F1 - Economics August 2007

ECONOMICS & THE BUSINESS ENVIRONMENT

FORMATION 1 EXAMINATION - AUGUST 2007 NOTES

Answer four Questions, Question 1 which is compulsory and any three 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. List on the cover of each answer booklet, in the space provided, the number of each question(s) attempted.

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

ECONOMICS & THE BUSINESS ENVIRONMENT THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND

FORMATION I EXAMINATION – AUGUST 2007

1.

2.

Write a note on four of the following:

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

(a)

ʼThe consumer will always be better off if goods (or services) are supplied by a perfectly competitive industry rather than an industry that is monopolisedʼ State, giving reasons, if you agree with this statement. (10 marks)

Is it possible for workers in Irish firms to be paid higher wages than is being paid to similar workers in foreign firms that are in competition with the Irish firms in question? Explain your answer. (10 marks) [Total: 20 Marks]

(a) (b) (c)

4.

Distinguish between the Short Run and the Long Run (as these terms are used in economic analysis). The Margin (or Marginal Analysis) Imperfect Competition. Consumer Price Index (CPI). The Law of Comparative Advantage (in international trade). (4 x 10 marks) [Total: 40 Marks]

(b)

3.

Answer four Questions, Question 1 which is compulsory and any three other questions.

Using a Circular Flow of Income diagram explain the factors that determine the level of economic activity in the Irish economy. (8 marks)

In respect of the Irish economy has Gross National Product (GNP) or gross Domestic Product (GDP) been growing at a faster rate in recent years? (Briefly explain your choice). (4 marks) Set out the economic implications of foreign immigration to Ireland in recent years.

(8 marks)

[Total: 20 Marks] (a) (b)

Explain how it is possible for the banking sector to create purchasing power and the factors that determine the amount of (or the limits to) the amount of purchasing power that they can create. (11 marks)

Set out 3 ways in which joining European Monetary Union (the Euro zone) has impacted on the Irish banking sector. (9 marks) Page 1

[Total: 20 Marks]

5.

(a)

(b)

The Minister for Finance bases his budget on an estimated level of activity in the Irish economy during the period of the budget. Explain the likely effect(s) on (i) Government revenue and (ii) the budget outturn (i.e. budget surplus or budget deficit) if economic activity is greater than expected during the period of the budget. (8 marks)

If the circumstances occur as set out in (a) above and given the present state of the Irish economy what action(s) do you think the Minister should take? Indicate how your recommendation would impact on the objectives of National Economic Policy. (12 marks) [Total: 20 Marks]

END OF PAPER

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SUGGESTED SOLUTIONS

ECONOMICS & THE BUSINESS ENVIRONMENT FORMATION I EXAMINATION – AUGUST 2007

SOLUTION 1

(i)

(ii)

(iii)

The format and nature of this question is to acquire an indication of the studentʼs 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.

The short run period is defined a period during which the quantity supplied of at least one factor of production is fixed; consequently the costs relevant to that factor of production will be fixed in the short run. In general the term is applied to the period required to adjust to emerging circumstance. As will be realised from the definition the term the short run does not refer to a precise calendar period, not only will it vary between industries but with the passage of time it will even vary within an industry. If it takes five years to replace an electricity generating station then the short run period for that industry would be five years ,in contrast to this the short run period is probably one day for a person selling daily newspapers outside a store in the city. Similarly if a firm has a 6 month lease on a premises and all its other costs are undertaken on a week-to-week basis then the short run for this firm is 6 months but when the firm has been trading for one month then the short run period becomes 5 months. Thus it will be realised the very concept of the short run is based on the existence of a fixed cost i.e. it is defined as the period during which some form of fixed cost exists. By implication the long run is a period long enough to permit a firm to extricate itself from any current fixed cost commitments.The law of diminishing marginal returns also arises because of a fixed factor of production and consequently is a short run phenomenon

