f1 - economics august 2007

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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.

ECONOMICS &

THE BUSINESS ENVIRONMENTFORMATION 1 EXAMINATION - AUGUST 2007

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


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THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND

ECONOMICS &

THE BUSINESS ENVIRONMENTFORMATION I EXAMINATION AUGUST 2007

Answer four Questions,

Question 1 which is compulsory

and any three other questions.

1. Write a note on four of the following:

(i) Distinguish between the Short Run and the Long Run (as these terms are used in economic analysis).(ii) The Margin (or Marginal Analysis)(iii) Imperfect Competition.(iv) Consumer Price Index (CPI).

(v) The Law of Comparative Advantage (in international trade). (4 x 10 marks)

[Total: 40 Marks]

2. (a) The consumer will always be better off if goods (or services) are supplied by a perfectlycompetitive industry rather than an industry that is monopolised State, giving reasons, if you agreewith this statement.

(10 marks)

(b) Is it possible for workers in Irish firms to be paid higher wages than is being paid to similar workersin foreign firms that are in competition with the Irish firms in question? Explain your answer.

(10 marks)

[Total: 20 Marks]

3. (a) Using a Circular Flow of Income diagram explain the factors that determine the level of economicactivity in the Irish economy.

(8 marks)

(b) 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)

(c) Set out the economic implications of foreign immigration to Ireland in recent years.(8 marks)

[Total: 20 Marks]

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

(11 marks)

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

[Total: 20 Marks]

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5. (a) The Minister for Finance bases his budget on an estimated level of activity in the Irish economyduring the period of the budget. Explain the likely effect(s) on (i) Government revenue and (ii) thebudget outturn (i.e. budget surplus or budget deficit) if economic activity is greater than expectedduring the period of the budget.

(8 marks)

(b) If the circumstances occur as set out in (a) above and given the present state of the Irish economywhat 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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ECONOMICS &THE BUSINESS ENVIRONMENT

FORMATION I EXAMINATION AUGUST 2007

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 also increases 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 of

the overall performance of students.

(i) The short run period is defined a period during which the quantity supplied of at least one factor of productionis fixed; consequently the costs relevant to that factor of production will be fixed in the short run. In general theterm is applied to the period required to adjust to emerging circumstance. As will be realised from the definitionthe term the short run does not refer to a precise calendar period, not only will it vary between industries but withthe passage of time it will even vary within an industry. If it takes five years to replace an electricity generatingstation then the short run period for that industry would be five years ,in contrast to this the short run period isprobably one day for a person selling daily newspapers outside a store in the city. Similarly if a firm has a 6 monthlease on a premises and all its other costs are undertaken on a week-to-week basis then the short run for thisfirm 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 definedas 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 returnsalso arises because of a fixed factor of production and consequently is a short run phenomenon

(ii) The margin is the area where change first occurs. In economics we are constantly attempting to establish therelationship between cause and effect. It pursuit of such relationships we constantly focus our attention on thatareas where change occurs e.g. if 100 people buy a good when its price is 130 and 98 people buy the samegood when its price is increased to 131, we tend to say that 2 people less buy the good when its price wasincreased 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 thequantity they purchase when price is increased as a marginal consumer i.e. the consumer who responds to thechange 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 isimplemented and similarly marginal revenue is the change in total revenue when the price of, or demand for, ourproduct changes.The concept is also used outside of economics e.g. the term marginal voters is applied to thosewhose allegiance is relatively easily swayed.

(iii) The term Imperfect Competition is used to describe a form of market structure with the followingcharacteristics:

G Product differentiation exists. The goods that are supplied by different producers are not homogeneous butthey are very close substitutes.

G There is freedom to enter the industry and freedom for firms to exit the industry. Thus firms have the rightand the opportunity to supply competitive products.

G There is perfect knowledge as to the level of profit being earned by all firms in the industry.G There are many buyers and many sellers each of whom act independently.G Firms are profit maximisers.

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

(iv) The Consumer Price Index (CPI) is designed to measure the change in the average level of prices (inclusive ofall indirect taxes) paid for consumer goods and services by all private household in the county and by foreigntourists holidaying in Ireland. The CPI is compiled by the Central Statistics Office and is probably the best knownof the various Irish published statistics. A household budget survey is undertaken to determine a representativeor average basket of consumer goods and services and the combination of goods and services that comprisethis basket is updated by periodic surveys. This representative basket is the basis of the weights applied to therecorded price changes in order to determine changes in the general level of prices for the average family. TheCPI is constructed through the collection of 55000 prices in a representative basket which cover over 1000different items.The CPI measures changes in the cost of buying a fixed basket of goods and certain caveats apply if using theCPI as a cost of living index. The index measures the cost of buying a fixed basket of goods and does not takeinto account the manner in which households may change their pattern of expenditure in response to changes inprices. The various weight used are used to determine the relative importance of the various items are averagesbased on surveys and their relevance to specific individuals will vary depending on individual circumstances. Itshould be noted that the index does not reflect changes that may have occurred in the quality of the goods thatare included in the index.

