Wednesday, 30 August 2017

Market Structure in Building and Construction

Oligopolies in a Fragmented Industry



The importance of industry structure to industry economics lies in the way that structure is seen as the most important determinant of competition in an industry, and the form that competition takes. The extent of control over prices is determined by the intensity of competition in a market, which is, in turn, determined by the number of firms and type of product. Related issues are the way the process of competition affects prices and profits, the ease of entry of new firms into or frequency of exit from an industry, the impact of demand shocks from the business cycle, and the effects of new technologies. These characteristics are the basis of the four types of market structure used in industry economics. 

Table 1. Types of Market Structure
Characteristics
Perfect Competition
Monopolistic competition
Oligopoly
Monopoly
Number of firms
Very large
Many
Few
One
Product
Identical, standardised
Differentiated
Either identical or differentiated
Unique, no close substitutes
Barriers to entry
None
Few
Significant
Very high
Firm's control over price
None
Limited
Constrained
Considerable, often regulated
Non-price competition
None
Emphasis on brand names, trademarks
Through product differentiation
Use of PR and advertising
Concentration ratio
0
Low
High
100
Examples
Personal services
Small retail, electrical goods
Automobiles, chocolate bars
Water and gas distribution
 

In the industrial organization or industry economics literature, industries are usually seen in terms of a number of firms which advance along a single technological trajectory, and these firms compete in enhancing the quality of their individual versions of the same basic product (homogeneity of product). This view fits some industries well, however many industries encompass several groups of products rather than a large number of versions of a single product. The products may be close substitutes in consumption, but embody different technologies, where R&D projects that enhance products in one group may generate huge spillovers for products in other groups.

For the construction industry the definition of the market is particularly opaque.  Are all buildings and structures to be regarded as a single product, or are bridges, shopping malls and apartment blocks distinct and different markets?  Some firms cross these boundaries, some stay within them.  It can be argued that the role of builders and contractors is to organise the production process, thus providing a service, while the delivery of the product (a building or structure) is the responsibility of the subcontractors who carry out the work.

Patterns of substitutability lead to a view of an industry as a chain of substitution, where industries are defined by their product. If industries are broken into separate sub-industries in order to address this problem, the choice can be between any number of different groups of products. The products may be close or distant substitutes for products of firms on other technological trajectories. When the linkages are strong they reflect the presence of scope economies, where the linkages are weak these scope economies will be absent and there will be a low degree of substitution across sub-markets.

Applying sub-markets to the building and construction industry raises a number of interesting issues. The first is, of course, the general lack of specialization of firms in the construction industry in terms of their product. The answer to the question "What does the industry produce?" is varied, some believe that the industry provides services (management, coordination, finance), others believe the industry delivers products (buildings and structures). The former group argues the main task of the industry is one of coordinating site processes, while the latter are more concerned with the building itself.

The building and construction industry is typically broken into the engineering, non-residential, and residential building sectors, and some firms that cross all of these areas, however firms typically work in either the residential or the non-residential sectors. Many of the larger firms cover both engineering and non-residential building in their activities. Within the non-residential building sector, there are ten or twelve different sub-markets, divided into offices, retail, factories, health, and so on.  Some firms specialize in building particular types of buildings, more commonly a building contractor will apply their management skills to a range of building types and not limit themselves to specific sub-markets. In this case, for the construction industry, sub-markets are difficult to identify because firms can be highly specialized in one area, or they can be highly generalized and put up a wide range of buildings and structures.

Therefore, in many of these sub-markets there are few significant barriers to entry for small firms, and such barriers will continue to be low while the industry maintains current practices based on a large number of small, specialised subcontractors. There is, however, a limited number of contractors capable of managing large projects, and the barriers to entry at this level in the form of prequalification are significant, based on track record, financial capacity and technical capability. Due to the risk characteristics of large projects a contractor has to have demonstrated the ability to manage and coordinate such works. Because there are only a few large contractors capable of undertaking major projects they tend to develop strong links with these clients, and these relationships are a significant barrier to entry to the types of projects carried out for such clients for other contractors. As prequalification becomes more rigorous and widespread in the industry, this is perhaps the most important barrier to entry.

The construction industry is predominantly made up of small firms, so the traditional approach based on the number of firms, barriers to entry and market power reveals a fragmented, diverse industry of firms with low barriers to entry. This supports the view of the industry as being an industry with the characteristics of perfect competition. The continuing widespread use of low bid tendering and reliance on price competition encourages the view that the industry is perfectly competitive. Some parts of the industry fit the perfect competition model, such as small and medium size contractors that rely on low-bid tendering to get work and labour based subcontractors, such as formwork, steel fixing, bricklaying and concreting.

However, this is also an industry that is highly concentrated with a small number of large contractors.  At this level the industry is oligopolistic, with high barriers to entry due to the prequalification systems and capability requirements used by clients to select contractors for major projects. Oligopolistic competition focuses on competition through product differentiation, or in the case of building and construction through specialization in particular types of projects (e.g. bridges, high-rise), forms of procurement (e.g. design and build, negotiated work), finance, or relationships with clients (alliancing, partnering). Suppliers of lifts and building automation systems are also in this type of market. The large contractors in the engineering construction and non-residential building sectors have the characteristics of an oligopoly. There are significant barriers to entry through client prequalification requirements for technical capability, track record and financial capacity. Some subcontracting sectors are also highly concentrated, with a small number of major manufacturers that supply facades, lifts and building automation systems.

Between these two market structures there are some firms in the industry that are in monopolistic competition. Those medium size contractors that have specialized and differentiated their product from others, or have developed ongoing relationships with clients, and thus get a large amount of negotiated work, have clearly broken out of the price-driven competition end of the business. Also, there are subcontractors that have developed the characteristics of monopolistic competition, in the more capital intensive subcontractors in the heating, ventilation and air conditioning (HVAC) sector for example. This part of the industry typically has a few large firms, often more or less national in scope, and a number of smaller firms working in local and regional markets. Medium size builders that have specialized in particular types of buildings and/or have developed relationships with repeat clients are also in this category. 

 Table 2. Construction Markets


Perfect Competition
Monopolistic competition
Oligopoly

Subcontractors


Contractors

Labour based subcontracting

Many small and medium contractors

Mechanical services
(HVAC)

Some medium sized contractors

Lifts, building automation

Large main contractors


The appropriate model of the construction industry's market structure will depend on the definition of industry products or markets adopted and the sector of the industry that is to be analysed. The oligopolistic characteristics of the large contractors in the industry have tended to be overlooked because of the numerical dominance of small firms, which typically operate under conditions of perfect competition.