ECONOMICS & THE BUSINESS ENVIRONMENT

FORMATION 1 EXAMINATION - APRIL 2010 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 – APRIL 2010

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 20 marks.

1.

2.

Write a note on four of the following: (i) (ii) (iii) (iv) (v)

The advantages and disadvantages of indirect taxation. Price Ceiling and Price Floor. Law of Diminishing Returns. The functions of money. The three main forms of Economic Systems.

(a)

Explain the term Utility. For analytical purposes economists make certain assumptions about consumer behaviour.

(b)

State and explain these FOUR principal assumptions.

(4 x 10 marks each) [Total : 40 Marks]

(10 marks)

A manufacturer of three different products calculates the price elasticity of demand for each product as follows: Product X: - 1.8 Product Y: -1.0 Product Z: -0.4

The company wishes to maximise its revenues. Explain in respect of each of these products, what change, if any, the company should make in the prices currently being charged to enable it achieve its aim. (10 marks) [Total : 20 Marks]

3.

(a) (b)

Explain with the aid of a diagram, the long run equilibrium position for a monopoly firm which seeks to maximise profits. (10 marks)

(i)

(ii)

State and explain three barriers to entry facing entrants to a monopoly market. Explain how deregulation could affect: (i) (ii) (iii)

Consumers of the good/service; Employees in the industry; Profits of existing firms.

Page 1

(10 marks)

[Total : 20 Marks]

4.

(a) (b)

Using a Circular Flow of Income diagram, explain the factors that determine the level of economic activity in the Irish economy. (10 marks)

Define economic growth and explain using examples relevant to the Irish economy, how governments can influence and promote economic growth. (10 marks) [Total : 20 Marks]

5.

(a)

Define Inflation and outline typical causes.

(c)

Ireland experienced an increase in the rate of price inflation during 2007 and subsequently has experienced a period of deflation. Discuss the economic effects of this development on the Irish economy. (8 marks) What fiscal policy measures has the government introduced in Ireland to reduce inflation? (3 marks)

(b)

(d)

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

END OF PAPER

Page 2

(6 marks) (3 marks)

[Total : 20 Marks]

SUGGESTED SOLUTIONS

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

FORMATION I EXAMINATION – APRIL 2010

SOLUTION 1 Write a note on four of the following: (i) The advantages and disadvantages of indirect taxation.

(40 – 4 x 10)

Advantages: 1. Indirect Taxes are productive of revenue 2. Indirect Taxes are equitable 3. Payment is convenient for the Taxpayer 4. Indirect Taxes do not constitute a disincentive to work 5. Indirect taxes may have a stabilizing effect on the level of income 6. Indirect Taxes are variable and specific

Disadvantages 1. Indirect taxes may be regressive 2. Indirect tax may be inflationary 3. Indirect tax may lead to misallocation of resources 4. Indirect tax may affect employment and the viability of industries 5. Indirect tax discriminates between individuals of the same economic standing.

(ii)

(iii)

Marks allocated: (2 x 5 marks )

Price Ceiling and Price Floor

Price Ceiling A price ceiling is where the price ceiling is where the price is not allowed to rise to its equilibrium level. If the price authority considers that the equilibrium price of a good or service is too high, it can set a maximum ceiling price. This is usually done with the aim of benefitting the consumer. (2) Diagram – explained (3)

Price Floor A price floor is the situation where the price is not allowed to decrease below a certain level. It only keeps the price from falling not from rising. If the pricing authority considers that the equilibrium price of a good or service to be too low, it can set a minimum or price floor. This can be done to protect the incomes of producers. (2) Diagram – explained (3) Marks allocated: (2 x 5marks )

Law of Diminishing Returns 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 marginal returns will begin to decline. The short run is defined as a period during which at least one factor of production is fixed in supply and since this law is based on the notion of a fixed factor of production it is a short run phenomenon. Note that the law does not state that total returns will begin to decline it refers only to the diminution of marginal returns. The common sense of the law may be realised by considering that if it did not apply the whole population could be fed by devoting enough workers to the cultivation of a specific area of land. Marks allocated: (10 marks) Page 4

(iv)

The functions of money The roles which money plays in an economy are: •

• •

•

(v)

A medium of exchange. This is the most important function of money, suppliers of factors of production receive money and then use this money to purchase the goods and services which they require. It obviates the need for a barter system. A store of value. This aspect of the role of money is facilitated because of the particular characteristics of money so that a time gap may exists between the receipt of money and its use. It is this quality of money which enables people to save for their old age or for future purchases. Inflation particularly lessens the usefulness of money for this purpose. A measure of value/unit of account. Money is the common denominator in which we measure and express value. A standard of deferred payment. This means that it is possible to express in money terms the price which must be paid at some future date. This feature of money makes possible credit trading and the drawing up of financial contracts. Marks allocated: (4 x 2.5 marks)

The three main forms of economic systems.