(v) The Law of Comparative Advantage which is known also as the Law of Comparative Cost illustrates how it iseconomically advantageous for a country to concentrate on the production of those goods in which it has thegreatest comparative advantage i.e. in the production of which it is relatively most efficient. Thus even thoughcountry A may be able to produce each of two goods using less resources than country B requires in order toproduce identical goods it may still be advantageous for country A to concentrate on the production of the goodat which they are relatively more efficient and import their requirements of the other goods. It is for this reasonthat countries often import goods which they are capable of producing in their own domestic economy sincethrough 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 whereeconomic agents concentrate on those tasks at which they are relatively more efficient and purchase their otherrequirements.Like all economic laws certain restrictions or assumptions apply to the application of the law of comparativeadvantage. These assumptions include the requirement that the relative prices of the goods in question are setwithin limits which render the trade beneficial to both the producer and the purchaser since no economic tradewill ever be voluntarily entered into unless it is mutually advantageous. The law also is based on the assumptionthat the costs incurred in transporting the goods to their markets are not so great as to erode any cost differentialsin production.

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

(a) If cost conditions are the same in both the perfectly competitive and the monopolistic industries then theequilibrium level of output of the monopolistic industry will always be lower and the equilibrium selling price of themonopolist will always be higher that they would be in an industry in which the firms sell their products underconditions 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 possiblethat the monopolistic firm will enjoy economies of scale in which case its unit cost of production will be lower thanthat which would apply in the perfectly competitive industry. If the monopolist enjoys economies of scale as aresult of the consequent lower costs of production s/he is enabled to lower the selling price of their goods if in sodoing the resultant demand would increase profitability. Thus the cost to the consumer would be lower eventhough the monopolist may still be earning supernormal profits. In such circumstances it could be said that partof 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 monopolisticrather than perfectly competitive industries.

(b) If Irish and foreign competitors are similar in every way and Irish workers negotiate a wage increase then it willnot be possible to pass this wage increase on to consumers by way of price increases. In such circumstanceseither employment and/or level of profit will come under pressure. However, if the structure of the industry is suchthat entrepreneurs are currently earning supernormal profit then additional costs that simply reduce the level ofsupernormal profit will not drive firms out of the industry though it may well alter their long run equilibrium level ofproduction and thus levels of employment. In circumstances where the Irish firm has been earning no more thanNormal Profit then any form of cost increase will cause the entrepreneur to exit the industry in the long run. Itshould be noted that entrepreneurs think in terms of after-tax returns so that lower levels of corporation tax maymaintain 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 higherwage costs may reflect improved productivity of workers so that despite this wage increase the net effect of theincreased wage rates and the improved productivity may be lower unit costs of production. Also when workersare well paid the level of nutrition, housing ,education, training and general health is more likely to be of astandard 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 a high wageeconomy captures the situation where workers in some European countries are among the highest paid and themost productive in the world.

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

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

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

The circular flow of income diagram, illustrates how income flows through an economy. Firms in order to producegoods and services require command over factors of production; entrepreneurs achieve this command bypurchasing or hiring the required factors of production. Households are the consumers of the goods and servicesand 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 outputof domestic firms and if all the revenue of firms accrued to domestic households - in the form of wages, rent, profitand interest - then there would be a continuous non-varying circular flow of income between domestic householdsand 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 ofthe income need be spent some of their income can be saved or it may be required in order to pay taxes. Anyincome which is not channelled back to domestic firms is in effect a withdrawal from the circular flow of incomeand 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. Domesticallyproduced goods and services are also purchased by (i) the government, (ii) by foreign purchasers of the goodswhich we export and (iii) by firms who use some of their income to purchase capital goods in the domesticeconomy as a form of investment. Because government spending, exports and investments increase the level ofactivity 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 thenbanks 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 produceof foreign firms (our imports) this will provide them with the currency they require in order to buy our exports. Thecircular 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 therewill be growth in the domestic economy. conversely, if withdrawals exceed injections the level of expenditure inthe domestic economy will diminish and the domestic economy will experience recession.

