F1 - Economics April 2007

ECONOMICS & THE BUSINESS ENVIRONMENT

FORMATION 1 EXAMINATION - APRIL 2007 NOTES

Answer four questions, question I which is compulsory and any 3 other questions.

TIME ALLOWED:

3 hours, plus 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 I EXAMINATION – APRIL 2007 Time allowed: 3 hours, plus 10 minutes to read the paper.

Answer 4 questions, question 1 which is compulsory and any 3 other questions. Question 1 is allocated 40 marks and each of the other questions are allocated 20 marks.

1.

Write (i) (ii) (iii) (iv) (v)

a note on four of the following: The characteristics of Economic Goods. Economic Rent. The factors that determine (or influence) Price Elasticity of Demand for a good (or service) Fiscal Drag. Formal and the Impact Incidence of a tax. [40 Marks]

2.

(a)

What is meant by ‘long run equilibrium’ as the phrase is used in relation to a firm that seeks to earn as much profit as possible. e.g. a profit maximising firm at long run equilibrium. (4 marks)

(b)

Under what conditions (or circumstances) would a profit maximising firm be at long run equilibrium? (6 marks)

(c)

An Irish firm that seeks to earn as much profit as possible is competing against firms from other Euro zone countries in a market that is perfectly competitive. If the Irish firm is at long run equilibrium explain how the Irish entrepreneur is likely to react to each of the following eventualities: (i) there is a general round of wage increases in Ireland; (ii) there is an increase in the world price of oil. (10 marks) [Total: 20 Marks]

3.

(a)

Is economic growth desirable? Explain your answer. (8 marks)

(b)

What is meant by sustainable economic growth?

(4 marks) (c) Is it possible for the Irish economy to have continuing growth rates of (say) 7% per annum? Justify your answer. (8 marks) [Total: 20 Marks]

Page 1

4.

(a)

From the following information calculate (i) the level of GNP in period 2 (ii) the Multiplier (iii) the marginal propensity to import (MPM) and (iv) the marginal propensity to save (MPS). (For the purpose of this question we are not including the government sector)

Private

PERIOD 1 PERIOD 2

GNP

CONSUMPTION

INVESTMENT

EXPORTS

IMPORTS

€

€

€

€

€

23800

17000

6000

3000

2200

18200

6300

3400

2400

(12 marks) (b)

State, giving reasons, if you would expect the value (and/or volume) of imports to increase if there is an increase in value (and/or volume) of exports. (8 marks) [Total: 20 Marks]

5.

(a)

What actions might an economic independent government take if it wished to increase the level of aggregate demand in the economy? (Ireland before we joined EMU or currently the UK government are examples of economically independent governments). or

Explain the policy instruments available to an economically independent government that seeks to regulate the macro economy. (10 marks) (b)

Explain how joining the European Union and EMU has affected the Irish government in its efforts to regulate the Irish economy. (10 marks) [Total: 20 Marks]

END OF PAPER

Page 2

SUGGESTED SOLUTIONS

ECONOMICS & THE BUSINESS ENVIRONMENT FORMATION I EXAMINATION – MAY 2007 SOLUTION 1. The format and nature of this question is to acquire an indication of the student’s overall understanding of the subject. It not only permits the exam paper to reflect more accurately the comprehensive nature of the syllabus but also increases the opportunity for students to obtain full reward for their studies. The topics chosen for the elements of this question are fairly precise and have links with the syllabi of various other subjects including taxation, advanced taxation, management accounting strategic management accounting & management and strategy. The pattern to date has been that the level of answering in this question has been a good predictor of the overall performance of students. (i)

In the study of economics we are concerned with goods which are capable of being bought and sold, such goods are known as economic goods and their characteristics are: ●

●

●

(ii)

Utility. Utility refers to the ability of a good to give satisfaction or satisfy a need or want, it is this ability which renders goods desirable. Thus since goods must be desirable if they are to be bought it is a characteristic of economic goods that they possess utility. It would be futile to attempt to sell something which is a nuisance or irritant and has no utility. Scarcity. Economic goods are scarce in relation to the demand for them. The concept of scarcity as used here means that there is not enough of the good to satisfy the demand of all those who want it; this is why people must pay a price in order to acquire it. Thus in this country fresh air would not be an economic good because even though it provides utility it is not scarce in relation to the demand for it. Transferable. Economic goods must be capable of being passed from one person to another i.e. they must be transferable. People are unable to sell what they cannot pass to the buyer and people won't buy what they cannot receive or control. It is because they do not satisfy this criterion of transferability that good health, pleasant disposition, beauty and intelligence are not economic goods even though they satisfy the first two criteria of possessing utility and are scarce in relation to the demand for them in the sense that not everybody has them though all desire them.

