f1 economics april

8/14/2019 F1 Economics April

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THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND

ECONOMICS &THE BUSINESS ENVIRONMENT

FORMATION I EXAMINATION APRIL 2006

Time allowed: 3 hours and 10 minutes to read the paper Answer 4 questions, question 1 which is compulsoryand any 3 other questions

Question 1 is allocated 40 marks and eachof the other questions is allocated 20 marks.

1. Write a note on four of the following:

(i) Law of Diminishing Marginal Returns.(10 marks)

(ii) The factors which influence demand for a good (or service).(10 marks)

(iii) The Entrepreneur (as a factor of production).(10 marks)

(iv) Automatic Stabilisers (in relation to fiscal policy).(10 marks)

(v) Advantages and Disadvantages of Indirect (Sales or Expenditure) form of taxation e.g. VAT.(10 marks)

[Total: 40 Marks]

2. An Irish firm that seeks to earn maximum profits produces one type of product which it sells in the domestic(Irish) market and in the European market. The firm is a monopolist in one of these markets and experiencesperfect competition in the other.

(a) State, giving reasons, in which market you think the firm is a monopolist.(2 marks)

(b) In respect of each of these markets explain the affect(s) on this firm of:(i) an increase in wage costs in the Irish economy;

(ii) if OPEC increases the selling price of petroleum products.(8 marks)

(c) Explain, using a diagram, long run equilibrium of a profit maximising monopolist.(10 marks)

[Total: 20 Marks]

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3. (a) Explain the factors that determine:(i) the upper limit; (3 marks)

(ii) the lower limit to the level of wages that will apply to a particular job. (3 marks)

(b) Two individuals A & B are employed in similar work and are in identical situations in terms ofallowances etc. for the purpose of income tax. A is employed in the public sector and B in the privatesector. In your opinion should A & B have the same amount of take-home pay from their employment?

(7 marks)

(c) Why is there (usually) a numerical difference between the potential level of Gross Domestic Product(GDP) and the actual level of GDP?

(7 marks)

[Total: 20 Marks]

4. (a) How is the rate of inflation calculated (or measured)?(3 marks)

(b) Why is inflation considered to be undesirable?

(8 marks)(c) Are there any limitations on the power of commercial banks to create purchasing power?(9 marks)

[Total: 20 Marks]

5. (a) Explain why the European Central Bank (ECB) might decide to increase interest rates.(8 marks)

(b) Trace the various ways in which an increase in interest rates could impact on the level of economicactivity in Ireland.

(12 marks)

[Total: 20 Marks]

END OF PAPER

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ECONOMICS &THE BUSINESS ENVIRONMENT

FORMATION I EXAMINATION APRIL 2006

SOLUTION 1

The format and nature of this question is to acquire an indication of the students overall understanding of thesubject. It not only permits the exam paper to reflect more accurately the comprehensive nature of the syllabusbut it also improves the opportunity for students to obtain full reward for their studies. The topics chosen for theelements of this question are fairly precise and have links with the syllabi of various other subjects includingtaxation, advanced taxation, management accounting strategic management accounting & management andstrategy. The pattern to date has been that the level of answering in this question has been a good predictor ofthe overall performance of students.

(i) The Law of Diminishing Marginal Returns states that as increasing quantities of a variable factor of

production are combined with a fixed factor of production a stage will eventually be reached when marginalreturns will begin to decline. The short run is defined as a period during which at least one factor ofproduction is fixed in supply and since this law is based on the notion of a fixed factor of production it is ashort run phenomenon. In the table illustrating the law which is set out below land is considered to be thefixed factor of production and labour is the variable factor and in this example diminishing marginal returnsset in with the employment of the fifth person. Note that the law does not state that total returns will beginto decline it refers only to the diminution of marginal returns. The common sense of the law may be realisedby considering that if it did not apply the whole population could be fed by devoting enough workers to thecultivation of a specific area of land.