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

(c) G Without foreign workers the Irish economy could not have experienced the high growth rates of recentyears.

G The size of the Irish GDP in absolute terms (and also per capita) has increased.G The size of the domestic market has increased for indigenous firms.G In their absence improvements in the economic infrastructure of the country would not have been as far

advanced as it is.G The presence of these workers has increased the pressure on the capital infrastructure of the country.G A relatively high proportion of wages of such workers is repatriated.G 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

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

(a) When a bank accepts a deposit and subsequently grants a loan it is not merely transferring purchasing powerfrom 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 itdoesnt need to keep this deposit entirely in a the form of cash., from experience the bank knows that only apercentage of the deposit will be required as cash and the more successful banks are in encouraging the publicto use cheques, debit cards or any other form of non-cash transfers the lower this percentage will be. For examplelet us assume that a bank considers 10% of deposits to be a prudent liquidity ratio, a prudent liquidity ratio is theratio which retains at the disposal of the bank sufficient liquid assets to enable it to satisfy all the demands makeon it for cash. Although more than 10% of balances are operational only approx.10% involve cash transactionsbecause most transactions are conducted without recourse to cash e.g. through the use of cheques. Thus in ourpresent example of the 1,000 in cash deposited with the bank it need hold only 100 to provide it with adequateliquidity and consequently 900 can be lent out. This 900 which has been lent out will in the course of fulfillingits money function(s) return to the banking system, the person to whom this loan is granted buys from the localoffice suppliers a photocopying machine for 900. The office supplier lodges the 900 in their bank account inbank 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 effectof the initial lodgement of 1000 would be the creation of 10,000 of additional purchasing power. This is anexample of the money multiplier in operation, in this example with a liquidity ratio of 10% the money multiplier is10. 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 followingfactors are also relevant.

G Banks ability to grant loans is related to the magnitude of their deposit base, so it is directly related to theirability to generate deposits.

G All of the money may not find its way back into the financial system.G 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 beprepared to loan to those who they consider to be a good risk.

G 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 ratioof assets in cash form.

G 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 loansas being the salient features in respect of the amount of purchasing power that banks can create.

(b) G Loss of revenue previously earned on currency conversions.G Access to European money markets without any exchange rate risk.

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

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SOLUTION 5

This question is based on the material contained in section 6 of the syllabus and emphasises the implicationsarising from our loss of economic sovereignty and the extent to which Irish business is reliant on Europeaninstitutions to provide an appropriate economic environment for Irish enterprises. The topic and strong linkageswith strategic management accounting and management and strategy. Part (b) of the question seeks to testknowledge on the current business environment and the parameter which govern decision making in themacroeconomy

(a) The revenue that the exchequer receives during the period of the budget depends on tax rates and the taxablebase. The taxable base is the level of income in the case of income tax, the level of expenditure in the case ofVAT, the extent of house purchases in the case of stamp duty, the level of profits in the case of corporation profitstax and so on. This taxable base varies with the level of activity in the economy. Since the tax rates are set forthe period of the budget, if economic activity is greater than estimated in the budgetary arithmetic then the taxablebase will increase and consequently tax revenue will exceed that which was forecast and for which allowancewas made. If there is an unexpected increase in economic activity and if government expenditure is as intendedthen the budgetary outturn will be better than expected at the time of the introduction of the budget. Thus if thefiscal stance had been expansionary the outcome will be a lower deficit, it may even be converted into abudgetary surplus. Conversely if the government had budgeted for a budget surplus then the outturn would bean even bigger budget surplus. All of this is an aspect of the fiscal stabilisation phenomenon.

(b) In recent budgets estimates of economic growth have been conservative so that tax receipts have been greaterthan anticipated. If the position prevails currently then the Minister will have additional funds at his disposal. Giventhe present situation of full employment and our relatively high rate of inflation a case can be made for simplytaking the excess out of circulation and reducing government debt. Given our large infrastructural deficit somewould suggest accelerating the plans to address these problems through bringing forward elements of theNational Development Plan. The ESRI has been advising strongly against overloading the construction industrywhich 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 competitivelevels 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 putpressure 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 ofPayments through stimulating a demand for imports, while on the other side of the Balance of Payments anyinflationary pressure would render our exports less competitive.

If there is a decision that the money be redistributed through welfare payments care would be necessary toensure that it does not impact on labour markets through putting upward pressure on the minimum wage withknock-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 thoughany such (in)action would ameliorate future budgetary positions through a reduction in the National Debt.

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f1 - economics august 2007

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