F1 Economics Aug 05 061205

THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND

ECONOMICS & THE BUSINESS ENVIRONMENT FORMATION 1 EXAMINATION - AUGUST 2005 Time allowed: 3 hours plus 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 (i) (ii) (iii) (iv) (v)

a note on four of the following: The factors that determine the demand for a good (or service). Opportunity cost. The Balance of Payments. The role of profit(s) in a free market economy. The Accelerator (or Acceleration Principle). [Total 40 Marks]

2.

(a)

What is meant by Economic Rent? Is it possible for entrepreneurs to earn a form of economic rent? (6 marks)

(b)

Set out the assumptions underlying the theory of Imperfect Competition and draw a diagram illustrating a firm at long run equilibrium under imperfectly competitive conditions. (14 marks) [Total 20 Marks]

3.

(a)

Define a Normal Good.

(4 marks)

(b)

A publican declared on a recent radio programme that when he lowered the selling price of the products that he was selling, the amount of money that he was taking in (i.e. his revenue) increased. In such a circumstance, is the demand for his products price elastic, inelastic or of unit elasticity? Explain your choice. (6 marks)

(c)

Based on this information would you recommend other publicans to also lower their prices if they wish to increase their revenue? Justify your recommendation. (3 marks)

(d)

Does the situation which pertains in (a) above ensure that the profits of that publican have increased? Explain your reasoning. (7 marks) [Total 20 Marks]

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4.

(a)

Under what macroeconomic circumstances might the government be inclined to introduce a Budget Surplus? (6 marks)

(b)

Explain the impact of the Budget Surplus on other national economic objectives. (6 marks)

(c)

Is Gross Domestic Product at current market prices just National Income by another name? Explain your answer. (8 marks) [Total 20 Marks]

5.

(a)

Distinguish between an economic union and a monetary union. (You may base your answer on the European Economic Union and the European Monetary Union). (12 marks)

(b)

Is the UK a member of the European Monetary Union? What are the implications of this for the Irish economy? (8 marks) [Total 20 Marks]

END OF PAPER

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SUGGESTED SOLUTIONS

ECONOMICS & THE BUSINESS ENVIRONMENT FORMATION 1 EXAMINATION - AUGUST 2005

TUTORIAL ELEMENTS QUESTION 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 lend themselves to very focussed answering. As in other years the marks awarded for this question were a good predictor of the overall performance of students.

SOLUTION 1. (i)

The main factors which affect the demand for a good is its selling price relative to the selling price of competitive goods. Factors other than its own price which influence the demand for a good include: • • • • •

(ii)

The availability of close substitutes and the selling prices of these substitute goods. The greater the substitutability between goods the more significant is its relative selling price and the less economic freedom has the firm in its marketing decisions. If there are complementary goods then lower prices of complementary goods stimulate the demand for the good in question. The income of those in the target market affects the demand for the good. For normal goods (or services) the higher the level of real income the greater will be the demand for the good (or service). Taste or fashion affects the demand for a good. The more it is in fashion the greater the demand. Expectations as to future changes in price, or concerns about, future availability of the item affect demand.

Opportunity cost is the cost of anything in terms of alternatives foregone and as such it includes explicit cost i.e. the price which I pay for an item and implicit cost i.e. any other cost even if it does not include the paying out of money. Since opportunity cost is defined as the cost of anything in terms of alternative foregone it is usually measured in terms of explicit cost i.e. the price paid for the item. The price which I pay for an item represents the sacrifice which I must make in order to acquire the item e.g. the time that I must work to earn the money to buy the item or alternatively all the other items that I now must do without since I cannot afford to buy them having bought the item in question. Very often this money cost (price) measures opportunity cost to an adequate degree of accuracy. However, just to show that opportunity cost is never less than the money cost it should be realised that buying an item also entails implicit costs such as the search costs in acquiring information regarding the availability and qualities of the good, the cost of the time spent travelling to where the good is to be purchased; additional implicit costs may also be relevant if, for example, there is wear and tear on the motor car in travelling to buy the good. The opportunity cost concept is still appropriate even when no money is involved e.g. the opportunity cost of investing your own money and time in a business is not only the wages that could have been earned if you had have worked elsewhere for a wage but also the return that could have been earned if the money had been invested elsewhere. Similarly the opportunity cost of watching a television programme is all of the other activities which you are precluded from undertaking as a result of watching the television programme.

