ECONOMICS &
THE BUSINESS ENVIRONMENT
FORMATION 1 EXAMINATION - AUGUST 2009
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 2009
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 answer 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 25 marks.
1.
2.
Write a note on four of the following:
(i)
(ii)
(iii)
(iv)
(v)
Capital (as a factor of Production).
The Accelerator.
The role of profit in a free market economy.
The Incidence of a Tax.
Balance of Payments.
(a)
Distinguish between money wages, real wages and labour costs. If money wages increase, must real
wages and labour costs increase also? Explain your answer.
(10 marks)
(b)
3.
4.
(a)
In previous economic downturns experienced in Ireland the Government never sought a general
reduction in money wages. Explain why are they doing so on this occasion?
(10 marks)
[Total : 20 Marks]
Explain what is meant by a ’diversified growth strategy’ and indicate why a firm might pursue such a
strategy.
(10 marks)
(b)
Set out the assumptions (or characteristics) of the Imperfectly Competitive form of market structure and
explain whether a firm in such a market would be earning supernormal profits at long run equilibrium.
(10 marks)
[Total : 20 Marks]
(a)
Why might people seek to hold assets in the form of money/cash rather than invest in interest bearing
securities/assets? (i.e. Keynes Liquidity Preference Theory).
(10 marks)
(b)
5.
(4 x 10 marks each)
[Total : 40 Marks]
(a)
(b)
What criteria would you employ in order to assess (or grade) the liquidity of an asset?
(10 marks)
[Total : 20 Marks]
Explain the factors (or circumstances) that determine/influence the foreign exchange value of a currency.
(10 marks)
Trace the (likely) affects on the Irish economy if the value of the Euro rose (say 10%) against all other
currencies.
(10 marks)
[Total : 20 Marks]
END OF PAPER
Page 1
SUGGESTED SOLUTIONS
ECONOMICS &
THE BUSINESS ENVIRONMENT
THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND
SOLUTION 1
FORMATION I EXAMINATION – AUGUST 2009
i)
Capital as a factor of production is defined as man-made wealth which is used in the production of goods
and services. Money in itself is not capital, it merely permits the purchase of capital goods (the money may
in fact be used for the purchase of consumption goods). An increase of money in an economy will not
increase the capital of an economy; in the absence of an increase in the supply of goods and services prices
will merely rise. Money is a store of wealth and can be exchanged for capital goods and to this extent only
can money be considered as being capital in the factor of production sense. Capital goods (known also as
producer goods) are goods, e.g. factories, industrial plant and machinery, which are used for the production
of other goods. Capital goods are sometimes referred to as intermediate goods in recognition the fact that
the end product of the industrial process is consumer goods and capital goods are merely a means towards
this end. The demand for capital arises because of the contribution which capital makes to production,
productivity is increased through the use of capital goods. If labour and material are used in producing a
machine and this machine is then employed in the production of a consumer good, the cost of production
of the consumer good is lower than it would have been if labour and material had been used in producing
the consumer good directly (i.e. without first producing the machinery). Capitalistic methods of production
are more roundabout, the more capitalistic the production process the greater the quantity of producer
goods which are utilised and consequently the more roundabout the method of production.
ii)
The Accelerator (or Acceleration Principle) is based on the observation that an increase in the demand for
final goods results in a more than proportionate increase in the demand for capital goods. In the following
example it is necessary for the firm to replace one machine a year as machines sequentially come to the
end of their working life. In this scenario when the firm experiences a 10% increase in the demand for tables
during year 3 there is a resultant 100% increase in the demand for table-making machinery (i.e. from 1 to
2) in that year
Year
1
2
3
4
Total Demand
for Tables
1000
1000
1100
1100
Total Number
of Machines Required
10
10
11
11
Gross
Investment
1
1
2
1
Net
Investment
0
0
1
0
While this principle is usually explained in terms of an increase in demand as explained in the above table,
it can also work in a downward direction when falling demand for consumer goods leads to a greater
percentage reduction in demand in capital goods industries. For this reason changes in the level of demand
in capital goods industries can be more volatile than demand swings in industries supplying consumption
goods.
