F1 - Economics August 2008

ECONOMICS & THE BUSINESS ENVIRONMENT

FORMATION 1 EXAMINATION - AUGUST 2008 NOTES

You are required to answer Question 1. You are also required to answer any three out of Questions 2 to 5. (If you provide answers to all of Questions 2 to 5, you must draw a clearly distinguishable line through the answer not to be marked. Otherwise, only the first three answers to hand for Questions 2 to 5 will be marked.)

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,17 Harcourt Street, Dublin 2.

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

FORMATION I EXAMINATION – AUGUST 2008

Time allowed: 3 hours, plus 10 minutes to read the paper.

You are required to answer Question 1. You are also required to answer any three out of Questions 2 to 5. (If you provide answers to all of Questions 2 to 5, you must draw a clearly distinguishable line through the answer not to be marked. Otherwise, only the first three answers to hand for Questions 2 to 5 will be marked.) Question 1 is allocated 40 marks and each of the other questions are allocated 20 marks.

1.

2.

3.

Write a note on four of the following:

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

Economies of Scale (illustrate your note with examples). Cross Elasticity of Demand. Marginal Revenue Productivity. The money multiplier (as the term is used in relation to credit creation by banks). Automatic (or built-in) Fiscal Stabilisers.

(a)

Why are firms in a perfectly competitive industry referred to as ʻPrice Takersʼ?

(c)

Would you expect a profit maximising firm at long run equilibrium to be earning supernormal profits? Explain your answer. (5 marks)

(b)

[40 Marks] (6 marks)

Short run average cost curves are depicted as being U shaped indicating that unit costs of production initially fall and eventually increase. What is the economic explanation for this behaviour of unit costs? (9 marks)

[Total: 20 Marks]

(a) (b) (c)

Explain what is meant by ʻVertical Growthʼ in relation to the strategic (or developmental) policy of a (4 marks) firm. Explain the (likely) benefits to a firm from a vertical growth strategy.

(8 marks)

Explain what is meant when a firm is said to ʻoutsourceʼ some of its activities and indicate reasons why a firm might adopt such a policy. (8 marks)

[Total: 20 Marks]

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4.

(a) (b)

(c)

How is the rate of inflation in respect of the Irish economy measured?

(6 marks)

Explain why it is important/desirable that the rate of inflation in Ireland should be kept as low as possible. (6 marks) If the rate of inflation in Ireland is increasing (say at a higher rate than in other countries) would you expect the price of non-traded goods (or services) to be increasing at a faster rate than goods (or services) in the traded sector? Explain your answer.

(Non-Traded goods are goods (and services) that do not enter into international trade whereas traded goods (or services) by their nature lend themselves to being imported or exported). (8 marks)

5.

[Total: 20 Marks]

(a) (b) (c)

State the Law of Comparative Advantage (in international trade) and indicate the assumptions on which it is based. (8 marks) Why do countries engage in international trade?

(6 marks)

Explain TWO factors (or developments) that would put downward pressure on the value of the euro. (6 marks)

[Total: 20 Marks]

END OF PAPER

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SUGGESTED SOLUTIONS

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

FORMATION I EXAMINATION – SEPTEMBER 2008

SOLUTION 1 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. (i)

(ii)

(iii)

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 essentially 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.

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.

Marginal Revenue Productivity is defined as the additional revenue earned from the extra output generated through employing an additional increment of a factor of production, For example if the revenue of the firm when 5 men are employed is €1,000 and revenue increases to €1,285 when an additional man is employed the marginal revenue productivity of the 6th man is €285. In may not always be possible to measure accurately and unambiguously the marginal revenue productivity of an individual e.g. in the case of a truck driver it is not possible to allocate a marginal revenue productivity to either the driver or the truck on their own. The best one can do is to determine the marginal revenue productivity of the economic unit which in this case is truck and truck driver combined. Also it is not possible to accurately calculate marginal revenue productivity in cases where there is no precise end product to be sold at market prices e.g. teachers or gardai. The marginal revenue productivity of labour is the highest amount of money a firm could pay for an additional worker without reducing the firmʼs profits. Page 4

(iv)

(v)