The margin is the area where change first occurs. In economics we are constantly attempting to establish the relationship between cause and effect. It pursuit of such relationships we constantly focus our attention on that areas where change occurs e.g. if 100 people buy a good when its price is €130 and 98 people buy the same good when its price is increased to €131, we tend to say that 2 people less buy the good when its price was increased by €1 rather than say that 98 people continue to buy the good even though its price has increased by €1. It may be said that the margin is the most sensitive constituent in response to the change which has occurred. Thus we refer to the consumer who purchases an increased quantity when price is reduced or who reduces the quantity they purchase when price is increased as a marginal consumer i.e. the consumer who responds to the change in price. Marginal costs and marginal revenue are other examples of the use of the marginal concept. When used in this context the term in relation to costs refers to the change in total costs as a decision is implemented and similarly marginal revenue is the change in total revenue when the price of, or demand for, our product changes.The concept is also used outside of economics e.g. the term marginal voters is applied to those whose allegiance is relatively easily swayed.

The term Imperfect Competition characteristics: ● ● ● ● ●

is used to describe a form of market structure with the following

Product differentiation exists. The goods that are supplied by different producers are not homogeneous but they are very close substitutes. There is freedom to enter the industry and freedom for firms to exit the industry. Thus firms have the right and the opportunity to supply competitive products. There is perfect knowledge as to the level of profit being earned by all firms in the industry. There are many buyers and many sellers each of whom act independently. Firms are profit maximisers. Page 4

(iv)

(v)

In the light of these characteristics of this form of market structure the long run equilibrium of the firm can be determined. The individual firm is subject to a downward sloping demand curve because of the availability of close substitutes. The firm will be at equilibrium producing a level of output at which marginal cost is equal to marginal revenue and at this particular level of production marginal cost will be increasing faster than marginal revenue; since this is the optimum level of production for a firm that seeks to earn as much profit as possible. In can also be determined that at this long run equilibrium the firm will be earning Normal Profit because there is perfect knowledge as to the level of profitability in the industry and other firms have freedom to enter the industry if they so desire.

The Consumer Price Index (CPI) is designed to measure the change in the average level of prices (inclusive of all indirect taxes) paid for consumer goods and services by all private household in the county and by foreign tourists holidaying in Ireland. The CPI is compiled by the Central Statistics Office and is probably the best known of the various Irish published statistics. A household budget survey is undertaken to determine a representative or average ʻbasketʼ of consumer goods and services and the combination of goods and services that comprise this ʻbasketʼ is updated by periodic surveys. This representative basket is the basis of the weights applied to the recorded price changes in order to determine changes in the general level of prices for the average family. The CPI is constructed through the collection of 55000 prices in a representative basket which cover over 1000 different items. The CPI measures changes in the cost of buying a fixed basket of goods and certain caveats apply if using the CPI as a cost of living index. The index measures the cost of buying a fixed basket of goods and does not take into account the manner in which households may change their pattern of expenditure in response to changes in prices. The various weight used are used to determine the relative importance of the various items are averages based on surveys and their relevance to specific individuals will vary depending on individual circumstances. It should be noted that the index does not reflect changes that may have occurred in the quality of the goods that are included in the index. The Law of Comparative Advantage which is known also as the Law of Comparative Cost illustrates how it is economically advantageous for a country to concentrate on the production of those goods in which it has the greatest comparative advantage i.e. in the production of which it is relatively most efficient. Thus even though country A may be able to produce each of two goods using less resources than country B requires in order to produce identical goods it may still be advantageous for country A to concentrate on the production of the good at which they are relatively more efficient and import their requirements of the other goods. It is for this reason that countries often import goods which they are capable of producing in their own domestic economy since through international trade they can acquire these goods at a lower opportunity cost than if they had have produced the goods themselves. The concept is analogous to the division of labour at the micro level where economic agents concentrate on those tasks at which they are relatively more efficient and purchase their other requirements. Like all economic laws certain restrictions or assumptions apply to the application of the law of comparative advantage. These assumptions include the requirement that the relative prices of the goods in question are set within limits which render the trade beneficial to both the producer and the purchaser since no economic trade will ever be voluntarily entered into unless it is mutually advantageous. The law also is based on the assumption that the costs incurred in transporting the goods to their markets are not so great as to erode any cost differentials in production.

