Economics & The Business Environment

ECONOMICS & THE BUSINESS ENVIRONMENT FORMATION 1 EXAMINATION - APRIL 2005 NOTES Answer four questions, question I which is compulsory and any 3 other questions.

TIME ALLOWED: Three hours and 10 minutes to read the paper.

INSTRUCTIONS: During the reading time you may write notes on the examination paper but you may not commence writing in your answer book. Marks for each question are shown. The pass mark required is 50% in total over the whole paper. Start your answer to each question on a new page. You are reminded that candidates are expected to pay particular attention to their communication skills and care must be taken regarding the format and literacy of the solutions. The marking system will take into account the content of the candidates' answers and the extent to which answers are supported with relevant legislation, case law or examples where appropriate.

The Institute of Certified Public Accountants in Ireland, 9 Ely Place, Dublin 2.

THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND

ECONOMICS & THE BUSINESS ENVIRONMENT FORMATION 1 EXAMINATION - APRIL 2005 Time allowed: 3 hours and 10 minutes to read the paper.

Answer four questions; question 1 which is compulsory and any 3 other questions. Question 1 is allocated 40 marks and each of the other questions is allocated 20 marks.

1.

Write a note on four of the following: (i) (ii) (iii) (iv) (v)

Cross Elasticity of Demand. The market conditions (or circumstances) that prevail when a firm is a price taker in that market. Fiscal Drag. Economies of Scale. Incidence of a Tax. [Total 40 Marks]

2.

(a)

Draw a short run average (or unit) cost curve and justify the shape you have drawn. (6 marks)

(b)

Is there any justification for considering Normal Profit to be a cost of production? Explain your answer. (4 marks)

(c)

A firm that seeks to make the maximum possible level of profit is contemplating taking on an additional product line. Set out the economic (or financial) information that you would require (or seek). Explain your approach. (10 marks) [Total 20 Marks]

3.

(a)

Explain the factors that determine the rate at which it is possible for the Irish economy to grow (i.e. the potential growth rate). (7 marks)

(b)

Explain the factors that determine the rate at which the Irish economy actually grows. (8 marks)

(c)

Explain the statistic (or information) that is used to measure the actual rate of growth in the Irish economy between any two periods. (5 marks) [Total 20 Marks]

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4.

(a)

Explain the functions of money.

(8 marks)

(b)

Does the fact that banks create purchasing power mean that they may not have enough money for depositors who seek access to their cash? Explain your answer. (12 marks) [Total 20 Marks]

5.

(a)

Explain the effect(s) that a Budget Deficit would have on the objectives of national economic policy. (8 marks)

(b)

Has membership of the European Union been beneficial to the Irish economy? Explain your answer. (12 marks) [Total 20 Marks]

END OF PAPER

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SUGGESTED SOLUTIONS

ECONOMICS & THE BUSINESS ENVIRONMENT FORMATION 1 EXAMINATION - APRIL 2005.

SOLUTION 1 (i)

Cross Elasticity of Demand measures the responsiveness of demand for a commodity in response to a change in the price of another commodity. The formula for calculating cross elasticity of demand is the proportionate change in the quantity demanded of one good (good X) divided by the proportionate change in the price of another good (good Y). If the answer obtained from the application of the formula is positive this indicates that an increase in the price of one good brings about an increase in the demand for the other good indicating that the goods stand in a substitute relationship to each other. The larger the numerical value the closer the degree of substitutability. If the answer from the calculation is negative then the goods stand in a complementary relationship to each other.

(ii)

A firm is said to be a price taker when, acting alone, it is unable to influence market prices i.e. market price(s) is a given and the firm has to make its business decisions within the constraint of this reality. Typically such a situation pertains when a firm is a small player in the market and the product that the firm is selling is homogeneous so that there is no marketable difference between the items produced by different suppliers. Because the product is no different from the offerings of competitors it is not possible for the firm to sell at a higher price than competitors, while on the other hand there is no incentive for the firm to sell at a lower price. The demand curve facing the individual firm in such circumstances is a horizontal demand curve at the market price. The horizontal demand curve reflects the fact that there is no demand for the product of the firm at any higher price and there is no incentive for the firm to sell at a lower price since due to the small scale of its operations it can sell its entire output without affecting market price(s). All of this is captured in the depiction of the representative firm in a perfectly competitive form of market structure. The viability and the profitability of such firms is determined by their cost base and if an individual firm suffers from some cost disadvantage it is not possible to recoup this additional cost through increasing prices. It is not unusual for Irish firms competing against large firms in export markets to see themselves as price takers and in the light of the foregoing comments such firms are particularly vulnerable if they are subject to cost pressures that are not being experienced by firms in other member states.

