Development of Hypotheses

Heterogeneity in contractors’ risk attitudes can be illustrated within a spectrum from the most risk-tolerant to the most risk-averse. For simplicity in comparison, since

how much more or less risk-tolerant/risk-averse is a relative measure, in the current study, different risk attitudes are grouped using relative classifications:

ƒ Most (or highly) risk-tolerant;

ƒ Moderately risk-tolerant;

ƒ Moderately risk-averse; and

ƒ Most (or highly) risk-averse.

In competitive bidding, there are always possibilities of profit/loss from a job. If a contractor anticipates a large amount of possible loss from the job, the contractor does not bid and waits for another job. Otherwise, the contractor would make a bid. The contractor’s anticipation is affected by his perception of risk. Thus, the contractor’s go/no-go decision depends on his own risk attitude, i.e., how much possible loss he allows in his risky decision.

Using the above classification, most risk-tolerant contractors accept large risks in order to gain potentially high profits. Moderately risk-tolerant contractors behave similarly, but they accept smaller risks than most risk-tolerant contractors. Both types of contractors have larger amounts of MLA than risk-averse contractors. In contrast, most risk-averse and moderately risk-averse contractors avoid the risks of large losses, but simultaneously they lose opportunities for large profits. These contractors are similar, but moderately risk-averse contractors are less risk-averse so that they accept some minimum level of risks more than most risk-averse contractors. These contractors have smaller amounts of MLA than risk-tolerant contractors.

Assuming that contractors’ cost estimates are randomly drawn from a same distributionN( ,μ σ_{e e}²), which means no difference in their estimation capability, extensions of the above idea follow:

ƒ Risk-tolerant firms would bid more often than risk-averse firms because they allow larger amounts of possible loss, and the bids from risk-tolerant firms would tend to be lower on average than those from risk-averse firms. Hence, they win more jobs;

ƒ Compared to most averse and moderately averse firms, most risk-tolerant and moderately risk-risk-tolerant firms would obtain more jobs while having lower profits per job on average. Sometimes most risk-tolerant firms would suffer large amounts of losses. Moderately risk-tolerant firms are also exposed to the risks of large losses, but less than the most risk-tolerant firms; and

ƒ Compared to most tolerant and moderately tolerant firms, most risk-averse and moderately risk-risk-averse firms would enjoy higher profits per job while obtaining a smaller number of jobs. Sometimes most risk-averse firms would suffer losses due to continuing overhead burden with too few jobs to cover it.

Similarly, moderately risk-averse firms are also exposed to risk of overhead burden, but less than the most risk-averse firms.

Table 5.2 provides the relative classification of risk attitude and descriptions for each group. Most risk-tolerant contractors would enjoy high success rate, but could suffer low average profit per job and possible large losses. In contrast, most risk-averse

contractors would enjoy high average profit per job, but could suffer low success rate and high overhead burden. Each of the extreme risk attitude groups has its own advantages and disadvantages as listed in the table.

High overhead burden is expected for most risk-averse contractors if they do not obtain enough jobs while they are reluctant to contract their capacity. Maintaining capacity level requires contractors to spend a fixed amount of money on overhead for personnel, space, etc., even though they do not utilize their capacities.

Table 5.2 Relative Classification of Different Risk Attitudes Most (Highly)

Allowance Largest MLA Relatively

Large MLA Relatively

Small MLA Smallest MLA Bid Frequency

Bid Amounts Low Relatively low Relatively high High

Success Rate High Low

Average Profit

In Table 5.2, moderately risk-tolerant and moderately risk-averse contractors locate between the two extreme risk attitudes. These contractors would make trade-offs

between the advantages and disadvantages of the extreme risk attitudes. The following hypotheses are proposed about expected relationships between contractors’ risk attitude and their performances.

H1. Profitability vs. Risk Attitude: Moderately risk-averse contractors have more firm profits than other contractors.

For a contractor to be most risk-tolerant or most risk-averse, there are apparent advantages as well as disadvantages: more jobs with lower profit per job versus higher profit per job with fewer jobs. Moderately risk-tolerant contractors are exposed to risks of large losses, even though their risks are smaller than those of most risk-tolerant contractors. In the highly risky construction business, a large loss could affect a firm badly. Being moderately risk-averse could be beneficial in the trade-offs between the profit per job and the amount of jobs won. These contractors avoid risk of large losses.

Moderately averse contractors could have overall higher profits than most risk-tolerant, moderately risk-risk-tolerant, and most averse contractors.

H2. Survival vs. Risk Attitude: Moderate risk-aversion is advantageous for survival in the construction market.

