ECONOMICS &
THE BUSINESS ENVIRONMENT
FORMATION 1 EXAMINATION - APRIL 2007
NOTES
Answer four questions,
question I which is compulsory
and any 3 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.
The Institute of Certified Public Accountants in Ireland, 9 Ely Place, Dublin 2.
THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND
ECONOMICS &
THE BUSINESS ENVIRONMENT
FORMATION I EXAMINATION – APRIL 2007
Time allowed: 3 hours, plus 10 minutes to read the paper.
Answer 4 questions, question 1 which is compulsory
and any 3 other questions.
Question 1 is allocated 40 marks and each
of the other questions are allocated 20 marks.
1.
Write
(i)
(ii)
(iii)
(iv)
(v)
a note on four of the following:
The characteristics of Economic Goods.
Economic Rent.
The factors that determine (or influence) Price Elasticity of Demand for a good (or service)
Fiscal Drag.
Formal and the Impact Incidence of a tax.
[40 Marks]
2.
(a)
What is meant by ‘long run equilibrium’ as the phrase is used in relation to a firm that seeks to earn
as much profit as possible. e.g. a profit maximising firm at long run equilibrium.
(4 marks)
(b)
Under what conditions (or circumstances) would a profit maximising firm be at long run equilibrium?
(6 marks)
(c)
An Irish firm that seeks to earn as much profit as possible is competing against firms from other Euro
zone countries in a market that is perfectly competitive. If the Irish firm is at long run equilibrium
explain how the Irish entrepreneur is likely to react to each of the following eventualities:
(i)
there is a general round of wage increases in Ireland;
(ii)
there is an increase in the world price of oil.
(10 marks)
[Total: 20 Marks]
3.
(a)
Is economic growth desirable? Explain your answer.
(8 marks)
(b)
What is meant by sustainable economic growth?
(4 marks)
(c)
Is it possible for the Irish economy to have continuing growth rates of (say) 7% per annum? Justify
your answer.
(8 marks)
[Total: 20 Marks]
Page 1
4.
(a)
From the following information calculate (i) the level of GNP in period 2 (ii) the Multiplier (iii) the
marginal propensity to import (MPM) and (iv) the marginal propensity to save (MPS). (For the
purpose of this question we are not including the government sector)
Private
PERIOD 1
PERIOD 2
GNP
CONSUMPTION
INVESTMENT
EXPORTS
IMPORTS
€
€
€
€
€
23800
17000
6000
3000
2200
18200
6300
3400
2400
(12 marks)
(b)
State, giving reasons, if you would expect the value (and/or volume) of imports to increase if there is
an increase in value (and/or volume) of exports.
(8 marks)
[Total: 20 Marks]
5.
(a)
What actions might an economic independent government take if it wished to increase the level of
aggregate demand in the economy? (Ireland before we joined EMU or currently the UK government
are examples of economically independent governments).
or
Explain the policy instruments available to an economically independent government that seeks to regulate
the macro economy.
(10 marks)
(b)
Explain how joining the European Union and EMU has affected the Irish government in its efforts to
regulate the Irish economy.
(10 marks)
[Total: 20 Marks]
END OF PAPER
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SUGGESTED SOLUTIONS
ECONOMICS &
THE BUSINESS ENVIRONMENT
FORMATION I EXAMINATION – MAY 2007
SOLUTION 1.
The format and nature of this question is to acquire an indication of the student’s overall understanding of
the subject. It not only permits the exam paper to reflect more accurately the comprehensive nature of the
syllabus but also increases the opportunity for students to obtain full reward for their studies. The topics
chosen for the elements of this question are fairly precise and 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)
In the study of economics we are concerned with goods which are capable of being bought and sold, such
goods are known as economic goods and their characteristics are:
●
●
●
(ii)
Utility. Utility refers to the ability of a good to give satisfaction or satisfy a need or want, it is this ability
which renders goods desirable. Thus since goods must be desirable if they are to be bought it is a
characteristic of economic goods that they possess utility. It would be futile to attempt to sell
something which is a nuisance or irritant and has no utility.