Land No. of men employed Total output Marginal output

1 1 10 -

1 2 24 14

1 3 40 16

1 4 58 18

1 5 73 15

1 6 86 13

1 7 98 12

(ii) The principle factor which affects the demand for a good is its own price, generally speaking if the price ofa good increases the demand for it falls and conversely if the price of the good is reduced then the demandfor it increases - always on the assumption that nothing else changes. The price of substitute goods alsoaffects the demand for a good, if a substitute good increases (falls) in price then the demand for the goodin question would increase(fall). Whereas if the price of a complementary good increases (falls) in price thenthe demand for the good in question would fall (increase). The general level of real income is another factorwhich has an influence on the demand for a good. For most goods if real income is increased the demandfor the good in question increases, in fact goods which are subject to this positive income effect are knownas Normal Goods. If the opposite occurs i.e. goods the demand for which falls when income rises, suchgoods are known as Inferior Goods. Taste or fashion also influences the demand for a good as doesexpectations as to future changes in prices or expectations as to the future availability of the item.

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Suggested Solutions


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(iii) The entrepreneur is the person (or persons) who bear the risks against which a business cannot insure.Some examples of risks against which insurance policies are not available are:l The possibility that new products may not sell at the price and in the quantity required to generate

an adequate profit.l The risk that competitive strategies by competitors will render your business unprofitable.l The possibility that unforeseen developments may affect the profitability of the firm.l Industrial Disputesl The entry of new firms into the industry.l The emergence of international trade agreements which increase competition.

It is sometimes thought that directors, top management or decision makers in a firm are the entrepreneursthough this is not necessarily so. If such people are employed by the firm and they receive a salary for theirefforts on the firm's behalf then they are merely a form of the factor of production labour. The return to theentrepreneur is known as profit and this form of return is different to the return to other factors of productionin that it is a residual rather than a specified amount, in addition to which is likely to be subject toconsiderable variation from one period to another. The return to the entrepreneur is unique also in that itmay be a negative return in circumstances where the firm suffers a loss; such an outcome is notconceivable in respect of any of the other categories of factors of production.

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

(i) Advantages of Indirect (or Expenditure )Taxes.l They are productive of considerable revenue particularly when imposed on goods which enjoy

a relatively inelastic demand.l They are equitable. In contrast to direct taxes which are imposed on income which it is often

difficult to determine precisely indirect taxes are imposed on expenditure which will be closelyrelated to a person's income and standard of living.

l Payment of indirect tax is convenient to the taxpayer as it is paid at the time of purchasing thegoods and thus the tax is a factor in deciding whether or not to purchase the item.

l Indirect taxes do not constitute a disincentive to effort since they are based on expenditurerather than income.

l They have a stabilising effect on the level of economic activity through their influence as

automatic stabilisers.

Disadvantages of Indirect Taxes.l They may be regressive if they are levied on goods which are bought in more or less the same

quantities by rich and poor alike.l They may be inflationary because they increase the selling price of goods and services.l They discriminate between individuals of the same economic standing when they are imposed

on specific goods rather than in a general way on all goods.

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Solution 2

This question is drawn from sections 1 & 2 of the syllabus. It relates to aspects of the course that have stronglinkages with Management Accounting and Financial Management. The question is so structured as to draw thestudent through the salient points to be covered.

(a) The firm is more likely to be a monopolist in the domestic market and to be subject to perfectly competitiveconditions in the export market as the falling comments indicate.l Because the Irish market is relatively small it is possible that foreign firms supplying competitive

items might not consider it to be economically worthwhile to enter the Irish market.l If the Irish firm was subject to perfectly competitive conditions in the domestic market it is unlikely to

build up the resources necessary to enter the export market. The usual situation is for a firm todevelop its business expertise to acquire a relatively dominant position in the domestic market andthen use this as a springboard into exporting.

l It is an unlikely scenario that firms would be price-takers in the domestic market and that one of theseprice-taking firms would enter exports markets without others following suit.

(b) (i) If there is an increase in wages in the Irish economy then this Irish firm suffers an increase in itscosts.l As the firm is a monopolist in the domestic market it is likely to pass all or part of the increase

in wages on to the selling price of the goods.l

The precise distribution of the cost will depend on the relative elasticities of supply anddemand in the market.l The foreign firms that are competitors of the Irish firm in the perfectly competitive export

markets have not suffered this increase in costs so the Irish firm would not be in a position toreflect the increased cost in the selling price of the goods on the export market.

l There may well arise a question as to the economic viability of continuing to compete in theexport market.

(ii) In the event of an increase in the prices of petroleum products. In addition to increasing the costs ofthe Irish firm this will also affect not only the cost structure of the Irish firm but also the cost structureof that firms competitors in the export market. Thus there will be an opportunity for the Irish firm torecoup these increased costs in the export market as well as in the domestic market.