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There is no opportunity cost in the use of an existing factor of production that is completely specific. If the factor of production has no other use, not even a scrap value, then it has no transfer earnings and consequently no opportunity cost is incurred through using it. Any payment to a factor of production in excess of its opportunity cost is known as an economic rent. (iii)

A country's Balance of Payments which is a record of that country's economic transactions with the rest of the world is divided into two principal sections viz. the current account and the capital account. The current account relates to transactions relating to the purchase or sale of good and services so that the current account section is essentially a record of income, as distinct from capital, transactions. That section of the current account which records the import and export of merchandise (goods) is known as the Balance of Trade. The term invisible exports is often applied to the export of services since nothing of a tangible nature leaves the country in return for the money which is received e.g. foreigners spending their holidays in Ireland; similarly the term invisible imports is applied to the purchase by Irish residents of foreign services. It is extremely unlikely that the value of goods and services imported would be exactly equal to the value of goods and services exported so that there will be a surplus if the value of goods and services imported is less than the value of goods and services exported and a deficit if the opposite applies; in recent years there has tended to be a surplus on the current account. The Balance of Payments is completed when the capital account section is associated with the current account section. The capital account section is an account of a country's inflow and outflow of capital and transactions of this nature cause a consequent net increase or decease in the external reserves of the country. Since the Balance of Payments is a financial statement it is a book-keeping exercise and consequently the totals of the current and capital accounts must balance in the sense that total credits must equal total debits. References to surplus or deficits refer to the current account section of the Balance of Payments or to a change in our level of foreign reserves.

(iv)

The earning of profit is a necessary element in the operation of a free enterprise economy. It enhances the efficiency of a free market system in the following ways: Normal profit is a cost of production; it is the cost of the entrepreneurship factor of production. It is the minimum amount that the entrepreneur must earn if he/she is to remain in that particular line of business. Supernormal profit is a reward to the entrepreneur for successful innovation, for introducing new commodities for which the public is prepared to pay an economic price. Supernormal profit acts as a signalling system from consumers to producers to indicate those goods the supply of which might be increased. The existence of supernormal profits stimulates the desire for entry into an industry. Supernormal profits provide the funds that enable a firm to expand and increase its level of production. Where price competition exists, the actions of competitors constrain the ability of rival firm it increase their selling prices, In these circumstances the firms earning the most profits will be the firms with lowest cost. In this way production is concentrated in the hands of the most efficient firms.

(v)

The Accelerator (or Acceleration Principle) is based on the observation that an increase in the demand for final goods results in a more than proportional increase in the demand for capital goods. In the following example it is necessary for the firm to replace one machine a year as machines sequentially come to the end of their working life. In this scenario when the firm experiences a 10% increase in the demand for tables during year 3 there is a resultant 100% increase in the demand for table-making machinery (i.e. from 1 to 2) in that year Year

Total Demand for Tables

Total Number of Machines Required

Gross Investment

Net Investment

1

1000

10

1

0

2

1000

10

1

0

3

1100

11

2

1

4

1100

11

1

0

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TUTORIAL ELEMENT QUESTION 2 This question was drawn from sections 2 & 3 of the syllabus. It relates to aspects of the course that have strong linkages with Management Accounting and Financial Management. The elements being sought in the answer are set out in the marking scheme. SOLUTION 2. (a)

Economic rent is defined as a payment to any factor of production in excess of its supply price; the supply price is the price which must be paid to bring the factor into a particular use. Though the concept was originally derived in relation to the factor of production land, which was considered to have no supply price, the concept has general application and may be related to each of the factors of production. Yes, it is possible for entrepreneurs to earn a form of economic rent. Normal Profit is the minimum amount of profit which an entrepreneur must receive if she is to continue to supply her services in the long run. Unless Normal Profit is being received an entrepreneur will not remain at that particular line of business in the long run, i.e. it is the supply price of the factor of production entrepreneurship. Supernormal profit is any profit received by an entrepreneur in excess of Normal Profit therefore supernormal profit is a form of economic rent.

(b)

Assumptions underlying the Theory of Imperfect Competition. (i) (ii) (iii) (iv) (v)

Product differentiation exists. The goods that are supplied by different producers are not homogeneous but they are very close substitutes. There is freedom for firms to enter or leave the industry. A firm has the right to supply a competitive product. There is perfect knowledge as to the level of profits being earned by all firms in the industry. There are many buyers and many sellers, each of whom acts independently of rivals. The sole objective of a firm is to maximise profits.