Scarcity. Economic goods are scarce in relation to the demand for them. The concept of scarcity as
used here means that there is not enough of the good to satisfy the demand of all those who want it;
this is why people must pay a price in order to acquire it. Thus in this country fresh air would not be
an economic good because even though it provides utility it is not scarce in relation to the demand
for it.
Transferable. Economic goods must be capable of being passed from one person to another i.e. they
must be transferable. People are unable to sell what they cannot pass to the buyer and people won't
buy what they cannot receive or control. It is because they do not satisfy this criterion of transferability
that good health, pleasant disposition, beauty and intelligence are not economic goods even though
they satisfy the first two criteria of possessing utility and are scarce in relation to the demand for them
in the sense that not everybody has them though all desire them.
The supply price of a factor of production is the sum of money which must be paid in order to acquire the
use of that factor. Economic Rent is any payment to a factor of production in excess of its supply price.
The supply price of the factor of production labour is the transfer earnings of the factor i.e. the payment (or
net benefits) which it can earn in the next best situation available so that if a firm employs an electrician at
a wage of € 600 and the transfer earnings of the electrician is €480 then in this instance the electrician
would enjoy an Economic Rent of €120.To the extent that workers would be willing, if necessary, to continue
working in their present jobs even if their wages were reduced then they are certainly earning some
Economic Rent. In general, the existence of Economic Rent may also be deduced if workers of similar
ability are employed elsewhere in comparable work and these workers would be willing to transfer from their
present employment to the job in question. One of the reasons why workers might enjoy an Economic Rent
could be due to the existence of a trade union in the particular job.
Since Economic Rent is a payment in excess of the supply price i.e. in excess of the transfer earnings of a
factor, then the more narrowly defined the occupation the lower will be the Economic Rent. For example if
the occupation of a person is "a CPA in firm A" then his/her Economic Rent may be close to zero since
he/she might be able to earn virtually the same salary as "a CPA in firm B". However if the individual's
occupation is defined within the firm as "an accountant" then the next best job available to him/her may be
as a general clerk with considerably lower earnings, in which case there would be an element of Economic
Rent in the payment that s/he receives in the position that is classified as ‘an accountant’ Rent. In relation
to entrepreneurs Normal Profit is considered to be the supply price of entrepreneurs so any payment in
excess of this supply price viz: Supernormal Profit would be considered a form of Economic Rent.
Page 3
(iii)
Price elasticity of demand refers to the sensitivity of demand for a good in response to a change in its own
price. The factors which affect price elasticity include the following.
●
●
●
●
●
The availability of close substitutes at competitive prices is the greatest single influence on price
elasticity of demand. Goods are purchased because they provide utility, if there are other goods
available at comparable prices which provide more or less the same utility consumers will switch to
buying these substitute goods if the price of the good in question is increased more than the price of
substitute goods. Similarly if the price of a good is reduced relative to the price of substitute goods the
consuming public will switch to buying the good which has become relatively cheaper. The closer the
degree of substitutability the more will consumers tend to switch their purchasing behaviour in
response to a change in relative prices and consequently the greater will be price elasticity.
If the good in question is one of two goods which are in joint demand then this complementarity affects
price elasticity of demand for the good. Reductions in the price of complementary goods will increase
the demand for the good in question e.g. a reduction in the price of motorcars will increase the
demand for petrol. If the good in question is the cheaper of two goods which are in joint demand, then
the demand for it is likely to be relatively inelastic in response to changes in its own price.
The proportion of income which is spent on the commodity also affects it elasticity. In general the
greater the proportion of a person's income which is spent on a good the greater will be that person's
price elasticity of demand for the good. The reason for this is that the greater the proportion of your
income which you spend on the goods the more significant to you is a change in its price.
The more durable the commodity the more elastic is the demand for it likely to be in response to
changes in its own price. This is because it is easier the postpone the purchase of such goods by
extending the life of the existing model. Examples of such goods are refrigerators, bicycles,
lawnmowers.
