Chapter 1 Intro

11/22/17
Introduction to Construction
Economics
Course : Construction Economics and Finance

(COTM 6021)
Denamo Addissie Nuramo
November 22/2017
Introduction to the course
The Construction Industry
Importance of Economics and Finance in the

Construction Industry
Market Structure in the Construction Industry
Engineering Economic Decision
November 22/2017 Construction Economics and Finance (COTM 6021) 2
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•  Full name
•  Academic background
•  Professional background
•  Expectations from this course
•  Future plans/vision
•  a significant part of the total economy/ engine of economic

growth
•  responsible for the output of buildings and infrastructure
upon which most other economic activities depend
•  in newly developing countries, it can contribute as much as
15 to 20 per cent of GDP because it accounts for a
significant amount of investment during a country’s
development
•  typically accounts for 14–16 per cent of total annual
economic activity; on the narrower definition, it only
accounts for about 6–8 per cent – it is difficult to assess
and , in many cases it is under-reported
•  There is a relationship between the level of construction
activity and a country’s stage of development.
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The construction industry – narrowly defined
The construction industry – broadly defined
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Parties traditionally supplying a construction project
the typical project process can easily become a series of ‘separate’

operations undertaken by various parties
Activity 1
①  Discuss the graph below:
②  In many ways construction is quite distinct from other

sectors of the economy. What are the main distinct
characteristic of the construction industry in comparison
with other economic sectors?
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Construction has five distinguishing characteristics:
①  each project is regarded as a unique one-off product;

②  dominated by a large number of relatively small firms;
③  the general state of the economy influences demand;
④  prices are determined by tendering; and
⑤  projects are characterized by their ‘lumpiness’ in terms of
their scale and expense.
•  Economics – is concerned with the allocation of scarce

resources
•  Economists argue that people must make careful choices

about:
–  what is made, how it is made and for whom it is made;
–  or in terms of construction, choices about what
investments are made, how these are constructed and on
whose behalf.
•  at its very simplest level, economics is ‘the science of

choice’.
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•  In a world of scarcity, for every want that is satisfied, some

other want, or wants, remain unsatisfied.
•  Opportunity cost - the value of the alternative forgone by

choosing a particular activity.
•  Whenever an economic decision is made there is a trade-

off between the use of one resource for one or more
alternative uses
Competition for Scarce Resources
•  if a resource is used for one purpose it is denied to another.
•  competition for scarce resources:

1.  between alternative projects designed to serve the same
purpose,
2.  between projects which serve different purposes, and
3.  between engineering projects and other potential modes
of investment.
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Competition for Scarce Resources
•  decision on how to employ resources often lies with

politicians, administrators, bankers and others
•  if they are to make a wise choice they must be properly

informed not only of the comparative technical merits of
alternatives but also of their relative costs and benefits.
•  this responsibility rests with professional engineers
•  Resources - the inputs used in the production of those

things that we desire.
•  Economists tend to refer to these resources as factors of

production to highlight the fact that only by combining
various factors can goods and services be produced.
•  Categories of factors of production: land, capital and labor

– and sometimes the entrepreneur
* Quantities
of each factor are needed to make any
good or service.
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•  Market Systems – the exchange arrangements of both

buyers and sellers for a particular good or service; eg.
building materials, housing, professional services, etc.
•  The recurrent feature of any market - the exchange of

information about factors such as price, quality and
quantity. Eg. Stock market in the Western economy,
construction market
•  ‘The construction industry is highly fragmented, with the

dominant firm being the small (local) contractor.’ The type
of construction – particularly in terms of its size and
complexity, its geographical location, and the nature of
the client – will define the market in each case.
•  Markets in the construction industry - comprising those

firms that are willing and able to compete for a contract in a
specific geographical area.
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A complex set of markets for one building project
Transaction costs which affect construction
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Economic Models
•  are simplified representations of the real world that we use
to understand, explain and predict economic phenomena.
•  Many of the processes in the construction industry do not
lend themselves easily to generalizations and models due
to:
–  the industry involves a large variety of interests and parties
that makes the process rather complex and plagued with
unwarranted assumptions about what is possible
–  economic analysis is only one of the disciplines contributing
to the process as a whole
–  there is a distinct lack of vision about the role of construction
in society and how it could better serve its clients
•  The construction industry should favor models that prioritize