Page 2
(iii)
The earning of profit is a necessary element in the operation of a free enterprise economy. It enhances the
efficiency of a free market system in the following ways:
•
•
•
•
•
•
Normal profit is a cost of production; it is the cost of the entrepreneurship factor of production. It is the
minimum amount that the entrepreneur must earn if he/she is to remain in that particular line of
business in the long run.
Supernormal profit is a reward to the entrepreneur for successful innovation, for introducing new
commodities for which the public is prepared to pay an economic price.
Supernormal profit acts as a signalling system from the market to producers indicating those goods
the supply of which might profitably be increased.
The existence of supernormal profits stimulates the desire for entry into an industry.
Profits provide the funds that enable a firm to expand and increase its level of production.
Where price competition exists, the actions of competitors constrain the ability of rival firms to increase
their selling prices. In these circumstances the firms earning the most profits will be the firms with
lowest cost. In this way production is concentrated in the hands of the most efficient firms.
(iv)
The incidence of a tax refers to be manner in which the burden of the tax is borne. A distinction can be
drawn between the impact or formal incidence of the tax which means the person or commodity on which
the tax was imposed, and the effective incidence of the tax which means who actually pays the tax e.g. a
tax on farmers may result in an increase in food prices by the amount of the taxes, in which case, though
the formal incidence of the tax would have been of farmers the effective incidence of the tax is on consumers
of the products. 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 it may be possible to shift
all or some of, of the incidence of a expenditure or excise tax, 'forward' on to customers or 'backwards' on
to suppliers depending 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.
(v)
A country's Balance of Payments which is a record of that country's economic transactions with the rest of
the world is divided into two principal sections viz. the current account and the capital account. The current
account relates to transactions relating to the purchase or sale of good and services so that the current
account section is essentially a record of income, as distinct from capital, transactions. That section of the
current account which records the import and export of merchandise (goods) is known as the Balance of
Trade. The term invisible exports is often applied to the export of services since nothing of a tangible nature
leaves the country in return for the money which is received e.g. foreigners spending their holidays in
Ireland; similarly the term invisible imports is applied to the purchase by Irish residents of foreign services.
It is extremely unlikely that the value of goods and services imported would be exactly equal to the value of
goods and services exported so that there will be a surplus if the value of goods and services imported is
less than the value of goods and services exported and a deficit if the opposite applies; in recent years there
has tended to be a surplus on the current account. The Balance of Payments is completed when the capital
account section is associated with the current account section. The capital account section is an account of
a country's inflow and outflow of capital and transactions of this nature cause a consequent net increase or
decease in the external reserves of the country. Since the Balance of Payments is a financial statement it
is a book-keeping exercise and consequently the totals of the current and capital accounts must balance in
the sense that total credits must equal total debits. References to surplus or deficits refer to the current
account section of the Balance of Payments or to a change in the level of foreign reserves that we hold.
Page 3
SOLUTION 2
This question is drawn from information set out in sections 1 and 2 of the syllabus. It focuses on the relevance of
economic performance to our standard of living; and underlines the implication that if our high wage economy is
to remain internationally competitive then we must achieve high levels of productivity in order to maintain unit
cost at competitive levels. Section (b) of the question requires knowledge of the new reality regarding the
constraints that our membership of the euro zone membership imposes on us and also highlights the policies by
which real wages (in general) were reduced and competitiveness maintained in the pre euro zone era.. The
knowledge being tested in the question has relevance to the management accounting and strategic performance
management and strategy leadership and knowledge management courses.
(a)
Money wage is a wage expressed in money terms e.g. €375 per week. Real wage is the wage expressed
in terms of its purchasing power. When money income is related to its purchasing power (the price level) it
indicates the real worth of the money income i.e. real income. An employer might consider real wages to be
money wages related to the productivity of the person receiving the wages.
Labour costs refer to the total cost (or expense) arising from the employment of labour. This concept would
include wages, payroll taxes, employer's contributions to employees' pensions, the cost of any facilities
provided for the benefit of staff e.g. subsidised canteen facilities, sports facilities etc. and any other ancillary
costs rising from the employment of labour. Again labour cost may be given a 'real' dimension by relating it
to productivity.