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SOLUTION 2 Information contained in sections 2, 6 and 8 of the syllabus has relevance for the information sought in this question. It relates to aspects of the Economics syllabus that have strong linkages with Management accounting, Strategic Management Accounting and Management & Strategy (a)

(b)

If cost conditions are the same in both the perfectly competitive and the monopolistic industries then the equilibrium level of output of the monopolistic industry will always be lower and the equilibrium selling price of the monopolist will always be higher that they would be in an industry in which the firms sell their products under conditions of perfect competition. Since the monopolist constitutes the entire industry it is typically a larger firm than the small firm which typifies the perfectly competitive industry. Because of this difference in size it is possible that the monopolistic firm will enjoy economies of scale in which case its unit cost of production will be lower than that which would apply in the perfectly competitive industry. If the monopolist enjoys economies of scale as a result of the consequent lower costs of production s/he is enabled to lower the selling price of their goods if in so doing the resultant demand would increase profitability. Thus the cost to the consumer would be lower even though the monopolist may still be earning supernormal profits. In such circumstances it could be said that part of the cost reducing benefits of the economies of scale is being passed on to the consumer. In addition security of supply and product development are features that are more characteristic of monopolistic rather than perfectly competitive industries.

If Irish and foreign competitors are similar in every way and Irish workers negotiate a wage increase then it will not be possible to pass this wage increase on to consumers by way of price increases. In such circumstances either employment and/or level of profit will come under pressure. However, if the structure of the industry is such that entrepreneurs are currently earning supernormal profit then additional costs that simply reduce the level of supernormal profit will not drive firms out of the industry though it may well alter their long run equilibrium level of production and thus levels of employment. In circumstances where the Irish firm has been earning no more than Normal Profit then any form of cost increase will cause the entrepreneur to exit the industry in the long run. It should be noted that entrepreneurs think in terms of after-tax returns so that lower levels of corporation tax may maintain the economic viability of the enterprise even in the face of higher wages. However a distinction should be drawn between higher wage costs and higher costs of production. The higher wage costs may reflect improved productivity of workers so that despite this wage increase the net effect of the increased wage rates and the improved productivity may be lower unit costs of production. Also when workers are well paid the level of nutrition, housing ,education, training and general health is more likely to be of a standard that would enable workers to achieve high levels of productivity ;in addition an attractive wage level encourages a high degree of commitment which impacts on the efficiency of labour. The phrase ʻ a high wage economyʼ captures the situation where workers in some European countries are among the highest paid and the most productive in the world.

Some possible developments that could lead to improved labour productivity and thus justify higher wage rates are --- improved technology, capital deepening, improved quality of the workforce, cooperation of the work force in the removal of labour side restrictions.

The ability of management to manage the process of production in a manner that maximises the potential of workers also influences the marginal productivity of workers and thus the economic viability of increased wages.

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Solution 3 The information sought in this question is contained in section 4 of the syllabus. The question draws the studentʼs attention to the interrelationship of the various elements that constitute our economy and thus encourages students to appreciate the macro parameters within which local - level decision making is set. In this way the quality of business decision making may be improved. . Part (c) of the question relates to an important aspect of development in the Irish business and economic environment which will resonate in future economic planning The topic of the question has direct relevance to the courses that will be pursued in Legal Framework, Strategic Management Accounting and Management & Strategy

The circular flow of income diagram, illustrates how income flows through an economy. Firms in order to produce goods and services require command over factors of production; entrepreneurs achieve this command by purchasing or hiring the required factors of production. Households are the consumers of the goods and services and they acquire the money which enables them to purchase the goods and services through selling their labour and any other factors of production which they own. If households spent all of their income in buying the output of domestic firms and if all the revenue of firms accrued to domestic households - in the form of wages, rent, profit and interest - then there would be a continuous non-varying circular flow of income between domestic households and domestic firms.