Moderately risk-averse contractors could avoid the disadvantages of being most risk-tolerant or most risk-averse: either a large amount of possible loss or a small amount of jobs won under overhead burden, which could result in financial problems. While moderate risk-tolerance assumes risk of large losses that could result in firm failure,

moderate risk-aversion could decrease risks of overhead burden by taking relatively more risks than most risk-averse contractors. Therefore, moderately risk-averse contractors would have more stable business operations and would survive longer.

H3. Growth vs. Risk Attitude: Moderate risk-aversion is in favor of growth in the construction market.

Most risk-tolerant contractors would have difficulty in growing due to the volatility in profitability even though they could obtain higher market share. Most risk-averse contractors would also have difficulty in growing because they would not bid often to obtain more jobs: they are selective in bidding. But, thanks to the stability in business (as proposed in Hypothesis 2 and more overall profits (as proposed in

Hypothesis 1), moderately risk-averse contractors could accumulate financial resources, spend them for expansions, and continue stable operation without putting assets at risk by accepting risky jobs.

H4. Diversification vs. Risk Attitude: Moderate risk-aversion is in favor of diversification.

Goals of market diversification can vary: firms can diversify to reduce diversifiable market risks, to grow, or to improve profitability. Whatever the goal of diversification by a firm is, diversification means additional competition by opening new establishments in new sectors. The success of diversification will depend on how a new establishment competes in a new sector. Establishments within a firm inherit the

organizational characteristics including corporate risk attitude. Then, based on the reasoning in H1 and H2, moderately risk-averse establishments would perform better in terms of profitability and survival. Therefore, moderately risk-averse contractors would have higher probability of success in their diversification than most risk-tolerant,

moderately risk-tolerant, and most risk-averse contractors.

H5. Diversification vs. Survival: More diversified contractors have longer longevity.

A firm’s establishments can share and develop together with the parent firm’s financial resources. If moderately risk-averse contractors are successful in

diversification as proposed in H4 and they survive longer as proposed in H2, more diversified firms would enjoy longer longevities. Every contractor may have bad years and good years. But, for diversified contractors, they have more chance to survive when their businesses go bad since they have their establishments as multiple buffers against firm failure.

5.7 Summary

Chapter V presented detailed descriptions of the methodologies and the

hypotheses developed for the current study. The procedure in the current investigation is summarized as follows:

ƒ Build a simulation model based on evolutionary theory and represent competition among contractors having different risk attitudes;

ƒ Observe the effects of risk attitude in industry-wide patterns that evolve as results of competition in the model and compare the model results to the patterns observed in the actual U.S. construction industry data in Chapter IV; and

ƒ Test hypotheses using the developed evolutionary model and make recommendations for construction contractors.

Using evolutionary approach, the current study considers contractors as individual entities competing with each other for common job opportunities in a

construction market. Considering that contractors may have different risk attitudes and that risk attitude is a universal trait, it is hypothesized that individual contractors’

different perceptions of risk and resulting different risk-taking behaviors in competition could affect competition among themselves and their own performances. The current study also takes multiple perspectives from the individual levels to the aggregate levels for the population of contractors. And, success of a contractor is analyzed within the domain of competition for the long-term.

Conventionally, different risk attitudes have been represented using expected utility theory. However, the theory and the method are not easy for practitioners to understand and it is also difficult to construct utility functions for individual contractors.

It has been 60 years since the concept was introduced and few practitioners have learned it yet. There are few studies that measured risk attitudes for a large sample of

contractors. Consequently, the effect of risk attitude on competition has not been studied for construction contractors.

The proposed new representation method uses the concept of Value at Risk that is easy for practitioners to understand and apply to real business decisions. Value at Risk measures the expected value of loss in a simple manner by combining the effects of undesirable results such as cost overrun and probabilities that the undesirable results occur. For the new method, a new term, maximum loss allowance is introduced. It is defined as the maximum amount of loss that an individual firm can allow for a job.

Using different amounts of MLA denominated in dollars, contractors’ different risk attitudes are simply and quantitatively expressed. Risk-tolerant contractors allow risks of losses to obtain potentially large profits, so they have large amounts of MLA. Risk-averse contractors do not allow possibly large losses, so they have small amounts of MLA. VaR and MLA have the same metric, dollars. Based on the comparison of these two measures, contractors’ go/no-go decisions can be easily described.

Five hypotheses were developed for the investigation of the effects of risk attitude on contractors’ competitive success in construction. The hypothesized effects by different risk attitudes are about the differentiations of performance among

contractors (winners vs. losers) in a market. The differentiations are expected to be observed in their profitability, survival, growth, and diversification level. Moderately risk-averse contractors would make trade-offs between the two extreme risk attitudes (most risk-tolerant and most risk-averse) better than moderately risk-tolerant contractors

that could suffer large losses. The developed hypotheses anticipate outperformance of moderate risk-aversion in the construction market.

CHAPTER VI