The expectations of consumers as to future price changes will affect elasticity. No matter what is
happening in respect of current prices if consumers expect prices to be lower in the future they will
refrain from buying in the present conversely they will bring forward their purchasing if they expect
prices to be even higher in the future.
(iv)
Fiscal policy refers to any conscious action by the government in relation to the magnitude, structure or
timing of government revenue or expenditure. Fiscal drag is the term which can be applied when the effect
of fiscal policy is to reduce the level of aggregate demand below what it would be in the absence of the fiscal
policy. However, the use of the term is more usually reserved for occasions attributable to the coming into
operation of the downward aspect of automatic stabilisation at a stage when the economy is operating below
the desired, or targeted, level. Whenever the government budgets for a surplus it is in effect deflating the
economy but such action is not normally referred to as fiscal drag since when budgeting for a surplus the
intention of the budget strategy is that purchasing power will be taken out of the economy. The term fiscal
strategy tends to be reserved for situations where the effect of fiscal policy is to deflate the economy in a
manner or to an extent which was not intended, an occurrence of this nature usually is attributable to the
economy being more buoyant than was envisaged at budget time so that tax revenues are greater than
anticipated. If this situation develops when the economy is at less than full employment then the effect of
fiscal policy is lessen the degree of economic activity, at least in the short term, until discretionary fiscal
policy may be implemented. Government tax revenue is predicated on some forecast level of economic
growth, for any given rates of taxation, tax revenue will be greater than anticipated when the rate of growth
in the economy exceeds forecasts. In such a circumstance the withdrawal of purchasing power in the
economy through taxation will be greater than intended and since increases in the level of discretionary
government expenditure takes time to implement the net effect is a withdrawal of purchasing power from,
and a consequent reduction in the level of, aggregate demand. It is this form of occurrence that is referred
to as fiscal drag.
(v)
The incidence of a tax refers to the manner in which the burden of the tax is borne. A distinction can be
drawn between the formal incidence of the tax which means the person or commodity on which the tax
was levied, and the effective incidence of the tax which means who actually pays the tax e.g. a tax on
builders may result in an increase in the price of houses by the amount of the taxes, in which case, though
the formal incidence of the tax would have been of builders the effective incidence of the tax is on
purchasers of the properties. This concept is relevant also in a slightly different context which recently hit
newspaper headlines when they reported government statements that there was a likelihood that any
reduction in stamp duty on houses which was intended to benefit purchasers of houses would end up in the
Page 4
pockets of builders, if as anticipited the price of houses would be increased to reflect any reduction in stamp
duty. With respect to direct taxes it is rather difficult to shift the incidence of such taxes e.g. if I am paid €400
per week and I had been paying €60 per week income tax, if my income tax liability is increased to €70 per
week it is extremely unlikely that I will be able to negotiate a wage increase of €10 in order that I may
maintain parity in my after-tax pay. In contrast to this situation in respect of direct taxes such as income tax
it may be possible for a retailer to shift ‘forward’ on to customers or 'backwards' on to manufactures all, or
some of, the incidence of an expenditure or excise tax. Whether or not this is possible depends on the
relative elasticities of supply and demand for the product on which the tax is levied. Whichever of supply or
demand is the more inelastic will tend to end up bearing the greater proportion of the tax and if for example
demand was perfectly inelastic then it would be possible to increase the price of the good by the full amount
of the tax without there being any resultant fall-off in demand.
Page 5
SOLUTION 2.
This question is drawn from information set out in sections 1 and 2 of the syllabus; part (c) of the question
depicts a situation encountered by Irish exporting firms. The area of the syllabus being tested is
complementary to topics developed in management accounting and strategic management accounting.
(a)
Long run equilibrium means that in a time period sufficiently long to enable a firm to adjust to market
conditions that it is performing in a manner that achieves, or gets as close as it can to achieving, its
objective(s). In relation to a firm which is pursuing a profit maximisation objective it means that under
exsisting market condition it is not possible for the firm to earn a higher level of profit by changing either its
level of output or its selling price. Thus there is no incentive for this firm to change its selling price or level
of production unless there is some change in market conditions.