The supply price of a factor of production is the sum of money which must be paid in order to acquire the use of that factor. Economic Rent is any payment to a factor of production in excess of its supply price. The supply price of the factor of production labour is the transfer earnings of the factor i.e. the payment (or net benefits) which it can earn in the next best situation available so that if a firm employs an electrician at a wage of € 600 and the transfer earnings of the electrician is €480 then in this instance the electrician would enjoy an Economic Rent of €120.To the extent that workers would be willing, if necessary, to continue working in their present jobs even if their wages were reduced then they are certainly earning some Economic Rent. In general, the existence of Economic Rent may also be deduced if workers of similar ability are employed elsewhere in comparable work and these workers would be willing to transfer from their present employment to the job in question. One of the reasons why workers might enjoy an Economic Rent could be due to the existence of a trade union in the particular job. Since Economic Rent is a payment in excess of the supply price i.e. in excess of the transfer earnings of a factor, then the more narrowly defined the occupation the lower will be the Economic Rent. For example if the occupation of a person is "a CPA in firm A" then his/her Economic Rent may be close to zero since he/she might be able to earn virtually the same salary as "a CPA in firm B". However if the individual's occupation is defined within the firm as "an accountant" then the next best job available to him/her may be as a general clerk with considerably lower earnings, in which case there would be an element of Economic Rent in the payment that s/he receives in the position that is classified as ‘an accountant’ Rent. In relation to entrepreneurs Normal Profit is considered to be the supply price of entrepreneurs so any payment in excess of this supply price viz: Supernormal Profit would be considered a form of Economic Rent. Page 3

(iii)

Price elasticity of demand refers to the sensitivity of demand for a good in response to a change in its own price. The factors which affect price elasticity include the following. ●

●

●

●

●

The availability of close substitutes at competitive prices is the greatest single influence on price elasticity of demand. Goods are purchased because they provide utility, if there are other goods available at comparable prices which provide more or less the same utility consumers will switch to buying these substitute goods if the price of the good in question is increased more than the price of substitute goods. Similarly if the price of a good is reduced relative to the price of substitute goods the consuming public will switch to buying the good which has become relatively cheaper. The closer the degree of substitutability the more will consumers tend to switch their purchasing behaviour in response to a change in relative prices and consequently the greater will be price elasticity. If the good in question is one of two goods which are in joint demand then this complementarity affects price elasticity of demand for the good. Reductions in the price of complementary goods will increase the demand for the good in question e.g. a reduction in the price of motorcars will increase the demand for petrol. If the good in question is the cheaper of two goods which are in joint demand, then the demand for it is likely to be relatively inelastic in response to changes in its own price. The proportion of income which is spent on the commodity also affects it elasticity. In general the greater the proportion of a person's income which is spent on a good the greater will be that person's price elasticity of demand for the good. The reason for this is that the greater the proportion of your income which you spend on the goods the more significant to you is a change in its price. The more durable the commodity the more elastic is the demand for it likely to be in response to changes in its own price. This is because it is easier the postpone the purchase of such goods by extending the life of the existing model. Examples of such goods are refrigerators, bicycles, lawnmowers. The expectations of consumers as to future price changes will affect elasticity. No matter what is happening in respect of current prices if consumers expect prices to be lower in the future they will refrain from buying in the present conversely they will bring forward their purchasing if they expect prices to be even higher in the future.

(iv)

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, or targeted, 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 since when budgeting for a surplus the intention of the budget strategy is that purchasing power will be taken out of the economy. The term fiscal strategy tends to be 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 usually is attributable to the economy being more buoyant than was envisaged at budget time so that tax revenues are greater than anticipated. If this situation develops when the economy is at less than full employment then the effect of fiscal policy is lessen the degree of economic activity, at least in the short term, until discretionary fiscal policy may be implemented. 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 form of occurrence that is referred to as fiscal drag.