strategies aimed to improve sustainability, competitiveness,
productivity and value to clients
The circular flow model: a two sector economy
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Microeconomics and Macroeconomics
Microeconomics:
the study of individual decision-
making by both individuals and
firms
Economics
Macroeconomics:
the study of economy-wide
phenomena resulting from
group decision-making in the
entire markets; deals with the
economy as a whole.
A model for construction economics: a new approach
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Economic Evaluation
•  aim - to secure the greatest benefit from the resources
available
•  an assessment of the costs and benefits of carrying out a

project as compared with doing nothing
•  if any of the proposed schemes are economic, and if they

are, to establish a priority ranking for the competing
proposals
Financial Planning
•  movement of money both required for and arising from

the project.
•  is directed at assessing the cash inflows and outflows

during the life of the project and ensuring that the
financial implications of these cash flows are accounted
for – i.e. where the money will come from when it is
needed, and how you will service the debt interest and
repayments as they come due
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Need for Judgment

•  Planning relates to the future.
•  Even the most sophisticated forecasting techniques have

fundamental uncertainties associated with them
•  One major uncertainty is the way technology will change,

and this can have the most profound effect on the future
course of events
•  When it is necessary to make assumptions about the

technological capabilities and needs of the future, personal
judgment and experience are the best guides
Project Life
•  in the economic analysis of a project, a limited period is
assigned as the useful life of the project.
•  the project components will have perished, or that the

project will have become obsolete, perhaps due to
advances in technology
•  the useful life assumed for the project determines the period
over which its economic viability has to be established
•  The useful life of a private sector project depends heavily on

predictions made about technological change; for public
works projects the useful life is normally not taken to be
more than 50 years
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Methods
Pay-back
This is one of the most used and trusted method because
of its simplicity in calculations and interpretation. Used
measure in this method is simply time it takes for return of
initial investment
Discounted pay-back
In discounted pay-back method we consider time-value of
money. This means that value of given sum changes over
time. For example 100BIRR today is more valuable than
100BIRR in 5 years.
Large-Scale Engineering Projects
These typically:
•  require a large sum of investment
•  can be very risky
•  take a long time to see the financial outcomes
•  lead to revenue and cost streams that are difficult to
predict
All the above aspects (and some others not listed here)
point towards the importance of EEA
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The Four Fundamental Principles of

Engineering Economics
①  An instant dollar is worth more than a distant dollar

②  Only the relative (pair-wise) difference among the
considered alternatives counts
③  Marginal revenue must exceed marginal cost, in
order to carry out a profitable increase of operations
④  Additional risk is not taken without an expected
additional return of suitable magnitude
Principle 1
An instant dollar is worth more than a
distant dollar…
66months
today monthslater
later
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Principle 2
Only the cost (resource) difference among
alternatives counts
6 months later
The data shown in the green fields are irrelevant items for decision
making, since their financial impact is identical in both cases
Principle 3
Marginal (unit) revenue has to exceed marginal
cost, in order to increase production
6 months later
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Principle 4
Additional risk is not taken without a suitable
expected additional return
6 months later
A simple illustrative example. Note that all investments imply

some risk: portfolio management is a key issue in finance
Economic Decision Components

Where economic decisions are immediate we need to
consider:
•  amount of expenditure
•  Taxes
Where economic decisions occur over a considerable period

of time we also need to consider:
•  interest
•  inflation
6 months later
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Thank you!
18

Chapter 1 Intro

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11/22/17

Course : Construction Economics and Finance

Denamo Addissie Nuramo

Introduction to the course

The Construction Industry

Importance of Economics and Finance in the

Market Structure in the Construction Industry

Engineering Economic Decision

November 22/2017 Construction Economics and Finance (COTM 6021) 2

November 22/2017 Construction Economics and Finance (COTM 6021) 3

• a significant part of the total economy/ engine of economic

The construction industry – narrowly defined

November 22/2017 Construction Economics and Finance (COTM 6021) 5

The construction industry – broadly defined

November 22/2017 Construction Economics and Finance (COTM 6021) 6

Parties traditionally supplying a construction project

the typical project process can easily become a series of ‘separate’