(b)
A profit maximising firm would be at long run equilibrium under the following conditions:
(c)
(i)
producing a level of output at which marginal cost is equal to marginal revenue.
(ii)
subject to the condition that when producing the level of output set out in (i) above marginal cost is
increasing at a faster rate than is marginal revenue.
(iii)
the firm must be earning at least Normal Profit.
(i)
A profit maximising firm at long run equilibrium in a perfectly competitive market would be earning
Normal Profit. If there was a general round of wage increases in Ireland and such a wage increase
was not being experienced by the foreign competitors then since the Irish firm acting on its own is not
in a position to influence market prices then this increase in costs would result in the firm earning less
than Normal Profit and thus it would be forced to leave the industry in the long run. If in the short run
the revenue of the firm was in excess of its variable costs then it would stay in the industry in the short
term and exit in the long run.
If all firms in the industry suffered the same increase in world oil prices and assuming that this
impacted to the same extent on all the firms then the increase could be passed on to the consumers
through increased selling prices.
(ii)
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SOLUTION 3.
Information set out in sections 5 and 6 of the syllabus is being sought in this question. Knowledge acquired
in this section of the course will provide a basis for further analysis of this and related topics in strategic
management and management and strategy.
(a)
Economic growth is desirable to extent that there are benefits attaching thereto. Economic growth is
measured by the increase in the quantity of goods and services available to us. Thus the principal reason
for pursuing economic growth is because it improves the general standard of living. Economic growth
provides the resources for investment and also incentives to invest. Through increased economic growth it
is possible to alleviate poverty and it is easier to gain acceptance for such redistributive policies when the
general standard of living is rising. In addition economies of scale are possible in activities undertaken by
the government so that during a period of economic growth government expenditure as a proportion of GDP
should fall. There are costs associated with economic growth as can be seen in the Irish economy at
present. Examples of these costs are infrastructural pressures, pollution, misdistribution of the benefits of
economic growth and the threat of inflationary pressures.
(b)
Sustainable economic growth means that it is possible for the economy to continue to grow in future periods
at the rate that is currently being experienced on that current rate of Economic growth will not inhibit the
future rate of Economic growth.
(c)
If an economy is not operating at full employment then, depending on the degree of underutilisation of
economic resources or current technological best practices it is possible for the economy to grow at a
spectacular rate in a form of ‘catching-up’ exercise. However once an economy is at a developed stage and
operating at full employment then future rates of growth are depending on capital deepening, more skilled
work force and the possibility of an increasingly immigrant work force. Significant increases in the population
of the country also impose pressures on the economic and social infrastructure so that continuing increases
in economic growth at rates of 7% become increasingly less likely.
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SOLUTION 4.
This question which relates to sections 5 and sections 8 of the syllabus illustrate in a quantified way the
interrelationships between different sectors of the economy. This approach will assist the student in
recognising precise linkages within the economic and business environment and will be of benefit when
studying the content of the management and strategy course.
(a)
(b)
(i)
Level of Income (Y)
=
Consumption + Investment + (Exports – Imports).
=
=
=
18050 + 6300 + (3400 – 2550)
18050 + 6300 + 850.
25200.
(ii)
From period1 to period 2 injections increased by € 700 (an increase of €300 in respect of investment
and an increase of €400 in respect of exports). As a result of this increase of €700 in injections GDP
increased by €1400 (from €23800 to € 25200) therefore the multiplier is 2.
(iii)
When income increased by €1400 imports increased by €350 therefore the Marginal Propensity
to Import (MPM) is equal to 350/1400 = 0.25.
(iv)
When income increased by €1400 consumption increased by € 1050 so that the Marginal Propensity
to Consume (MPC) is 1050/1400 = 0.75. Since the Marginal Propensity to Save is defined as 1 – MPC
therefore the Marginal Propensity to Save is equal to 0.25.