(v)

The incidence of a tax refers to the manner in which the burden of the tax is borne. A distinction can be drawn between the formal incidence of the tax which means the person or commodity on which the tax was levied, and the effective incidence of the tax which means who actually pays the tax e.g. a tax on builders may result in an increase in the price of houses by the amount of the taxes, in which case, though the formal incidence of the tax would have been of builders the effective incidence of the tax is on purchasers of the properties. This concept is relevant also in a slightly different context which recently hit newspaper headlines when they reported government statements that there was a likelihood that any reduction in stamp duty on houses which was intended to benefit purchasers of houses would end up in the Page 4

pockets of builders, if as anticipited the price of houses would be increased to reflect any reduction in stamp duty. 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 in respect of direct taxes such as income tax it may be possible for a retailer to shift ‘forward’ on to customers or 'backwards' on to manufactures all, or some of, the incidence of an expenditure or excise tax. Whether or not this is possible depends 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.

Page 5

SOLUTION 2. This question is drawn from information set out in sections 1 and 2 of the syllabus; part (c) of the question depicts a situation encountered by Irish exporting firms. The area of the syllabus being tested is complementary to topics developed in management accounting and strategic management accounting. (a)

Long run equilibrium means that in a time period sufficiently long to enable a firm to adjust to market conditions that it is performing in a manner that achieves, or gets as close as it can to achieving, its objective(s). In relation to a firm which is pursuing a profit maximisation objective it means that under exsisting market condition it is not possible for the firm to earn a higher level of profit by changing either its level of output or its selling price. Thus there is no incentive for this firm to change its selling price or level of production unless there is some change in market conditions.

(b)

A profit maximising firm would be at long run equilibrium under the following conditions:

(c)

(i)

producing a level of output at which marginal cost is equal to marginal revenue.

(ii)

subject to the condition that when producing the level of output set out in (i) above marginal cost is increasing at a faster rate than is marginal revenue.

(iii)

the firm must be earning at least Normal Profit.

(i)

A profit maximising firm at long run equilibrium in a perfectly competitive market would be earning Normal Profit. If there was a general round of wage increases in Ireland and such a wage increase was not being experienced by the foreign competitors then since the Irish firm acting on its own is not in a position to influence market prices then this increase in costs would result in the firm earning less than Normal Profit and thus it would be forced to leave the industry in the long run. If in the short run the revenue of the firm was in excess of its variable costs then it would stay in the industry in the short term and exit in the long run. If all firms in the industry suffered the same increase in world oil prices and assuming that this impacted to the same extent on all the firms then the increase could be passed on to the consumers through increased selling prices.

(ii)

Page 6

SOLUTION 3. Information set out in sections 5 and 6 of the syllabus is being sought in this question. Knowledge acquired in this section of the course will provide a basis for further analysis of this and related topics in strategic management and management and strategy. (a)

Economic growth is desirable to extent that there are benefits attaching thereto. Economic growth is measured by the increase in the quantity of goods and services available to us. Thus the principal reason for pursuing economic growth is because it improves the general standard of living. Economic growth provides the resources for investment and also incentives to invest. Through increased economic growth it is possible to alleviate poverty and it is easier to gain acceptance for such redistributive policies when the general standard of living is rising. In addition economies of scale are possible in activities undertaken by the government so that during a period of economic growth government expenditure as a proportion of GDP should fall. There are costs associated with economic growth as can be seen in the Irish economy at present. Examples of these costs are infrastructural pressures, pollution, misdistribution of the benefits of economic growth and the threat of inflationary pressures.

(b)

Sustainable economic growth means that it is possible for the economy to continue to grow in future periods at the rate that is currently being experienced on that current rate of Economic growth will not inhibit the future rate of Economic growth.

(c)

If an economy is not operating at full employment then, depending on the degree of underutilisation of economic resources or current technological best practices it is possible for the economy to grow at a spectacular rate in a form of ‘catching-up’ exercise. However once an economy is at a developed stage and operating at full employment then future rates of growth are depending on capital deepening, more skilled work force and the possibility of an increasingly immigrant work force. Significant increases in the population of the country also impose pressures on the economic and social infrastructure so that continuing increases in economic growth at rates of 7% become increasingly less likely.

Page 7

SOLUTION 4. This question which relates to sections 5 and sections 8 of the syllabus illustrate in a quantified way the interrelationships between different sectors of the economy. This approach will assist the student in recognising precise linkages within the economic and business environment and will be of benefit when studying the content of the management and strategy course. (a)

(b)

(i)

Level of Income (Y)

=

Consumption + Investment + (Exports – Imports).

= = =

18050 + 6300 + (3400 – 2550) 18050 + 6300 + 850. 25200.

(ii)

From period1 to period 2 injections increased by € 700 (an increase of €300 in respect of investment and an increase of €400 in respect of exports). As a result of this increase of €700 in injections GDP increased by €1400 (from €23800 to € 25200) therefore the multiplier is 2.