An “economic system” is the set of institutions within which a community decides what, how and for whom to produce goods and services. At one extreme there is the centrally planned or command economy and at the other the free market economy. In between is the mixed economy that is some combination of the two extremes.

Centrally Planned or Command Economy: is where all decisions pertaining to economics are taken by a central authority. It is characterised by collective ownership of resources therefore the price mechanism does not operate e.g. Cuba or North Korea.

A Market Economy is a free enterprise, laissez-faire or capitalist economic system. Land and capital are privately owned. An economy that decides what, how and for whom goods and services are produced by channelling individual choice through a market is called a market economy. Markets consist of large numbers of buyers and sellers and price is determined by supply and demand. Adam Smith and the classical economists held the “invisible hand” leads to desirable market outcomes.

Mixed Economy. A Mixed economy contains a mixture of private enterprise and state involvement in production and distribution. The reasons for government involvement are: • To provide goods and services that private industry will not or cannot supply. • To correct inequalities in the distribution of wealth between individuals. • To curb monopoly power. • To overcome frictions e.g. in the movement of labour; and • To relieve shortages e.g. housing. Marks allocated: (3 x 3 marks + 1 for economic system)

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SOLUTION 2 (a) Explain the term Utility. For analytical purposes economists make certain assumptions about consumer behaviour. (10 marks) State and explain these FOUR principal assumptions. (b)

A manufacturer of three different products calculates the price elasticity of demand for each product as follows: Product X: - 1.5 Product Y: -1.0 Product Z: -0.3 The company wishes to maximise its revenues. Explain in respect of each of these products, what change, if any, the company should make in the prices currently being charged to enable it achieve its aim. (10 marks) [Total : 20 Marks]

(a)

Utility in economics refers to the level of satisfaction a consumer derives from consuming a particular good or service. It can be measured and as such is described in economics via Indifference curves. 1. 2. 3. 4.

(b)

The consumer has a limited income. The consumer’s income is not large enough to satisfy his/her needs and wants, therefore the consumer must choose between those goods he wishes to buy. The consumer aims to gets maximum satisfaction / utility from that income. A consumer will spend his/her limited income in such a way that he/she will achieve the most satisfaction / best value for money. He will obey the Equi-Marginal Principal of Consumer Behaviour. The consumer acts rationally. The consumer acts in that manner consistent with his preferences. If the person sees an identical commodity priced differently in two adjoining shops they will but it at the lower price. The consumer is subject to the law of diminishing marginal utility. As a consumer consumes additional units of a good his/her marginal utility for this good will eventually decline. Marks allocation: (2 for Utility, 2 marks for each assumption explained.)

A manufacturer of three different products calculates the price elasticity of demand for each product as follows: Product X: - 1.8 Product Y: -1.0 Product Z: -0.4

The company wishes to maximise its revenues. Explain in respect of each of these products, what change, if any, the company should make in the prices currently being charged to enable it achieve its aim. (30 marks)

Type of Elasticity Price Change

Comparison

Effect on Total Revenue

Product X: - 1.8

Elastic because PED > 1

Product Y: -1.0

Unit Elastic Because PED = 1

Inelastic because PED < 1

Because: the % Δ in demand equals the % Δ in price

Because: the % ↑ in price exceeds the % ↓ in demand

Decrease price

Leave price unchanged

This will increase

Will remain unchanged

Because: the % ↑ in demand exceeds the % ↓ in price

Product Z: -0.4

Increase price

This will increase

Marks allocation:(2 for discussing price elasticity, 2 marks for use of diagrams, 3 x 2 marks for discussion and correct answer in relation to each product.)

Page 6

SOLUTION 3 (a) Explain with the aid of a diagram, the long run equilibrium position for a monopoly firm which seeks to maximise profits. (10 marks)

(b)

(a)

(i) (ii)

State and explain three barriers to entry facing entrants to a monopoly market. Explain how deregulation could affect: (i) Consumers of the good/service; (ii) Employees in the industry; (iii) Profits of existing firms.

