, compared to advanced manufacturing techniques in 2016, is well behind. Companies in the aerospace or automotive industries have developed their automated factories, integration capabilities and use of new materials like carbon fibre. Adidas makes 300 million shoes a year and in 2017 opened a fully automated factory in Germany. There are many examples. The lag is primarily due to the dynamic of a project-based industry, where it is hard for contractors and consultants to spread costs incurred with innovation across projects. Consequently, the manufacturers and suppliers of building and construction products, machinery and equipment do most of the research and innovation because they, like car companies, can spread the development costs over many clients. The role of contractors is to seek efficiencies in delivery, as the examples show. What these examples also show is that the gap between the industry’s larger, leading edge firms and SMEs is growing, and can be expected to increase because the great majority of smaller firms cannot innovate as fast or as effectively as larger firms.


A period of technology-driven restructuring of the building and construction industry may be about to start, similar to the second half of the 1800s when the new materials of glass, steel and reinforced concrete arrived, which led to new methods of production, organization and management. There are many implications of such a restructuring. Some firms are rethinking their processes in response to developments in AI, robotics and automation as capabilities improve quickly and the range of new products using these technologies expands. Many firms, however, are not. Meanwhile, frontier firms are exploring new tech and pushing the boundaries of what is possible, and are inventing new processes.

Other relevant posts:


Construction’s three pathways to the future here

WEF Shaping the future of construction here

BIM is essential but not transformational here

Technological diffusion takes time here

Disruptive change in construction here

Frontier firms in construction here


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About the Blog

This blog is interested in the organisation of the building and construction industry and its role in the creation of the built environment.

Like many industries, construction is being reshaped by rapid and widespread advances in materials, technology and capability. The blog collects data and discusses these trends and their effect on industry structure and performance.

 

The economic perspective focuses on firms and industries rather than individual projects.

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Gerard de Valence

I studied politics, philosophy and economics at Sydney University and worked in the private sector for a decade before becoming an academic in the School of the Built Environment at the University of Technology Sydney and UCL’s Bartlett School of Construction and Project Management in London. The ABOUT page has my bio.