(b)
If money wages increase by a smaller amount than the cost of living then, though money wages would have
risen, from the employee's point of view their real wage would have fallen. From the employer's perspective,
the employer would consider real wages to have fallen if wage costs per unit produced i.e. unit wage costs,
have fallen; unit wage cost would fall if productivity rose faster than money wages. Since labour costs cover
the total expenses arising from the employment of labour the effect which an increase in money wages has
on the labour costs of a firm depends also on what changes, if any, are taking place in the total number
employed, payroll taxes and other ancillary labour costs. For example it is possible that total labour costs of
the firm could be reduced if some form of productivity agreement is a quid pro quo for an increase in money
wages. Similarly unit labour costs could be reduced despite an increase in money wages if labour
productivity increases by more than the increase in money wages.
An economically independent country can implement Fiscal, Monetary or Exchange Rate Policies in order
to control the macroeconomy. Now that Ireland is a member of the euro zone these policy instruments are
no longer available to the authorities. Monetary and exchange rate policies are conducted by the European
Central Bank and the Stability & Growth restrict the magnitude of government deficits and consequently the
extent to which such a policy can be employed to expand the economy. The current economic crisis is of
such proportions that some short term breaching of the Stability & Growth Pact seems to be allowed.
However our national finances are in such a state that the fiscal resources at the disposal of the government
are severely restricted. Prior to joining the European Union and the Euro zone it would have been possible
for the government to devalue our currency in an effort to regain competitiveness. A devaluation of the
currency is a reduction in the real value of our income and in the past our real wages were reduced in this
manner. In the absence of this method of reducing real wages the only manner in there can be a general
reduction in real wages is through a reduction in money wages.
Page 4
SOLUTION 3
Part (a) of the question is taken from section 4 of the syllabus and part (b) is taken from section 2. Diversification
has always been a strategy adopted by economic agents and the development of world wide brands and the
emergence of the global market place have further encouraged strategies of this nature. Part (b) of the questions
draws attention to the manner in which the form of market structure influences the behaviour and profitability of
firms. Knowledge gained in studying these topics should be of benefit in studying the following courses --- strategic
corporate finance, strategic performance management, managerial finance, strategy leadership and knowledge
management.
(a)
Diversification refers to a company expanding its operations into other areas of business activity whether
these areas are related or unrelated to its existing business activities.. The two principal reasons why a firm
might adopt such a strategy relate to cost considerations and risk reduction.
The cost aspect refers to economies of scope. Economies of this nature are said to exist if the cost o
producing two or more outputs jointly is less than the cost of producing the outputs separately. In relation to
the production of two goods A & B economies of scope would exist if the cost of producing A on its own plus
the cost of producing B on its own is greater than the cost of making A & B together. The most usual practical
example of this is in relation to the branding of products. Companies spend many millions establishing a
brand in a particular industry and this brand identity can then be extended to its products in different
markets. The Virgin brand is an example where vast sums of money were spent establishing the brand
name in the music industry and the brand now extends intro the airline, mobile phones, financial services.
You will have noticed the advertising at many large international sporting events just the name (or brand) of
a firm is advertised rather than individual products.
(b)
By operating a diversified portfolio of activities containing a mix of uncorrelated business activities a firm can
reduce its risk exposure. If two activities are correlated the profit levels of each activity will move together
so that the combined profits will show large swings over time --- if business conditions are propitious for one
activity then they are for both and vice versa. A diversified strategy business activities are not correlated
which means that the level of profits from one activity are not related to the level of profits from the other
activity so that the combined level of profits will be less variable --- all your eggs are not in one basket.
Assumptions Underlying the Theory of Imperfect Competition.
•
•
•
•
•
Product Differentiation exists. The goods/services that are supplied by different producers are not
homogeneous but they are very close substitutes.
Freedom to enter and exit the industry applies. Anyone has the right to supply a competitive product.
There is perfect knowledge as to the level of profits being earned by each firm in the industry.
There are many buyers and many sellers, each of whom acts independently of rivals.
Profit maximisation is the objective of firms.