(iii)

When income increased by €1400 imports increased by €350 therefore the Marginal Propensity to Import (MPM) is equal to 350/1400 = 0.25.

(iv)

When income increased by €1400 consumption increased by € 1050 so that the Marginal Propensity to Consume (MPC) is 1050/1400 = 0.75. Since the Marginal Propensity to Save is defined as 1 – MPC therefore the Marginal Propensity to Save is equal to 0.25.

As shown in the above example when there is an increase in the level of exports there is an increase in the level of injections into the economy. The extent to which an increase in exports increases the level of income in the economy depends not only on the magnitude of the increase in exports itself but also on the magnitude of the multiplier. Thus when exports increase purchasing power within the economy increases and in the course of spending this additional income there emerges an increase in demand for imported goods and services. In addition to purchasing additional imported goods and services consumers also spend some of their additional money on indigenous goods and services and as many of these goods use imported raw materials this is another source of increased demand for exports. Given the importance of oil products in the conduct of economic life any increase in wealth within the economy will result in a direct and indirect increase in demand for this imported product.

Page 8

SOLUTION 5. The material for this topic is contained in sections 6 & 8 of the syllabus. It has links with the legal framework syllabus and also is complementary to aspects of the strategic management course. Exam questions based on new circumstances arising from the shift of macroeconomic decision making to European institutions help to develop students’ understanding of the changed and changing business environment that applies to Irish firms and institutions. (a)

The policy instruments available to an economically independent government are Monetary Policy, Exchange Rate Policy and Fiscal Policy. It is generally accepted that it is not possible to consider monetary policy and exchange rate policy as two distinct objectives. The level of interest rates within a jurisdiction affects both the level of economic activity and the external value of the currency so that if interest rates are being used as a tool for regulating the level of domestic demand they it is not available as a discretionary tool for the influencing the external value of the currency. However, there is a convention in text books to discuss each of them separately. In terms of monetary policy if the authorities wish to stimulate the economy policies could be directed towards lowering interest rates and increasing the money supply. In terms of exchange rate policy if there had been a fixed exchange rate policy in place a decision might be made to devalue the currency alternatively a policy of ‘benign neglect’ could be adopted whereby the authorities take no action in the fact of a downward float in the foreign exchange value of the currency. In terms of fiscal policy an expansionary fiscal policy in conducted through budget deficits. A reversal of each of the above polices would be the appropriate action if the wish was to deflate the economy in such circumstances increased interest rates, currency appreciation and budget surpluses would be the order of the day.

(b)

Ireland and the other member states have sacrificed some economic sovereignty upon joining the European Union and European Monetary Union. Monetary policy for the Euro zone is within the jurisdiction of the European Central Bank. Thus the level of interest rates that apply within the Irish economy are set by the ECB and are not at the discretion of the Irish authorities except in so far as we are members of the decision making board within the European system of Central Banks. In contrast to the approach adopted by the Irish authorities which would be determined by what is best for the Irish economy the ECB will base its decision making on what is appropriate for the Euro zone in general rather than concentrating on what is in the best interest of any individual member state. Even more obvious is the inability of the Irish authorities by their own actions to influence the foreign exchange value of the Euro currency. Despite our membership of European Monetary Union the Irish authorities still have some control over fiscal policy; it is still possible to stimulate the economy by an expansionary fiscal policy. However, there is a constraint on this discretion since under the terms of the Stability & Growth Pact budget deficits should not be greater than 3% of GDP. However, since tax harmonisation is not a feature of European Monetary Union the Irish government has discretion over the manner in which it imposes its taxes.

Page 9

ECONOMICS &THE BUSINESS ENVIRONMENT. MARKING SCHEME--- May 2007

Q1.

10 marks for each of 4 satisfactory answers.

Q.2. (a)

Q.3

40 marks

An adequate definition

4 marks

(b)

3 conditions @ 2 marks each

6 marks

(c)

Reaction to each devloment @ 5 marks

(a)

4 aspects of economic growth @ 2 marks each

8 marks

(b)

An adequate explanation

4 marks

(c)

2 relevant considerastions @ 4 marks each

8 marks

Q.4. (a) (b) Q.5. (a) (b)

10 marks

4 parts to the question @ 3 marks each.

12 marks

2 reasons @ 4 marks each.

8 marks

1 policy instrument @ 4 marks & 2 @ 3 marks each.

10 marks

Restriction on fiscal policy @ 4 marks. Non-availability of other 2 instruments @ 3 marks each

10 marks

Page 11