Because banks operate on a fractional reserve system it is possible for them to loan out a multiple of the amount of cash which is deposited with them. Thus the banking sector in the conduct of its day-to-day operations creates purchasing power rather than merely transferring the value one person's savings into another person's spending. The basis which renders it possible for the banks to create purchasing power is the fact that when a cash deposit is made into a bank the person doing so normally does not seek the return of this lodgement entirely in a cash form. The person will use cheques, direct debits, standing orders, credit cards and other forms of banking instruments in order to pay for their purchases. Arising from this, banks have discovered that their customers will require to access only (say) 10% of the amount of cash deposits and loans granted in the form of actual cash. This 10% is known as the bank's liquidity ratio (or the bank's cash ratio). If the bank's liquidity ratio is 10% then a cash lodgement of €100 would support liabilities (in the form of customers' loans) to a value of €1000. This process gives rise to the concept of the money multiplier --- which is also referred to as the credit multiplier. The formula for the money multiplier is 1 divided by the liquidity ratio. Thus if the required liquidity ratio is 10% the money multiplier is 10 and if the required liquidity ratio was 20% the relevant multiplier is 5. On the basis of liquidity ratio of 10% if €1000 cash is lodged in a bank it is possible for the banks through giving loans to create purchasing power to the value of €10,000. From this it can be seen that the amount of purchasing power which it is possible for banks to create depends on the amount of cash lodged with the bank and the liquidity ratio which the bank requires. While this ratio determines the amount of purchasing power which it is possible for the banking sector to create the actual increase in purchasing power depends on the level of demand for such loans from credit worthy applicants.

Automatic (or Built-in) Fiscal Stabilisers. Tax revenue that rises and government expenditure that falls as National Income rises are known as automatic stabiliser, Automatic stabilisers have the effect of dampening fluctuation in the trade cycle; they dampen oscillations around the trend growth path. If there is an injection of income into the economy then the subsequent leakage of part of this money through the payment of taxes lessens the impact of the injection on the level of aggregate demand. The main advantage of automatic stabilisers in controlling aggregate demand is the fact that they operate instantaneously - as soon as aggregate demand fluctuates the stabilising process comes into play. This stabilisation process is extremely beneficial when an economy is operating at a desired level, in which circumstances the stabilisation process ensures that there are no major deviations from an acceptable level of economic activity. However, if the economy is under performing the operation of automatic stabilisers still applies and in these circumstances they hold back the economy through lessening the impact of any demand stimulus to which the economy might be subject. In such a circumstance the term fiscal drag is often applied. Social welfare payments are another source of automatic stabilisers since the number of people eligible for such payments varies inversely with the state of the economy so that the government spends more money on such payments in a downturn and less money on payments of this nature in a buoyant economy.

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SOLUTION 2 This question is drawn from information set out in sections 1 and 2 of the syllabus. The question focuses on factors influencing the firmʼs cost structure and the manner in which the competitive environment modifies the behaviour of a firm and influences its profitability. The information being sought in the question has relevance to the management accounting and strategic performance management courses.

(a)

Included in the characteristics of, or the assumptions underlying, the theory of perfect competition are the following: ●

●

● ●

●

There are many competitive sellers in the market none of whom produces a sufficiently large quantity to influence, by their own actions, the price at which the good (or service) is sold. Similarly there are a large number of buyers of the product so that no individual buyer can influence the price of the good. There is no collusion among buyers or among sellers. Each firm is selling a homogeneous product i.e. there is no distinguishable difference between the product produced by individual firms e.g. potatoes. Within the market there is perfect knowledge as to quality, prices and profits.

The price at which the product will be sold will be determined by the total supply available on the market and the total market demand. However, given the above market characteristics, once the market price is determined the price at which an individual producer can sell their produce is fixed. Under the assumptions of the model the individual firm is selling a product which is no different to that available from all other sellers and this fact is known to all buyers – perfect knowledge- therefore no buyer would be prepared to pay a price above the going price to any seller. In addition since each seller supplies an insignificant portion of the total market quantity they have not enough market power to influence the available market prices. Thus each seller is a price taker they can sell at the market price which is the available price but they cannot influence this price.

(b)

(c)

Admittedly if all sellers banded together they could influence the market price but one of the assumptions of the model, as set out above, is that firms do not collude.

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. during a time period when the supply of at least one factor of production cannot be altered. There are two factors initially tending to reduce unit cost as output expands. ● As the level of production increases there is a sufficient amount of work to justify the employment of specialists or to permit existing workers to concentrate on a narrow range of duties. As the dexterity of workers improves through the constant repetition of a narrow range of operations, the time taken to produce each unit is reduced with a consequent beneficial effect on average costs. ● 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 that do not vary over a certain range of output so that as the level of production increase the proportion of fixed cost that is included in unit cost is reduced. This spreading of the constant charge that constitutes fixed cost over an increased volume of output reduces the fixed cost element in unit fixed cost and thus contributes to a reduction in short run average costs.