Since economic agents are aware of the level of profits they would be aware if firms are earning
supernormal profit and so would wish to enter the industry. Firms are able to satisfy their wish to enter the
industry since there are no barriers obstructing entry as implied by the freedom to enter assumption. The
entry of new firms will continue until supernormal profits are competed away so that at long run equilibrium
firms will earn no more that Normal Profit.
Page 5
SOLUTION 4
Sections(a) and (b) of this question are taken from section 8 of the syllabus but each section approaches the topic
from a different aspect. The knowledge being tested bears on the conduct of banks, the current ‘credit crunch’ and
the ‘liquidity trap’ that currently exists. Knowledge of these topics enables a student to better understand the
underlying forces determining the rhythm of economic activity: knowledge of this nature will assist a student to
understand and interpret the economic environment in which s/he operates. The information being tested is
relevant to strategic corporate finance, strategic performance management, strategy leadership and knowledge
management.
(a)
The classical economists tended to see money as playing a neutral role in the economy in the sense that
people used it as a medium of exchange and if they wished not to spend it they lent it at the highest available
rate of interest subject to due allowance being made for risk factors. Keynes put forward the notion that
people may desire to hold their assets in the form of money balances rather than to invest ---in support of
this notion he introduced a liquidity preference theory in which he explained why people might desire to
hold money balances. He distinguished three reasons to explain this desire viz: a transaction motive, a
precautionary motive and a speculative motive. The transaction motive is essentially the need to hold money
for use as a medium of exchange and the precautionary motive is a variation of this same idea in that it
refers to the need for money balances to facilitate undertaking economic transactions that arise in an
irregular and unpredictable pattern. In support of the speculative motive Keynes postulated that funds could
leak out of the circular flow of income, he envisaged that the rate of interest would not fulfil a market clearing
function in that at low rates of interest holders of money would not be prepared to lend - he termed this a
liquidity trap. This was in contrast to the approach of the classical economists who argued that while lenders
would prefer to receive a high rate of interest funds would continue to be lent even at low rates of interest
on the basis that a low rate of interest was better than none.
The transaction motive is the term applied to the demand for money which stems from a need to finance
day-to-day expenses. The actual quantity of money which is required for transaction purposes depends on
our level of expenditure and the main determinant of our level of expenditure is our level of income.
The precautionary motive is the term applied to the need to hold money to meet those contingencies which
arise in a non-regular fashion e.g. illness, house repairs, breakdowns of car or household appliances,
domestic accidents etc. The amount of money which it is desired or felt necessary to hold for this purpose
depends on our income which determines our lifestyle and also current rates of interest. If interest rates are
high it is more costly to hold money so that precautionary balances will be kept to a minimum.
(b)
The speculative motive for holding money is related to peoples desire to have money available for
speculative or investment purposes when prices and circumstances are propitious. In circumstances when
the prices of assets are high so that capital losses could ensue or when there is a danger of being locked
into an asset with a low rate of return what seems profitable in the short run would not be so in the long run.
Keynes also held that people will prefer to retain liquidity rather than invest if the economic environment is
such that perceived uncertainty and risk is at an unacceptable level for the rates of return on offer.
The liquidity of an asset refers to the ease with which the form of an asset can be changed.. For example if
I have shares in a company and I wish to purchase a house then I sell the shares and use the money
obtained in order to purchase the house. Since using one form of asset in order to acquire a different asset
usually entails selling it and using the money thus obtained for the purchase of the required item money is
the most liquid of assets. In fact often the term liquidity is used in reference to the ease with which an item
can be converted into cash.
There are a number of elements which combine to determine liquidity viz;
(i)
Marketability which refers to ease and speed with which the value of the asset can be realised.
(ii)
Capital Certainty which refers to the extent to which it is possible to predict (or know) the value that
will be received for an asset when it is sold at some future date.
(iii) Reversibility refers to any loss that may be incurred in reselling an item if it is resold almost
immediately after buying it.
(iv) Divisibility refers to the smallest unit of an asset that can be bought and sold.
Page 6
There is no rigid demarcation line between the liquidity of different forms of assets; also assets will vary in
respect to the relative importance of the various elements determining liquidity. While it is obvious that
money (or cash) is the most liquid form of asset money does not give a return over time (in any meaningful
sense) while other assets do.