(10 marks) [Total : 20 Marks]

A Monopoly is a market structure in which there is either only one producer or seller in the market. The one firm produces the goods for a particular sector/industry. Entry is typically restricted due to high costs or other barriers, which may be economic, social, or political. Since the firm is the sole supplier there is no distinction between the firm and the industry, so the firms demand curve is also the industries demand curve.

Assumptions of a monopoly are: 1. There is only one firm 2. A single product is produced and there is no close substitute. 3. Information is not freely available to firms interested in entering the industry. 4. There are barriers to entry of new firms. 5. Monopolists are price makers, a negatively shaped demand curve. 6. Inefficient producer – waste of scare resources. 7. Make Super Normal Profits. Monopoly Diagram

Diagram of LR equilibrium of Monopoly.

1.

Equilibrium • Occurs at point Qm where • MC = MR and MC is rising and cuts MR from below. 2. Price charge & /Output produced • The firm produces output Qm and sells it at price Pm on the market 3. Cost of production • The cost of producing this output shown at point AC. 4. Super Normal Profits. • This firm is earning SNP’s – represented by the shaded area above. • They are earning SNP’s because AR > AC and • They can continue to earn SNP’s because barriers to entry exist.. 5. Waste of Scarce Resources • Because the firm is not producing at the lowest point of the AC curve it is wasting scarce resources. Marks allocation: ( 3 for explaining Monopoly, 2 for correctly labelled diagram, 5 for explanation of the diagram) Page 7

(b) (i)

(ii)

Student to list and explain three: 1. Legal / Statutory Monopoly Other firms may not be allowed into the industry because the government confers on a firm the sole right to supply a particular good or service e.g. Iarnród Éireann. Ownership of a patent / copyright 2. If a firm has the sole right to a manufacturing process then no other firm can compete with it. Other firms are not allowed to use this patent until the time period for it has expired. 3. Ownership of raw materials A firm may have complete control over the source of essential raw materials i.e. an oil drilling company. 4. Large capital investment • In some industries the minimum size of a firm required to operate efficiently is so large that there is no room for competitors once one firm has established itself. • Competitors are discouraged from entering because of the high initial start-up costs. 5. Trade agreements /collusion/cartels By entering trade agreements with other firms, a firm can share out the market so that no competition exists within its segment of the market. 6. Mergers / takeovers A firm may ensure its survival by merging / taking over other rival firms in the same line of business, such that it becomes a monopolist and no competition exists within the industry. 7. Monopolies based on fear, force or threats An individual / firm may stop other individuals/firms providing similar goods/services by means of threats/force /instilling fear into potential entrants i.e. the supply of illegal drugs. 8. Brand proliferation A firm may gain monopoly power if, through its advertising, consumers are convinced that there is no suitable alternative to its particular brands.

Statement Explanation (i)

(ii)

(iii)

Consumers of the good/service o Lower Prices. o Increased availability of service. o Increased efficiency. o Loss of essential non-profit making services. o Loss of quality in service o Higher prices in future o Increased competition / an increase in supply may cause prices to fall. o With an increase in the number of suppliers, availability of the good/service may expand e.g. taxis in Dublin. o With increased choice in suppliers the consumer may benefit from increased efficiency by firms. o Non-profit making services may be discontinued by companies in an effort to reduce costs o Quality of services may disimprove to cut costs o There may be higher prices in the future in order to survive the competition Employees in the industry o Loss of employment in existing businesses. o Job opportunities with new suppliers. o Changed working conditions. o With increased competition existing suppliers may suffer from a loss of business resulting in a loss of jobs. o New suppliers may offer increased employment opportunities. o The drive towards increased profits may mean that businesses may reduce the benefits to existing / new employees.

Profits of existing firms o Decreased profits o Increased profits o If existing businesses experience a loss of business, their market share falls resulting in a loss of profits. Page 8

o •

If the existing businesses are able to meet the new competition and expand their business activities the opposite of the above may occur. Business may experience economies of scale.