In view of the foregoing assumptions each firm faces a downward sloping demand curve for its product. Because there are many goods that are close substitutes, if the producer increases the selling price of these goods there will be a reduction in demand because some consumers will switch to the substitute goods which have become relatively cheaper. Not all consumers will switch to the competitive goods because consumers do not perceive the goods as being perfect substitutes. Similarly if the producer lowers the selling price there will be an increase in sales as some consumers of other substitute goods will switch to the good in question because it has become relatively cheaper. Thus the level of demand is inversely related to price which means there is a downward sloping demand curve facing each firm, indicating that if the firm increases the selling price of its good there will be a reduction in the quantity demanded. Since the firm is a profit maximiser it will be at equilibrium at the level of output at which marginal cost is equal to marginal revenue subject to the condition that, at that point marginal cost is increasing faster than marginal revenue. If the firm is to be at long run equilibrium then at least Normal Profits must be earned and given the assumptions of this model only Normal Profits will be earned. If Supernormal Profits were being earned in the industry then other firms would be encouraged to seek entry into the industry in pursuit of these Supernormal Profits, remember that according to the assumptions there is perfect knowledge as to the level of profits being earned in the industry and there is freedom of entry into the industry. This market entry would continue while Supernormal Profits are available so that for a long-run equilibrium to exist only Normal Profits must be earned. All of the foregoing is captured in the following diagram:

Long run equilibrium of the firm under Imperfect Competition Page 5

TUTORIAL ELEMENT QUESTION 3. The nature of this question permitted the elements of a comprehensive answer to be set out in sub-sections to the question and the appropriate weighting to be indicated. This question which encourages a form of lateral thinking has links with section 3 of the Management and Strategy syllabus.

SOLUTION 3. (a)

A Normal Good is a good such that more of it is bought when income increases and conversely less of it is bought when income falls; this occurrence is signified by Income Elasticity of Demand for the goods being positive i.e. income and quantity demanded move in the same direction. The formula for calculating Income Elasticity of Demand is the percentage change in quantity demanded divided by the percentage change in income.

(b)

Since the revenue of the firm increased when the selling prices were lowered the percentage increase in the level of sales must have been greater than the percentage reduction in the selling price. In which case the calculation of price elasticity would provide a result greater than 1 in absolute terms. This signifies that demand for the goods was price elastic in response to the price reduction.

(c)

If an individual firm changes the selling price of the goods (or services) that it provides demand would change by a greater amount if its competitors do not also change their selling prices. In the circumstances set out in (a) above competitors have not changed their selling prices. If all firms reduced their selling prices this would have the effect of an inward movement(a shift) to the left of the demand curve facing each individual firms signifying that less would be sold, by a firm at any given price as a result of competitors lowering their selling price. Thus if other publicans lowered their prices they would experience a less elastic response than was experienced by the publican in (a) above. In the absence of precise information it is likely that if all the publicans lowered their prices pro rata than each would end up with more or less their original (pre- any price reduction) market share. It is likely that there would be some increase in the volume of sales within the industry since demand for the output at the industry level would likely increase as a result of the general price reduction. It is not possible to specify the effect of such developments on the revenue of firms within the industry. The point to note is that the change in demand experienced by an individual firm in response to a price change is more elastic if competitors do not also reduce their prices.

(d)

The increase in revenue experience by the publican in (a) does not necessarily mean that his profits have increased. The increase in demand generated by his lower prices means that there has been an increase in the volume of sales, thus there will an increase in his costs as he buys in the extra stock. Also it is possible that there may be an increase in other categories of variable cost e.g. part-time labour to service the extra demand. However most of his costs are likely to be of a fixed nature in which case there would be significant contribution towards overheads from any increase in the volume of sales. On a trivial response one could say that he would not have initiated the reduction unless he expected the action to increase his profits and while this could well be so, expectations are not always realised. Also there could be some over-riding critical short term objective e.g. revenue generation.

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TUTORIAL ELEMENT QUESTION 4. The purpose of this question was to test student’s awareness of the economic environment within which we operate. The details sought in this answer are constantly rehearsed in all forms of media and professional journals. The question is set out in sub-sections to deepen students’ understanding of relevant aspects of the topic.

SOLUTION 4. (a)

A budget surplus indicates that the governments revenue is greater than its expenditure. Since government expenditure is an injection into the circular flow of income and taxation is a leakage the net effect of the budget surplus is to cause the level of aggregate demand to be lower than it would otherwise be. Thus it would be an appropriate budgetary response if the government wanted to reduce the level of demand in the economy. This deflationary impulse would dampen any existent or nascent inflationary tendencies in the economy. The reduction in purchasing power in the economy would also have beneficial effect on our Balance of Payments since our demand for imported goods and services would be reduced to an extent that depends on our marginal propensity to import. Our Balance of Payments is likely to improve from the export side also as economies tend to become more competitive in deflationary conditions with a resultant improvement in the price competitiveness of our exports. The funds that are available to the government from the budget surplus affect not only exchequer borrowing for the current year since the excess money accruing from the budget surplus may be used to reduce the level of National Debt with benefits in future periods through reduced servicing costs..