SOLUTION 5
Ireland being a small open economy, the member of a large trading bloc and a monetary zone we are an exemplar
of the globalisation of business. Part (a) of the question focuses students’ attention on the factors that determine
the foreign exchange value of our currency and thus, one the parameters within which our economy must operate.
Section (b) of the question highlights the competitive consequences as a result of a significant portion or our
international trade being with non-euro zone countries. The information being tested in the question would
complement the courses in strategy corporate finance, strategic performance management, strategy leadership
and knowledge management.
(a)
The foreign exchange price/value of a currency is determined by the forces of supply & demand in precisely
the same way as the price of to every other good & service is determined. The forces of supply and demand
for currencies can be analysed in terms of those arising from trade and those arising from international
finance (the asset approach).
When we import goods or services from outside the euro zone, or give foreign aid, or invest outside the euro
zone we make our currency available (i.e. supply it) on foreign markets. Conversely when non-euro zone
members buy our exports of goods & services, or invest in the euro zone they create a demand for our
currency. If the demand for the euro currency is greater than the supply the there would be upward pressure
on the value of the currency while the opposite would apply if the supply of the currency exceeds the
demand.. If there was an increase in the level of demand for the euro currency in circumstances where the
European Central Bank (ECB) did not wish the value of the currency to rise they could increase the supply
of the currency on the market by selling their own currency conversely if contrary circumstances prevailed
they could pursue a policy of buying their own currency. Such interventions should be seen as smoothing
operations undertaken in order to avoid the disruptive influence of short term volatility --- over the longer
term markets forces will determine the value of a currency.
In addition to the determining influence of international trade monetary policy also has a role to play in
determining the foreign exchange value of a currency. If the ECB increases interest rates to such an extent
that the rate of return to risk from holding euros is more attractive than that from holding other
internationally traded currencies then there will be an inflow of funds to the euro zone with a concomitant
rise in the value of the euro. Conversely if there are inflationary tendencies within the euro zone then the
value of the euro will be subject to downward pressure on the currency and the downward pressure will be
intensified as funds flee the currency.
(b)
Market perceptions as to the soundness or the fragility of an economy to emerging market conditions are a
source of upward (or downward) pressure on the foreign exchange value of the currency of such a country
(or monetary zone). Any time that the market perceives a (possible) foreign exchange risk in holding
currency interest rates on loans to such jurisdictions will rise and there will be tendency for funds to be
moved out of such currencies and into to what are seen as safer/more attractive havens.
An increase in the value of the Euro makes our exports more expensive in terms of foreign currencies while
our imports from outside the Euro zone would be cheaper. The effect that such a change in the value of the
euro would have on our Balance of Trade depends on our price elasticity of demand for imports from outside
the euro zone and the price elasticity of demand for our exports from non-euro zone countries. We are
heavily dependent on imports, so to the extent that these are now relatively cheaper in euro terms there will
be downward pressure on our rate of inflation. Indigenous suppliers to the domestic market will experience
a reduction in their cost of imported raw material and petroleum products which will further reduce our rate
of inflation. Should this reduction in the cost of living continue into the long run it is likely to result in lower
wage settlements in future national wage agreements.
Page 7
While the cost of exports to, and imports from, countries within the euro zone would be unaffected by any
change in the value of the euro, we have greater exposure to trade with non-euro zone countries than does
any other country within the euro zone. England and the USA are major purchasers of our exports our loss
of competitiveness in such markets as a result of an upward float in the value of the euro could have a
considerable affect on our Balance of Trade. The magnitude of this problem depends on the source of any
competition which we may have in these markets and whether close substitutes for our products are
available from non-euro zone countries.
The servicing of that portion of our National Debt that is denominated in foreign currencies will be reduced.
This will have a beneficial effect on government finances and this benefit can be enjoyed either by taxation
being lower than it otherwise might be and/or an improvement in the general standard of living through
increased government expenditure.
Though not directly on the international trade side, foreign firms operating in the Irish economy will enjoy an
enhancement in the value of their repatriated profit. If the ECB considers itself to be in a position to reduce
interest rates because of the strength of the currency then any lowering would act as stimulus to economic
growth.
Page 8