Models of construction price determination: A comparative appraisal

This study compares the neo-classical micro-economic theory with tendering theory in the context of price formation in the building industry. It examines the two theories and determins that while there are problems with the application of both theories, there are no a priori reasons why either theory should be inapplicable. After discussing the appropriate criteria for selecting between competing theories, the theories were compared on how well they explain and predict the impacts of changes in the level of activity in the market/industry, the distribution of tenders, the strategy for maximising profit, the winner's curse, the accuracy of estimates, the socially accepted price and adjustments to productive capacity. On all criteria the neo-classical model performed better than did the tendering theory. However, both theories have a non-falsifiable motivational core assumption. In addition, neo-classical micro-economics has a set of ceteris paribus conditions and tendering theory has a probabilistic outcome which in practice means that neither theory is falsifiable. Although it is therefore not possible to verify or falsify either theory, the assumptions used in the neo-classical theory are more realistic and clearly identify the domain of the theory, while the assumptions of tendering theory are such that the building industry is not likely to be part of its domain, and it is therefore not applicable to the industry. It is, however, possible to synthesise neo-classical micro-economics with elements of tendering theory into a neo-classical tendering theory that predicts the winning price, the probability of success with a given bid and the potential profit probability density function. This theory has distinctly neo-classical characteristics. The units of analysis are the firm and the market, not the individual tender or the industry. The profit maximising price is determined by market conditions. Tendering decisions are made in two stages. The objective in stage 1 is to assess if the winning tender will be sufficiently high to satisfy the aims of the tenderer. In stage 2 the objective is to establish a bid with a desired probability of being successful or the desired risk/reward ratio.