However, economic life is not as simple as that. Households have many options on how to allocate their income, their income can be spent on domestically produced goods or on foreign produced goods; Alternatively not all of the income need be spent some of their income can be saved or it may be required in order to pay taxes. Any income which is not channelled back to domestic firms is in effect a withdrawal from the circular flow of income and of itself results in a diminution in the level of activity in the domestic economy. Withdrawals consist of (i) savings, (ii) money spent on buying imported goods and services and (iii) payments of tax.

Similarly the income of firms is not derived solely from the spending of domestic households. Domestically produced goods and services are also purchased by (i) the government, (ii) by foreign purchasers of the goods which we export and (iii) by firms who use some of their income to purchase capital goods in the domestic economy as a form of investment. Because government spending, exports and investments increase the level of activity in the domestic economy they are referred to as injections into the circular flow of income.

The withdrawals and injections in the circular flow of income may be related to each other. If people save then banks and other financial institutions will have funds to lend, similarly if tax revenues increase it will be possible (easier) for the government to increase (or maintain) its spending and if our currency is used to buy the produce of foreign firms (our imports) this will provide them with the currency they require in order to buy our exports. The circular flow of income diagram shown in part (a) of this question illustrates this analysis.

If injections exceed withdrawals the level of expenditure in the domestic economy will rise and consequently there will be growth in the domestic economy. conversely, if withdrawals exceed injections the level of expenditure in the domestic economy will diminish and the domestic economy will experience recession. Page 7

(b) (c)

Gross Domestic Product has been growing at a faster rate than Gross National Product since the Irish economy in recent years has been one of the fastest growing economies in the world and net factor income from the rest of the world is a negative amount. ● ● ● ● ● ● ●

Without foreign workers the Irish economy could not have experienced the high growth rates of recent years. The size of the Irish GDP in absolute terms (and also per capita) has increased. The size of the domestic market has increased for indigenous firms. In their absence improvements in the economic infrastructure of the country would not have been as far advanced as it is. The presence of these workers has increased the pressure on the capital infrastructure of the country. A relatively high proportion of wages of such workers is repatriated. The future plan of such individuals as to whether or not they stay is an imponderable that has considerable significance for long term economic planning.

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Solution 4

(a)

Part (a) of this question is drawn from section 7 of the syllabus and part (b) from section 8. The question heightens studentʼs awareness of their business environment through deepening their understanding of the manner in which the financial sector operates. The knowledge gained is complementary to aspects of the syllabi for legal framework and management & strategy.

When a bank accepts a deposit and subsequently grants a loan it is not merely transferring purchasing power from lenders to borrowers but rather because of the fractional reserve system it can lend out a multiple of the original deposit and in this way actually create purchasing power. When a bank receives a deposit for €1,000 it doesnʼt need to keep this deposit entirely in a the form of cash., from experience the bank knows that only a percentage of the deposit will be required as cash and the more successful banks are in encouraging the public to use cheques, debit cards or any other form of non-cash transfers the lower this percentage will be. For example let us assume that a bank considers 10% of deposits to be a prudent liquidity ratio, a prudent liquidity ratio is the ratio which retains at the disposal of the bank sufficient liquid assets to enable it to satisfy all the demands make on it for cash. Although more than 10% of balances are operational only approx.10% involve cash transactions because most transactions are conducted without recourse to cash e.g. through the use of cheques. Thus in our present example of the €1,000 in cash deposited with the bank it need hold only €100 to provide it with adequate liquidity and consequently €900 can be lent out. This €900 which has been lent out will in the course of fulfilling its money function(s) return to the banking system, the person to whom this loan is granted buys from the local office suppliers a photocopying machine for €900. The office supplier lodges the €900 in their bank account in bank B and this bank which also operates a liquidity ratio of 10% seeks to lend out €810 from the lodgement of €900 and so this process continues until the repercussions of the original lodgements peter out. The final effect of the initial lodgement of €1000 would be the creation of €10,000 of additional purchasing power. This is an example of the money multiplier in operation, in this example with a liquidity ratio of 10% the money multiplier is 10. In general terms the money multiplier is the inverse of the liquidity ratio. In practice the creation of purchasing power is not as mechanical as the foregoing might suggest, the following factors are also relevant.