(b)

Distribution of income within the economy is likely to alter as a result of the budget surplus as generally it is the lower paid workers who tend to be more exposed in the event of downturns in the economy. Other downside effects on objectives of national economic policy as a consequence of the creation of the budget surplus would be the reductions that would be caused in the levels of employment and in the rate of economic growth. The degree of damage to these objectives depends on the state of the economy prior to the creation of the budget surplus. The government’s spatial strategy also is likely to be affected since some regions are more economically vulnerable.

c)

Gross Domestic product at current market prices and National Income are two distinct and different national statistics. Gross Domestic Product (GDP) is the total value of goods and services produced in (say) the Irish economy irrespective of who owns the factors of production that produced the goods. GDP at current market prices indicates that the value of the relevant goods and services is based on current market prices. National Income is the amount of money that accrues to (say) Irish residents from current economic activity. National Income is equal to Net National Product at factor cost so that in order to link GDP at current market prices and National Income it would be necessary to deduct from GDP at current market prices the following: Net Factor Income from abroad, Net Expenditure Taxes and Provision for depreciation.

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TUTORIAL ELEMENT QUESTION 5. Questions on the European dimension of the subjects are set in order to emphasise the significance of our membership of European economic institutions and the shifting sands of economic sovereignty. The question has links with section 7 of Legal Framework

SOLUTION 5. (a)

An Economic Union is a trading area or market within which goods, services, persons and capital can move without hindrance. This feature is usually referred to as the ‘four freedoms’ in acknowledgement of the four areas specified. Thus it is an agreement between countries whereby they agree to eliminate customs duties and other restrictions on trade between them. In addition they impose a common system of tariffs and taxes on goods being imported from outside the area. All of the foregoing could be captured in a Customs Union but an Economic Union is a deeper integration since it entails also the free movement of capital and labour within their areas of jurisdiction. The free movement of labour implies mutual recognition of courses of study and training together with recognition of parity between national qualifications; it carries with it also the right to seek employment and/or practice your profession within the countries that are signatories to the agreement. The main features of a monetary union are: • • • • •

The complete liberalisation of capital transactions so that individuals and companies can transfer money to, and hold bank accounts in, other Member States. Also there would be full integration of banking and other financial markets. The irreversible locking of exchange rates. Complete convertibility of currencies. A Single currency. This is the ultimate feature of monetary union and it captures all of the features mentioned above. The conduct of a uniform monetary and exchange rate policy. Within the European Monetary Union this is assured because under the terms of membership each of the participating countries surrenders control over their monetary and exchange rate policies to the European Central Bank.

A monetary union cannot exist without there being an economic union in existence. However, it is possible for there to exist some form of economic union without proceeding to the deeper integration of a monetary union; this is the case in respect of the North American Free Trade Agreement. (b)

The UK which is our main trading partner is not a member of European Monetary Union. This means that any alteration in the value of the euro against sterling impacts on our foreign trade. If the Euro appreciates against sterling(or sterling depreciates relative to the Euro),then imports from that country would enjoy a competitive price advantage over domestic suppliers, in addition to which our exporters would be subject to a loss of price competitiveness in UK markets. Since we import a significant proportion of or industrial raw materials from the UK inflationary pressures in the Irish economy would be lower than they would otherwise be and our exporters would enjoy a cost advantage over competitors who source their raw materials within the Euro zone. The opposite of the foregoing would apply in the event of the Euro depreciating against sterling. Since Ireland is the country within the Eorozone that has most trade with countries outside the zone we are the most economically exposed country in relation to changes in the foreign exchange value of the Euro.

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ECONOMICS &THE BUSINESS ENVIRONMENT. MARKING SCHEME--- AUGUST 2005.

Q1.

10 marks for each of 4 satisfactory answers.

Q.2.

(a) (b)

Understanding of Economic Rent Assumptions Accurate diagram

6 marks. 7 marks 7 marks

Q.3

(a) (b) (c) (d)

Definition of Normal Good Explanation of elasticity experienced Appreciation of change in elasticity Appreciation of influence on costs/profits

4 6 3 7

marks. marks marks marks

Q.4.

(a) (b) (c)

2 appropriate circumstances @ 3 marks each Effect on 2 other objectives @3 marks each Understanding of each term @ 2 marks each Understanding of relationship between them

6 6 4 4

marks marks marks marks

Q.5.

(a)

Understanding of economic union Understanding of monetary union Position regarding UK Implications of UK position

6 6 1 7

marks marks mark marks

(b)

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40 marks.