(iii)

Fiscal policy refers to any conscious action by the government in relation to the magnitude, structure or timing of government revenue or expenditure. Fiscal drag is the term which can be applied when the effect of fiscal policy is to reduce the level of aggregate demand below what it would be in the absence of the fiscal policy. However, the use of the term is more usually reserved for occasions attributable to the coming into operation of the downward aspect of automatic stabilisation at a stage when the economy is operating below the desired level. Whenever the government budgets for a surplus it is in effect deflating the economy but such action is not normally referred to as fiscal drag which term is rather reserved for situations where the effect of fiscal policy is to deflate the economy in a manner or to an extent which was not intended, an occurrence of this nature would be experienced if the economy became more buoyant than was envisaged at budget time. For example government tax revenue is predicated on some forecast level of economic growth, for any given rates of taxation, tax revenue will be greater than anticipated when the rate of growth in the economy exceeds forecasts. In such a circumstance the withdrawal of purchasing power in the economy through taxation will be greater than intended and since increases in the level of discretionary government expenditure takes time to implement the net effect is a withdrawal of purchasing power from, and a consequent reduction in the level of, aggregate demand. It is this development which is referred to as fiscal drag.

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(iv)

(v)

Economies of scale are cost reducing benefits which accrue to a firm as a result of an increase in the scale of output. They are sometimes analysed in terms of internal economies of scale which are applicable to a particular firm as its level of production increases and external economies of scale which accrue from the growth of an industry and these external economies may be availed of by all firms in the industry. Internal economies of scale are usually categorised as technical economies, marketing economies and financial economies. •

Technical economies are one source of reductions in unit cost as the level of production increases, for example increased use of machinery becomes possible, the use of specialised machinery becomes feasible and economical, the cost of overheads does not grow pro rata with increases in production, and a more economical linking of the processes of production becomes possible.

•

Marketing economies stem from a stronger position in negotiating the purchase of raw materials together with reductions in relative ordering costs. Economies accrue also in distribution as large scales of operation facilitate improved load factors in delivery vehicles together with the implementation of more economical delivery schedules.

•

Financial economies of scale accrue because large firms are generally considered to constitute a lower financial risk in relation to borrowing and consequently enjoy more favourable borrowing terms. In addition large firms may have access to sources of funds which are not available to smaller firms.

•

Some examples of external economies of scale are the growth of specialised sub-contracting firms and the development of a supporting economic infrastructure

The incidence of a tax refers to be manner in which the burden of the tax is borne. A distinction can be drawn between the impact or formal incidence of the tax which means the person or commodity on which the tax was imposed, and the effective incidence of the tax which means who actually pays the tax e.g. a tax on farmers may result in an increase in food prices by the amount of the taxes, in which case, though the formal incidence of the tax would have been of farmers the effective incidence of the tax is on consumers of the products. With respect to direct taxes it is rather difficult to shift the incidence of such taxes e.g. if I am paid €400 per week and I had been paying €60 per week income tax if my income tax liability is increased to €70 per week it is extremely unlikely that I will be able to negotiate a wage increase of €10 in order that I may maintain parity in my after-tax pay. In contrast to this situation it may be possible to shift all or some of, of the incidence of a expenditure or excise tax, ’forward’ on to customers or ’backwards’ on to suppliers depending on the relative elasticities of supply and demand for the product on which the tax is levied. Whichever of supply or demand is the more inelastic will tend to end up bearing the greater proportion of the tax and if for example demand was perfectly inelastic then it would be possible to increase the price of the good by the full amount of the tax without there being any resultant fall-off in demand

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SOLUTION 2. (a)

Short run average cost refers to the effect on unit cost of production when there is an alteration in the level of production in the short run i.e. while the supply of at least one factor of production cannot be altered. Short run average cost curves are usually depicted as being U shaped as illustrated below. decreasing unit cost increasing returns due to specialisation and better spread of fixed costs unit cost increasing unit cost decreasing returns due to law of diminishing marginal returns.

output per period Short run average cost curve.