Marks allocation:( 3 x 1 for barriers explained, 3 x 2 for each statement, 1 overall applied example/discussion)

Page 9

SOLUTION 4 (a) Using a Circular Flow of Income diagram explain the factors that determine the level of economic activity in the Irish economy. (10 marks) (b) Define economic growth, and explain using examples relevant to the Irish economy, how governments can influence and promote economic growth. (10 marks) [Total : 20 Marks] (a)

The circular flow of income diagram, illustrates how income flows through an economy. Firms in order to produce goods and services require command over factors of production; entrepreneurs achieve this command by purchasing or hiring the required factors of production. Households are the consumers of the goods and services and 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 output of domestic firms and if all the revenue of firms accrued to domestic households - in the form of wages, rent, profit and interest - then there would be a continuous non-varying circular flow of income between domestic households and 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 of the income earned is spent, some of their income can be saved or it may be required in order to pay taxes. Any income which is not channelled back to domestic firms is in effect a withdrawal from the circular flow of income and 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. Domestically produced goods and services are also purchased by (i) the government, (ii) by foreign purchasers of the goods which we export and (iii) by firms who use some of their income to purchase capital goods in the domestic economy as a form of investment. Because government spending, exports and investments increase the level of activity 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 then banks 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 produce of foreign firms (our imports) this will provide them with the currency they require in order to buy our exports. The circular flow of income diagram shown below illustrates this analysis. If injections exceed withdrawals the level of expenditure in the domestic economy will rise and consequently there will be growth in the Irish economy. Conversely, if withdrawals exceed injections the level of expenditure in the domestic economy will rise and consequently there will be a decline in growth in the Irish economy.

Marks allocation: (2 for Diagram, 5 for explanation, 2 for reference to the Irish Economy). Page 10

(b)

Economic Growth can be defined as a steady increase in Gross Domestic Product (GDP) of a country as a result of an increase in the economy’s productive capacity. It is concerned with improving living standards and this is a result of growth in physical output of physical goods and services.

In general there is agreement that the government can influence economic growth but there is disagreement as to what policies should be adopted. Typical measures the government can use to influence economic growth are:

•

•

• • •

•

•

• • •

Labour. Through education and training and the identification of new work practices. Recently the Irish government has put money into training to upskill those currently unemployed. Public Sector Investment. An example of this in Ireland might be that despite the recession, the government is still keen to continue with the capital investment program of the National Development Plan. In particular, infrastructure investment. Maintenance of Law and Order. Tax System. In particular tax on profits. Differential rates of Corporation Tax on returned profits and dividends can be used in an effort to get increased retention of profits and through this increased investment. Ireland’s corporation tax, despite the recession is still one of the lowest in Europe. Aggregate Demand. A high level and consistent level of AD can be achieved by way of fiscal and monetary policy. Competitiveness. Achieved by and large through cost levels, innovation, enterprise and production techniques and methods. People’s attitudes. People need to have confidence in the economy and have attitudes that are favorable to growth. Interest Rates. If the cost of borrowing is high, investment will be low. Research and Development. Level of State Intervention.

Students may come up with more specific measures and examples within the Irish Economy.

Marks allocation:(2 for Economic Growth, 1 mark for each relevant factor x 5, 3 for discussion in relation to the Irish economy)

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SOLUTION 5 (a) Define Inflation and outline typical causes.

(b)

(c)

(d) (a)

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

(6 marks).

(3 marks)

Ireland experienced an increase in the rate of price inflation during 2007. Discuss the economic effects of this development on the Irish economy. (8 marks) What Fiscal policy measures has the government introduced in Ireland to reduce inflation? (3 marks) [Total : 20 Marks]

Price is the relationship between a quantity of money and a quantity of goods. Thus the higher the price of a good the lower the value of a unit of money in terms of that good, and by extension if the price of goods in general is rising then the value of a unit of currency is falling. Inflation can be described as an increase in the general price level or a reduction in the value of a unit of currency. It is described by many as ‘too much money chasing too few goods.

Cost Push Inflation Cost-push inflation occurs when businesses respond to rising production costs, by raising prices in order to maintain their profit margins. There are many reasons why costs might rise: Rising imported raw materials costs perhaps caused by inflation in countries that are heavily dependent on exports of these commodities or alternatively by a fall in the value of the Euro in the foreign exchange markets which increases the Irish price of imported inputs.

Rising labour costs - caused by wage increases which exceed any improvement in productivity. This cause is important in those industries which are ‘labour-intensive’. Firms may decide not to pass these higher costs onto their customers (they may be able to achieve some cost savings in other areas of the business) but in the long run, wage inflation tends to move closely with price inflation because there are limits to the extent to which any business can absorb higher wage expenses.

Higher indirect taxes imposed by the government – for example a rise in the rate of excise duty on alcohol and cigarettes, an increase in fuel duties or perhaps a rise in the standard rate of Value Added Tax or an extension to the range of products to which VAT is applied. These taxes are levied on producers (suppliers) who, depending on the price elasticity of demand and supply for their products, can opt to pass on the burden of the tax onto consumers. For example, if the government was to choose to levy a new tax on aviation fuel, then this would contribute to a rise in cost-push inflation.