As shown in the above example when there is an increase in the level of exports there is an increase in the
level of injections into the economy. The extent to which an increase in exports increases the level of income
in the economy depends not only on the magnitude of the increase in exports itself but also on the
magnitude of the multiplier. Thus when exports increase purchasing power within the economy increases
and in the course of spending this additional income there emerges an increase in demand for imported
goods and services. In addition to purchasing additional imported goods and services consumers also
spend some of their additional money on indigenous goods and services and as many of these goods use
imported raw materials this is another source of increased demand for exports. Given the importance of oil
products in the conduct of economic life any increase in wealth within the economy will result in a direct and
indirect increase in demand for this imported product.
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SOLUTION 5.
The material for this topic is contained in sections 6 & 8 of the syllabus. It has links with the legal framework
syllabus and also is complementary to aspects of the strategic management course. Exam questions based
on new circumstances arising from the shift of macroeconomic decision making to European institutions
help to develop students’ understanding of the changed and changing business environment that applies to
Irish firms and institutions.
(a)
The policy instruments available to an economically independent government are Monetary Policy,
Exchange Rate Policy and Fiscal Policy. It is generally accepted that it is not possible to consider monetary
policy and exchange rate policy as two distinct objectives. The level of interest rates within a jurisdiction
affects both the level of economic activity and the external value of the currency so that if interest rates are
being used as a tool for regulating the level of domestic demand they it is not available as a discretionary
tool for the influencing the external value of the currency. However, there is a convention in text books to
discuss each of them separately.
In terms of monetary policy if the authorities wish to stimulate the economy policies could be directed
towards lowering interest rates and increasing the money supply. In terms of exchange rate policy if there
had been a fixed exchange rate policy in place a decision might be made to devalue the currency
alternatively a policy of ‘benign neglect’ could be adopted whereby the authorities take no action in the fact
of a downward float in the foreign exchange value of the currency. In terms of fiscal policy an expansionary
fiscal policy in conducted through budget deficits.
A reversal of each of the above polices would be the appropriate action if the wish was to deflate the
economy in such circumstances increased interest rates, currency appreciation and budget surpluses would
be the order of the day.
(b)
Ireland and the other member states have sacrificed some economic sovereignty upon joining the European
Union and European Monetary Union. Monetary policy for the Euro zone is within the jurisdiction of the
European Central Bank. Thus the level of interest rates that apply within the Irish economy are set by the
ECB and are not at the discretion of the Irish authorities except in so far as we are members of the decision
making board within the European system of Central Banks. In contrast to the approach adopted by the Irish
authorities which would be determined by what is best for the Irish economy the ECB will base its decision
making on what is appropriate for the Euro zone in general rather than concentrating on what is in the best
interest of any individual member state. Even more obvious is the inability of the Irish authorities by their
own actions to influence the foreign exchange value of the Euro currency. Despite our membership of
European Monetary Union the Irish authorities still have some control over fiscal policy; it is still possible to
stimulate the economy by an expansionary fiscal policy. However, there is a constraint on this discretion
since under the terms of the Stability & Growth Pact budget deficits should not be greater than 3% of GDP.
However, since tax harmonisation is not a feature of European Monetary Union the Irish government has
discretion over the manner in which it imposes its taxes.
Page 9
ECONOMICS &THE BUSINESS ENVIRONMENT.
MARKING SCHEME--- May 2007
Q1.
10 marks for each of 4 satisfactory answers.
Q.2. (a)
Q.3
40 marks
An adequate definition
4 marks
(b)
3 conditions @ 2 marks each
6 marks
(c)
Reaction to each devloment @ 5 marks
(a)
4 aspects of economic growth @ 2 marks each
8 marks
(b)
An adequate explanation
4 marks
(c)
2 relevant considerastions @ 4 marks each
8 marks
Q.4. (a)
(b)
Q.5. (a)
(b)
10 marks
4 parts to the question @ 3 marks each.
12 marks
2 reasons @ 4 marks each.
8 marks
1 policy instrument @ 4 marks & 2 @ 3 marks each.
10 marks
Restriction on fiscal policy @ 4 marks.
Non-availability of other 2 instruments @ 3 marks each
10 marks
Page 11