② In many ways construction is quite distinct from other

November 22/2017 Construction Economics and Finance (COTM 6021) 8

Construction has five distinguishing characteristics:

① each project is regarded as a unique one-off product;

November 22/2017 Construction Economics and Finance (COTM 6021) 9

• Economics – is concerned with the allocation of scarce

• Economists argue that people must make careful choices

• at its very simplest level, economics is ‘the science of

November 22/2017 Construction Economics and Finance (COTM 6021) 10

• In a world of scarcity, for every want that is satisfied, some

• Opportunity cost - the value of the alternative forgone by

• Whenever an economic decision is made there is a trade-

November 22/2017 Construction Economics and Finance (COTM 6021) 11

Competition for Scarce Resources

• if a resource is used for one purpose it is denied to another.

• competition for scarce resources:

November 22/2017 Construction Economics and Finance (COTM 6021) 12

Competition for Scarce Resources

• decision on how to employ resources often lies with

• if they are to make a wise choice they must be properly

• this responsibility rests with professional engineers

November 22/2017 Construction Economics and Finance (COTM 6021) 13

• Resources - the inputs used in the production of those

• Economists tend to refer to these resources as factors of

• Categories of factors of production: land, capital and labor

• Market Systems – the exchange arrangements of both

• The recurrent feature of any market - the exchange of

• ‘The construction industry is highly fragmented, with the

November 22/2017 Construction Economics and Finance (COTM 6021) 15

• Markets in the construction industry - comprising those

November 22/2017 Construction Economics and Finance (COTM 6021) 16

A complex set of markets for one building project

November 22/2017 Construction Economics and Finance (COTM 6021) 17

Transaction costs which affect construction

November 22/2017 Construction Economics and Finance (COTM 6021) 18

November 22/2017 Construction Economics and Finance (COTM 6021) 19

• The construction industry should favor models that prioritize

November 22/2017 Construction Economics and Finance (COTM 6021) 20

Microeconomics and Macroeconomics

November 22/2017 Construction Economics and Finance (COTM 6021) 21

A model for construction economics: a new approach

November 22/2017 Construction Economics and Finance (COTM 6021) 22

• an assessment of the costs and benefits of carrying out a

• if any of the proposed schemes are economic, and if they

November 22/2017 Construction Economics and Finance (COTM 6021) 23

• movement of money both required for and arising from

•  a significant part of the total economy/ engine of economic

②  In many ways construction is quite distinct from other

①  each project is regarded as a unique one-off product;

•  Economics – is concerned with the allocation of scarce

•  Economists argue that people must make careful choices

•  at its very simplest level, economics is ‘the science of

•  In a world of scarcity, for every want that is satisfied, some

•  Opportunity cost - the value of the alternative forgone by

•  Whenever an economic decision is made there is a trade-

•  if a resource is used for one purpose it is denied to another.

•  competition for scarce resources:

•  decision on how to employ resources often lies with

•  if they are to make a wise choice they must be properly

•  this responsibility rests with professional engineers

•  Resources - the inputs used in the production of those

•  Economists tend to refer to these resources as factors of

•  Categories of factors of production: land, capital and labor

•  Market Systems – the exchange arrangements of both

•  The recurrent feature of any market - the exchange of

•  ‘The construction industry is highly fragmented, with the

•  Markets in the construction industry - comprising those

•  The construction industry should favor models that prioritize

•  an assessment of the costs and benefits of carrying out a

•  if any of the proposed schemes are economic, and if they

•  movement of money both required for and arising from

•  is directed at assessing the cash inflows and outflows

•  Even the most sophisticated forecasting techniques have

•  One major uncertainty is the way technology will change,

•  When it is necessary to make assumptions about the

•  the project components will have perished, or that the

•  The useful life of a private sector project depends heavily on

①  An instant dollar is worth more than a distant dollar