(c)

The following points covered:(i) The firm faces a downward sloping demand curve.(ii) The firm produces the level of output at which marginal cost is equal to marginal revenue (and at that

level of output marginal cost is increasing at a faster rate than marginal revenue.)(iii) At equilibrium the firm is earning supernormal profit (i.e. average cost is lower than average

revenue).

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Long run equilibrium of a monopolist.

Supernormal profit

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Solution 3

Parts (a) & (b) of the question which are taken from section 3 of the syllabus have links with the syllabus formanagement & strategy: part (c) of the question is taken from section 5 of the syllabus. The question relates tomaterial currently under general public discussion.

(a) (i) The upper limit to the level of wages that will be paid by a profit maximising firm is determined by theincrease in revenue accruing to the firm that is directly attributable to employing the person i.e. themarginal revenue productivity of the employee. The actual value of marginal revenue productivity is

a combination of the actual increase in total production marginal physical productivity and theincrease in total revenue as a result of selling the additional output. A strong trade union may ensurethat employees are paid up to their marginal revenue productivity but no trade union, no matter howstrong their negotiating power, can extract wage levels higher than the marginal revenue productivityof the employee because this would imply a reduction in the profits of the firm from suchemployment. Where marginal revenue productivity is difficult to calculate traditional wage relativitiesand differentials may emerge.

(ii) The lower limit to the level of wages that a person will accept is determined by the transfer earningsof the employee i.e. what they could earn in the next best area of employment.The actual level of wages paid will lie between the marginal revenue productivity and the transferearning. The precise level of wages depends in the relative negotiating strength of the two parties tothe contract.

(b) Money wages are not the only form of benefit associated with a job, there may be other forms of monetarybenefits as well as non-monetary benefits. Thus it is more meaningful to consider the net advantagesassociated with particular forms of employment. Pension rights, expense accounts, loans at preferentialrates, subsidised housing, allowances for children and other forms of benefits-in-kind are examples of non-wage monetary benefits. Forms of non-monetary benefits are job security, socially attractive working hours,opportunities for career development and promotion, congenial working environments, employmentlocated in areas with a good social infrastructure.

Thus comparisons between different forms of employment should be based on the net advantagesassociated with each. Both monetary non-wage benefits and the non-monetary benefits tend to be greaterin the public sector then the only way that net advantages would be equalised for similar work would be ifwages in the private sector had some compensatory element.

(c) The potential level of GDP is the value of the output of goods and services that the resources of theeconomy are capable of producing if they are being fully utilised. Whereas the potential level of GDP is afunction of the physical stock of factors of production and their efficiency the actual level of GDP is thevalue of the production in the economy during a specified period usually a year. The potential level ofGDP is the upper limit to what the actual level of output might be. While the potential level of GDP dependson the stock & efficiency of factors of production the actual level depends on the level of demand beingexperienced for the goods and services that we are capable of producing. The elements of this demandare consumption, investment, government expenditure of domestically produced goods and services andnet exports i.e. exports minus imports.

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Solution 4

This question is based on sections 5 & 7 of the syllabus. It examines knowledge of a topic that is of particularrelevance to the Irish economy given our international economic liaisons and our loss of economic sovereignty/

(a) The rate of inflation in Ireland is measured by reference to the Consumer Price Index which is compiled bythe Central Statistics office. This index 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 households in thecountry and by foreign tourists holidaying in Ireland. The CPI measures in index form the monthly changes

in the cost of purchasing a fixed representative basket of consumer goods and services thus it isessentially a weighted average of the price changes occurring in respect of a representative basket ofgoods. The representative share of each item in this basket is proportional to the average amountpurchased by all households in the country as determined by the Household Budget Survey and bysurveys relation to tourists, expenditure. An EU-Harmonised Index of consumer Prices is now calculatedin each Member State of the European Union. The purpose of this index is to allow a comparison ofconsumer price trends in the different Member States.