● ● ●

●

●

(b)

Banksʼ ability to grant loans is related to the magnitude of their deposit base, so it is directly related to their ability to generate deposits. All of the money may not find its way back into the financial system. Attention must also be focussed on the demand for loans. While banks may have the ability to grant loans the general public may not wish to borrow the entire funds which are available. Similarly banks will only be prepared to loan to those who they consider to be a good risk. Banks do not have one liquidity ratio, they know from experience that at particular times of the year e.g. Christmas, there will be an increase in the demand for cash so at such time they need to hold a higher ratio of assets in cash form. Banks must comply with the regulations of the Financial Regulator and the laws of the land.

However, many text books concentrate on (i) the deposit base, (ii) the liquidity ratio and (iii)the demand for loans as being the salient features in respect of the amount of purchasing power that banks can create.

● ● ● ● ● ● ● ●

Loss of revenue previously earned on currency conversions. Access to European money markets without any exchange rate risk. Foreign banks and financial institutions have freedom of access to the Irish market and furthermore the increased attractiveness of the market makes entry more likely. Virtual banks can be set up here (i.e. without a physical presence) Growth of IFSC in which the banking sector has a considerable stake. Virtual elimination of opportunistic speculation regarding the foreign exchange value of our legal tender. Freedom for banks to enter the pan European banking sector. Freedom from political restrictions on their operations.

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SOLUTION 5

(a)

(b)

This question is based on the material contained in section 6 of the syllabus and emphasises the implications arising from our loss of economic sovereignty and the extent to which Irish business is reliant on European institutions to provide an appropriate economic environment for Irish enterprises. The topic and strong linkages with strategic management accounting and management and strategy. Part (b) of the question seeks to test knowledge on the current business environment and the parameter which govern decision making in the macroeconomy The revenue that the exchequer receives during the period of the budget depends on tax rates and the taxable base. The taxable base is the level of income in the case of income tax, the level of expenditure in the case of VAT, the extent of house purchases in the case of stamp duty, the level of profits in the case of corporation profits tax and so on. This taxable base varies with the level of activity in the economy. Since the tax rates are set for the period of the budget, if economic activity is greater than estimated in the budgetary arithmetic then the taxable base will increase and consequently tax revenue will exceed that which was forecast and for which allowance was made. If there is an unexpected increase in economic activity and if government expenditure is as intended then the budgetary outturn will be better than expected at the time of the introduction of the budget. Thus if the fiscal stance had been expansionary the outcome will be a lower deficit, it may even be converted into a budgetary surplus. Conversely if the government had budgeted for a budget surplus then the outturn would be an even bigger budget surplus. All of this is an aspect of the fiscal stabilisation phenomenon.

In recent budgets estimates of economic growth have been conservative so that tax receipts have been greater than anticipated. If the position prevails currently then the Minister will have additional funds at his disposal. Given the present situation of full employment and our relatively high rate of inflation a case can be made for simply taking the excess out of circulation and reducing government debt. Given our large infrastructural deficit some would suggest accelerating the plans to address these problems through bringing forward elements of the National Development Plan. The ESRI has been advising strongly against overloading the construction industry which is already at full employment and they argue that spending in this area will result in poor value for money. In official circles there is a reluctance to reduce tax rates the feeling being that they already are at competitive levels in addition to which it is difficult to claw back any such tax reductions in future less affluent times.

It should be realised that any possible actions by the Minister in spending the additional revenues would put pressure on inflation. Given the present state of full employment any such spending would put upward pressure on wage rates and possibly create a need for additional immigrant labour.

There is also a possibility that any increases in spending at this time could cause problems on our Balance of Payments through stimulating a demand for imports, while on the other side of the Balance of Payments any inflationary pressure would render our exports less competitive. If there is a decision that the money be redistributed through welfare payments care would be necessary to ensure that it does not impact on labour markets through putting upward pressure on the minimum wage with knock-on effects to wages in general. If on the other hand the additional money is not spent then there is a deflationary effect on the economy though any such (in)action would ameliorate future budgetary positions through a reduction in the National Debt.

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