The downward section of the U curve is attributable to the following two reasons: (i) As the level of production increases there is a sufficient volume of work to justify the employment of specialists or to permit existing workers to concentrate on a narrow range of duties. Since workers improve their productivity through concentration and specialisation, unit costs of production are reduced. (ii) As a firm expands its level of production, its costs of production do not increase pro rata e.g. fixed costs are defined as costs which do not vary over a certain range of output, thus the spreading of fixed costs over a larger volume of output reduces the fixed cost element in unit production costs and consequently unit costs fall as output expands. Despite the foregoing if the volume of production continues to expand unit costs will eventually increase due to the coming into effect of the Law of Diminishing Marginal Returns. This law states that as increasing quantities of a variable factor of production are combined with a fixed factor of production, a stage will eventually be reached where marginal returns begin to decline. (b)

Costs of production are all those expenses that must be recouped if production is to take place. If the revenue realised on the sale of the goods is insufficient to cover the wages, rent, cost of raw material and all of the other expenses then production would not continue. The entrepreneur is the person who mobilises and organises the other factors of production in order to produce the goods and services which eventually are offered for sale. Even if the other factors of production are available in the absence of the entrepreneurial function the production would not take place and unless there is a return, or an acceptable likelihood of a return, the entrepreneur has no incentive to get involved. Normal Profit is the minimum return that the entrepreneur requires if he/she is undertake the entrepreneurial role and in the absence of such a rate of return the envisaged economic activity would not take place. Therefore Normal Profit is a cost of production because if the enterprise does not generate a return sufficient to enable the entrepreneur to earn Normal Profit then the economic activity will cease or will not be undertaken in the first instance

(c)

A firm that seeks to earn the maximum possible level of profits will base their decisions on the effect of proposed actions on their bottom line . Accordingly the firm in question would calculate the various costs that would be incurred if they expand into the additional product line. These additional costs of production would be incurred under the usual cost headings viz: additional wages, raw material costs, energy costs etc. Collectively they can be termed marginal cost. On the revenue side the firm will undertake research into market conditions, extent of competition, possible reaction of market incumbents to the new entrants etc as it attempts to estimate the increase in the revenue of the firm i.e. marginal revenue. If the marginal revenue exceeds the marginal costs then profitability will be improved if the expansion takes place. There is one important consideration in this type of decision. If general overheads do not increase when the contemplated action is undertaken then marginal costs will consist entirely of the additional variable costs. This is usually referred to in terms of analysing if the new activity will make a contribution towards the fixed costs (or overheads) of the firm and is similar to the economic conditions for profit maximisation in the short run. Page 5

SOLUTION 3 (a)

The level of output, that it is possible to produce in the Irish economy, is determined by (i) the quantity and quality of factors of production within our economy and (ii) the state of technology, which exists in (or is available to) the Irish economy. The greater the stock of factors of production that is available the greater the level of output that the economy is capable of producing i.e. the greater the potential level of national income. A greater stock of factors of production is available in the USA compared with Ireland, consequently the potential level of national income in that country is greater than ours .The quality or efficiency of these factors of production is also a relevant consideration e.g. the fertility of the land, the economic quality of the workforce, the efficiency of the infrastructure etc. The state of technology in an economy has such an important bearing of the potential level of national income that it is considered to be the most important determinant in the growth of an economy. One of the main reasons for the economic resurgence of Germany despite its defeat in the Second World War was the level of technical knowledge and ability available within that economy.

(b)

While this potential level of GDP places an upper limit to the amount of goods and services that it is possible to produce in Ireland the actual level of national output or aggregate demand is determined by the level of demand within the economy. In relation to a small open economy such as the Irish economy demand is usually categorised as consumption, investment, government expenditure and net exports and this relationship is usually depicted as Y = C + I + G + (X-M) where each of these symbols have their usual meaning. Often this relationship is illustrated with a diagram of the circular flow of income where consumption, investment, government expenditure and exports are shown as injections into the economy and consequently these forces create the demand which culminates in the actual aggregate level of economic activity. In a circular flow of income diagram savings, taxation and imports are shown as withdrawals from the circular flow and consequently, of themselves, reduce the level of aggregate demand. Exports are a very important element of demand for the Irish economy; so that if foreign purchasers of Irish merchandise and service are experiencing economic buoyancy in their domestic market this will stimulate their demand for our exports and consequently our actual level of demand. Thus potential level of GDP is what the economy is capable of producing when there is full employment of all the factors of production whereas actual level of GDP is the recorded level of economic activity in the economy.

(c)

Our Gross Domestic Product is a measure of the total value of goods and services produced in the Irish economy, thus a comparison of GDP for different years would indicate the rate of growth experienced between the two periods. Care would have to be taken if using GDP at current market prices since expenditure taxes and/or subsidies might have changed in the intervening period. Using GDP @ factor Cost would obviate this problem. An allowance for inflation would also be relevant and the case could be made for including provision for depreciation.