(b) l Exports constitute a very significant source of demand in the Irish economy. If our rate of inflation isgreater than that being experienced by our trading partners then our exports will becomeuncompetitive with a consequent depressing effect on the level of our GDP.

l With rising prices being experienced in the domestic economy imports will become more competitive

as a result of which imports will gain market share.l Direct foreign investment into the Irish economy will become less attractive on two accounts. Firstly

there will be an increase in costs of doing business in the host country and secondly when profitsare being repatriated they will be worth less when converted into the currency of the investor if ourexchange rate has worsened to reflect our inflation.

l Inflation increases uncertainty and thus business risk which worsens the trading climate.l During a period of inflation borrowers tend to gain at the expense of lenders. This may encourage

further borrowing thus adding further to inflationary pressure.l In the absence of the indexing of tax allowances or credits there is a transfer of resources to the

exchequer.l There is a redistribution of income within the State. Those on fixed incomes and the economically

vulnerable tend to suffer most.l Business planning becomes more difficult in the uncertain inflationary climate.l Cash flow problems may emerge and historical depreciation may be inadequate as assets being

replaced are subject to the increased prices.

(c) The fundamental consideration in determining the scale of bank lending is their ability to attract deposits.Their ability to create money stems from the general acceptability of cheques and other bank generatednon-cash methods of payment for goods and services. However, money still has an important role to playand banks must ensure that they have available sufficient cash to meet the liquidity requirements of theirdepositors. The proportion of their reserves that they must hold in cash form is known as their liquidity ratio.It is these two elements their deposit base and their liquidity ratio - that determine the amount ofpurchasing power that it is possible for banks to create. Subject to the upper limit imposed by theseconsiderations the level of purchasing power that is actually created depends on the level of demand fromthose who constitute an acceptable risk. Thus the limitations on the power of commercial banks to create

purchasing power are:l The banks, ability to make loans is dependent upon their ability to acquire lodgements.l The must retain sufficient liquidity in order to satisfy the demands of its customers for cash.l On the demand side of the equation the number and value of loans depends on the number of

suitable applicants.

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Solution 5

This question is taken from section 8 of the syllabus and has links with the Legal Framework syllabus. Questionson the European dimension of the subjects are set in order to emphasise the significance of our membership ofEuropean economic institutions and the shifting sands of economic sovereignty. The question highlights themanner in which actions of the ECB can impact on the well-being of the Irish economy.

(a) The European Central Bank (ECB) would increase in interest rates if it wishes to deflate economic activityin the Euro zone The ECB is the central bank for the entire Euro zone so that it controls the level of interes

rates within the system. If it were to increase the rate at which it lends to the banking system then thiswould result in all the banks in the euro zone increasing the rate of interest they charge. The principalobjective of the ECB is safeguarding the integrity or stability of the currency this translates into ensuringthat there is no inflation. The recipe for tackling inflation is to deflate the economy. Thus one of thecircumstances which would precipitate an increase in interest rates would be if there was an inflationarythreat. The manner in which the increase in interest rates is transmitted throughout the economy is set outsection (b) of this question.Another reason why interest might be increased would be if the ECB wished to prevent any downward floatin the value of the euro on foreign exchange markets. An increase in interest rates would stimulate demandfor the currency and thus either increase its value or prevent its value falling on foreign exchange markets.

(b) As already mentioned an increase in interest rates gives a downward thrust to economic activity. The level

of economic activity depends on the level of demand being experience, the components of demand areconsumption, investment, government expenditure and net exports; the level of demand attributable toeach of these sources is reduced as a result of an increase in interest rates.

Consumption. All purchases financed through credit trading are more expensive leading to areduction in demand. In addition the payments on all variable interest mortgagesincrease so that people have less discretionary income.

Investment. Investments are invariably financed by some form of credit which will lessen thelevel of demand. The construction sector will experience a fall-off in demand anddevelopment that will have with considerable knock-on effects throughout theeconomy. Firms will postpone expansion plans because of the increased cost offinancing and also with lower levels of demand throughout the economy there may

wait for more propitious trading circumstances. All stock-carrying expensesincrease resulting in a probable lowering of current production to the level of salesbeing experienced.

GovernmentExpenditure. With lower levels of economic activity government finances will come under

pressure as levels of income and expenditure taxes reflect the lower level ofaggregate demand in the economy. The government expenditure on various formsof welfare payments will increase. The financing of the National Debt will increaseadding further to difficulties the government might have in attempting to implementany form of counter-cyclical macroeconomic policy.

Net Exports. The upward pressure on costs in the economy will make it more difficult to retaincompetitiveness against competitors from outside the Euro zone. Imports fromareas may enjoy price advantages against domestic products.

Expectations. Economic agents may incline towards a view that the increase in interest ratesbeing experienced may be just the first of a series and may adopt a wait-and-seeapproach in their business affairs resulting in an additional downward impulse toeconomic activity.

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