The upward portion of the short run average cost curve reflecting the eventual increase in short run unit cost is due to the emergence of the dominating influence of the Law of Diminishing Marginal Returns.

If a profit maximising firm is at long run equilibrium the firm must be in its best possible position in terms of profitability and must be earning at least Normal Profit which is the supply price of the factor of production entrepreneurship. Whether or not the firm is earning supernormal profit depends on market conditions. If there is freedom of entry into the market then the firm will not earn supernormal profit in the long run because the existence of supernormal profits would attract other firms into the industry and this would continue until the influx of firms causes profits in the industry to be reduced to the level of Normal Profit. This is the position in relation to perfectly competitive and imperfectly competitive markets.

If however there are barriers preventing entry into an industry then it is possible for a firm to continue to earn supernormal profit in the long run. This is the situation that is depicted in monopoly situations.

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Solution 3 This question introduces a new aspect of the course which is set out in section 4 of the syllabus and it also seeks information from section 3 of the syllabus. This aspect of the subject has relevance for managerial accounting and also provides a foundation for the strategic performance management and strategy, leadership and knowledge management courses. (a) When a firm grows vertically, either moving up or moving down its vertical chain it is attempting to integrate additional value adding activities into its existing activities. (b)

(c)

The likely benefits from such a growth strategy include: Location Benefits. Integrating consecutive activities from the vertical chain can reduce production costs. For example steel smelting plants are often located next to steel rolling plants; this reduces transport and heating costs. ● Eliminate or minimise the problems of availability and flow of raw materials. ● Protection from monopoly suppliers. In circumstances where raw materials are supplied by a monopoly prices would be higher than they would be in a competitive market. A possible solution would be to purchase the monopoly supplier and transfer the raw material between divisions of the same company. ● Transaction costs can be reduced. Transaction costs can be minimised when firms integrate activists rather than trading with providers for their requirements. When goods or services are traded the cost of organising the transaction can by very high e.g. the cost of managers negotiating the contract and the cost of lawyers writing the contracts represent transaction costs. For market based transaction to have a low transaction cost the contract has to be as complete as possible. This entails low complexity, low uncertainty, easy monitoring and feasible enforcement. These considerations give rise to factors such as comprehensively specifying the details of the contract e.g. the characteristics of the product, the materials used the price and time of delivery, and how performance will be measured, how contract will be enforced. All of which can be complex and time consuming thus adding to transaction costs. ●

Outsourcing is the term applied when a firm contracts out some aspects of its activities to another firm rather that do the work ʼin-houseʼ. A firm could adopt such a policy because: ● There are considerable economies of scale in the aspect of the work in question so that they subcontract the work out to a firm that specialises in that type of work. ● The work is not central to the firmʼs core activity. ● The work is seasonal or subject to peaks and troughs and could lead to industrial relation problems if workers employed in that work were to seek the same conditions as other workers or general transferability within the firm. ● The nature of the work being outsourced lends itself to competitive tendering. ● There are no significant transaction costs in outsourcing the particular work.

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SOLUTION 4 Aspects of this question impinge on sections, 6, 7 and 8 of the syllabus. This pervasiveness of the topic is manifest also in its relevance to many of the other subjects that contribute to the academic training and professional formation of the accountant. (a)

(b)

(c)

Price is the relationship between a quantity of money and a quantity of goods. Thus the higher the price of a good the lower the value of a unit of money in terms of that good, and by extension if the price of goods in general is rising then the value of a unit of currency is falling. Inflation can be described as an increase in the general price level or a reduction in the value of a unit of currency. The general price level in Ireland is measured by means of composite or weighted price index which is known as the Consumer Price Index (CPI) There is also a harmonised consumer price index whereby each of the states in the euro zone calculates the index in an identical manner.

Price indices are based on average patterns of expenditure. The mechanics of the compilation of the CPI are that a national houshold survey is undertaken in order to determine the manner in which the average family spends its income. This pattern of expenditure provides the weights (or importance) to be attached to the various price changes which is monitored through the reports from enumerators who record the prices at which the goods are being sold in stores/shops around the country. Some representative or normal period is chosen as the base period so that subsequent price changes can be related to a representative or normal period. The reason why it is important the rate of inflation should be kept as low as possible is because of its many undesirable and economically disruptive effects. These undesirable features include: ● A loss of international competitiveness which is particularly important in an economy as open as the Irish economy ● Business planning becomes more difficult. ● There are cash flow implications as historical cost depreciation policies fail to provide adequate resources for the replacement of assets. ● Lessens the efficiency of money in fulfilling its economic functions. This can occur to such an extent that there develops a significant movement into holding assets in a non-cash form ● Considerable redistributive effects occur in the course of which those on fixed income and the economically vulnerable suffer most. ● Saving behaviour is discouraged as borrowers gain at the expense of savers. ● When intervention becomes necessary policy induced recessions introduced to tackle inflation can be very costly in terms of increased unemployment and lost output.