Demand Pull Inflation Demand-pull inflation is likely when there is full employment of resources and when SRAS is inelastic. In these circumstances an increase in AD will lead to an increase in prices. AD might rise for a number of reasons – some of which occur together at the same moment of the economic cycle • A depreciation of the exchange rate, which has the effect of increasing the price of imports and reduces the foreign price of Irish or European exports. If consumers buy fewer imports, while foreigners buy more exports, AD will rise. If the economy is already at full employment, prices are pulled upwards. • A reduction in direct or indirect taxation. If direct taxes are reduced consumers have more real disposable income causing demand to rise. A reduction in indirect taxes will mean that a given amount of income will now buy a greater real volume of goods and services. Both factors can take aggregate demand and real GDP higher and beyond potential GDP. • The rapid growth of the money supply – perhaps as a consequence of increased bank and building society borrowing if interest rates are low. Monetarist economists believe that the root causes of inflation are monetary – in particular when the monetary authorities permit an excessive growth of the supply of money in circulation beyond that needed to finance the volume of transactions produced in the economy. • Rising consumer confidence and an increase in the rate of growth of house prices – both of which would lead to an increase in total household demand for goods and services • Faster economic growth in other countries – providing a boost to Irish exports overseas.

Page 12

Finally, the wage price spiral – “expectations-induced inflation” Rising expectations of inflation can often be self-fulfilling. If people expect prices to continue rising, they are unlikely to accept pay rises less than their expected inflation rate because they want to protect the real purchasing power of their incomes. For example a booming economy might see a rise in inflation from 3% to 5% due to an excess of AD. Workers will seek to negotiate higher wages and there is then a danger that this will trigger a ‘wage-price spiral’ that then requires the introduction of deflationary policies such as higher interest rates or an increase in direct taxation. (b)

(c)

Marks allocation: ( 3 x 2, definition, cost-push and demand pull explained)

The general price level in Ireland is measured by means of composite or weighted price index which is known as the Consumer Price Index (CPI) There is also a harmonised consumer price index whereby each of the states in the euro zone calculates the index in an identical manner.

Price indices are based on average patterns of expenditure. The mechanics of the compilation of the CPI are that a national houshold survey is undertaken in order to determine the manner in which the average family spends its income. This pattern of expenditure provides the weights (or importance) to be attached to the various price changes which is monitored through the reports from enumerators who record the prices at which the goods are being sold in stores/shops around the country. Some representative or normal period is chosen as the base period so that subsequent price changes can be related to a representative or normal period. Marks allocation: ( 3 for discussion and explanation) 1.

2. 3. 4. 5.

6. 7. 8. 9.

10. 11.

12.

Lower standard of living Because of the higher cost of living, people have reduced purchasing power which causes a reduction in their standard of living. Increased wage demands Workers, experiencing a reduction in their standard of living, will try to negotiate wage increases to compensate for the higher cost of living. Loss of competitiveness If inflation is higher in Ireland than that of our trading partners it will result in a loss of competitiveness in our exports abroad possibly lowering our exports. Loss of employment Employers, faced with increased wage demands and a possible loss of exports may be forced to reduce costs and thereby reduce the numbers employed. Government Finances With higher prices the government may collect increased indirect tax revenues. Savings discouraged/Consumption Encouraged If the inflation rate is greater than the (nominal) rates of interest offered on savings, the real rate of interest available to savers falls thereby discouraging savings. Borrowing encouraged If the inflation rate increases the real rate of interest charged on borrowings falls and so the cost of repayments falls. This makes borrowing more attractive. Increased disparity between different sectors of the population. While those at work may seek a wage increase to compensate for the drop in their living standards, those on fixed incomes must wait for the government to decide to adjust their payments. This widens the gap between these sectors. Pressure on social partnership/ industrial relations unrest Falling living standards threatens the existence of social partnership agreements and may prevent future agreements. Balance of Payments problems: If the volume of exports falls and the volume of imports rises the Balance of Payments position will deteriorate. Pressure on the ECB: Rising inflation may force the ECB to take corrective action to control it. Uncertainty: Rising inflation rates in Ireland creates uncertainty for investment decisions. Makes business planning and profit calculation difficult. Marks allocation: ( 5 x 1 areas discussed and explained, 3 overall applied explanation) Page 13

(d)

1. 2. 3.

Tax increases and levies. Cuts in Public sector pay. Cuts in Public Expenditure, both capital and current. Marks allocation: ( 3 x 1 areas discussed and explained)

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