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SOLUTION 4. (a)

(b)

Money is anything which is generally acceptable in payment for goods and services. Whatever is chosen to be used as money must be capable of fulfilling the following roles, which are known as the functions of money. If circumstances develop which inhibit the ability of money to effectively fulfil these functions e.g. during a period of inflation, then money loses its effectiveness and either some other currency or item is used to replace it or there is a reversion to a system of barter. Accordingly the functions of money are; •

To act as a medium of exchange. This is the most important function of money and it fulfils this role when a person exchanges the good or service which they own for money and then use the money (or some of it) to purchase the good or service which they require. Rather than suffering the draw backs inherent in a situation where people attempt to satisfy directly all their own need this quality of money facilitates the division of labour since it enables people to specialise and use the money thus obtained to purchase their requirements.

•

To constitute a store of value. It is this quality of money which enables a person to sell the goods and services which they own at a time which is most beneficial to them and use the money thus obtained as a store of value which can be used whenever they decide to purchase their requirements.

•

To be a measure of value/unit of account. Money is the common denominator which we use to measure and express value. It is the unit in which prices are quoted and accounts are kept.

•

To provide a standard for deferred payments. It is this feature which makes possible credit trading and drawing up of financial contracts with a money consideration being paid over at some future time. All borrowing and lending is possible because of this. Transactions of this nature depend on being able to express in money terms the price that must be paid at some future date.

The ability of the banking sector to create purchasing power stems from the general acceptability of cheques and other forms of non-cash in payment for goods and services. The actual amount of purchasing power that it is possible for banks to create depends on the value of its cash holdings and the required liquidity ratio e.g. if €1000 cash is lodged with the banks and if banking experience is that 10% of the value of deposits needs to be held in cash form then the required liquidity ratio is 10% so that this lodgement would support loans to the value of €10,000. Banks have learnt from experience the liquidity ratio that they require in order to satisfy demands for cash so they are not very likely to be over extended on their loan portfolio. However to the extent that they might be short of liquidity it is possible for them to borrow from other financial institutions on the inter-bank market, they can also increase their liquidity by reducing the amount of their overnight and on-call lending. In addition the central bank stands at the apex of the system in its capacity of lender of last resort. To the extent that banks have underestimated their required level of liquidity, profits are reduced through the bank having to seek short term external funding.

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SOLUTION 5. (a)

A budget deficit occurs when the revenue accruing to the national exchequer does not cover the expenditure so that any shortfall has to be borrowed. The term is usually applied to the current section of the national budget since as a book-keeping exercise total receipts plus borrowing must be equal to the total of current and capital expenditure. The manner in which a budget deficit would impact on the objectives of national economic policy is set out hereunder. Unemployment would be less than would otherwise be the case because the injection of government expenditure is greater than the leakage of demand that occurs through taxation. Economic Growth would be stimulated through the expansionary budget. National Debt would be increased through the borrowing that is necessary to make up the shortfall in revenues. Our Balance of Payments position is likely to worsen, at least in the short term, as the increase in purchasing power stimulates an increased demand for imports. Depending on the state of the economy the budget deficit may intensify inflationary pressures. In the absence of precise taxation and spending details it is not possible to speculate on the likely effects of the budget deficit on any national objectives regarding the distribution of national income or regional development.

(b)

A comparison of our economic well being at the present time with our economic circumstances at the time of joining the then EEC would confirm that we are economically better off. While some might argue as to the precise extent that this is attributable our membership of the European Union there is unanimity that membership has been economically beneficial. European Funds have been made available to us to develop our economic infrastructure. In addition we were a net beneficiary of funds through our participation in the Common Agricultural Policy. Our access to European Markets has been enhanced and this is manifest in the increase in our exports to, and imports from, these markets. It is worthy of note that were we not members of the European Union we would be virtually excluded from such markets so that the possibility of just continuing as we had been was not an option. The performance of the Irish economy has been boosted by direct foreign investment and the attractiveness of our country to direct foreign investors is enhanced by our membership of the European Union. Because of our membership Ireland provides for such investors a gateway to EU markets. While there is no gainsaying the continuing importance of non-European markets e.g. USA, a comparison of the changing geographical dispersion of our exports, and the new European sourcing for many of our imports, illustrate opportunities that have accrued through membership. However, there is no denying that membership has entailed some downsides and compromises. Some sectors of Irish economic activity have been non-viable as a result of the creation of freer intra-European trade; in addition the control of macroeconomic policy has to a large extent moved from the national to the Community level.

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