As explained in the earlier sections of the answer to this question the increase in prices is measured over a wide range of goods and there is no suggestion that all items included in the measure as changing at the same rate. If the general rate of inflation is higher in Ireland than in other countries then our economy is being subject to demand pressures greater than is being experienced elsewhere. For the purpose of exposition let us divide goods (and services) into those that are internationally traded and those that are not. Internationally traded goods often have common sources of origin and flow freely between countries on the basis of demand and prices. Thus allowing for some local differences the selling prices of these goods will tend to be similar from one country to another. The same analysis is not applicable to non-traded goods, of which services is a very good example. In respect of these items if prices are higher in Ireland than in other countries it is not possible to import these services from other countries and thus there is not the threat of imports which would put downward pressure on the domestic prices of these goods. Examples of such services in Ireland in recent times have been the price of houses/ rents, legal services, dentists, transport costs etc. You will have noticed this phenomenon when you take a foreign holiday, the price of clothes, shoes etc will not vary much between countries but the cost of accommodation, eating out, and medical services etc will vary considerably.

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SOLUTION 5 The material for this topic is contained in sections 8 & 9 of the syllabus and is complementary to aspects of the strategic performance management and the strategy, leadership and knowledge management courses. Exam questions based on new circumstances arising from the shift of macroeconomic decision making to European institutions help to develop studentsʼ understanding of the changed and changing business environment that applies to Irish firms and institutions. (a)

(b)

(c)

The Law of Comparative Advantage states that a country should concentrate on the production of those goods in which it has the greater comparative advantage i.e. in the production of which it is relatively more efficient. If a country specialises in the production of those goods in which it has a relative cost advantage then mutually advantageous trade can take place between the countries provided the terms of trade lie between the opportunity costs of producing the goods in each of the countries.

Assumptions underlying the theory of comparative advantage. (i) It is assumed that the cost of transporting the goods from the country in which they are produced is not so great as to cancel out the lower production costs. (ii) In most examples of the Law of Comparative Advantage it is assumed that there are constant returns to scale though in practice constant, increasing or decreasing returns to scale might be experienced. Implicit in the theory is the assumption that there cannot be decreasing returns to scale of such an extent that the comparative advantage is lost when the level of production is increased. (iii) It is assumed that when a country specialises in the production of certain goods that there is sufficient alternative work available for the factors of production which are released through the withdrawal from producing those goods in which there is a comparative disadvantage. (iv) While the theory assumes that there is mobility of factors of production within an economy it does not presume that factors of production e.g. workers and capital may move internationally. It should also be noted that workers may not be mobile within the economy. (v) The Theory of Comparative Advantage illustrates the increase in total production, and thus the possible gains from trade. Whenever a country decides to produce more of one good at the expense of not producing (or producing less of) some other good there is bound to be winners and losers. Thus whether or not there is an improvement in general welfare through international trade depends on how these possible gains are distributed e.g. farming may become more profitable but the clothing industry may suffer - the benefits to the farming sector may exceed the losses in the clothing industry, but how are the benefits to be distributed throughout the economy?.

Countries engage in international trade for the following reasons. ● In order to extend the consumption possibilities of a country beyond its own production possibilities e.g. petroleum products are required in the Irish economy. ● There is an increase in total output if countries specialise in the production of those goods in which they are relatively more efficient and engage in trade. ● With specialisation and increased levels of output economies of scale are possible. In the absence of such trade many items e.g. motor cars and aeroplanes would be prohibitively expensive. ● International trade intensifies competition and thus lessens the likelihood of dominant firms emerging; this increase in competition also puts pressure on firms to be more efficient. ● It promotes closer links between countries and this has the effect of increasing co-operation and lessening the possibility of wars.

The following are two examples of developments that would put downward pressure on the foreign exchange value of the euro. ● If interest rates ain the euro zone were at a lower rte than that obtainable with other comparable monetary zones e.g. the US dollar zone then fund managers would wish to sell the euro and transfer their cash into monetary zones where the rate of return would be greater. ● If the eurozone countries were running considerable deficits on their international trading then there would be less demand for the currency.

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