You are on page 1of 9

ECONOMICS &

THE BUSINESS ENVIRONMENT


FORMATION 1 EXAMINATION - APRIL 2008

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 INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND

THE BUSINESS ENVIRONMENT


FORMATION I EXAMINATION – APRIL 2008

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 Question 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 Question 2 to 5 will be marked.
Question 1 is allocated 40 marks and each of the other questions are allocated 20 marks.

1. Write a note on four of the following:

(i) Opportunity Costs.


(ii) Price Elasticity of Demand.
(iii) Distinguish between potential Gross Domestic Product and actual Gross Domestic Product and indicate
the factors which determine each.
(iv) Regressive Taxes.
(v) The Multiplier.
[40 Marks]

2. (a) Is there any justification for considering Normal Profit to be a cost of production? Explain your answer.
(4 marks)

(b) ʻIf a firm which seeks to earn the highest possible level of profit is at long run equilibrium it must be
producing a level of output at which (i) marginal cost is equal to marginal revenue and (ii) at that level of
output marginal cost is increasing at a faster rate than marginal revenueʼ. Explain why this is so.
(6 marks)

(c) Would you expect a profit maximizing firm at long run equilibrium to be producing the level of output at
which its average (or unit) costs are at a minimum (i.e. at the lowest point on its average cost curve)?
Explain your answer.
(10 marks)

[Total: 20 Marks]

3. (a) What is meant by ʻhorizontal growthʼ in relation to the strategy (or development) of a firm?
(4 marks)

(b) Explain the (likely or expected) benefits to a firm from horizontal growth.
(8 marks)

(c) ʻIn oligopolistic markets, firms recognise their interdependenceʼ. Explain this statement and indicate how
such recognition might influence the behaviour of such firms.
(8 marks)

[Total: 20 Marks]

Page 1
4. (a) What is meant by a ʻbudget deficitʼ in terms of the national budget? (5 marks)

(b) Discuss the likely affects on the objectives of National Economic Policy if the government were to introduce
a budget deficit. (15 marks)

[Total: 20 Marks]

5. (a) Under what circumstance(s) is the European Central Bank likely to decide to increase its interest rate.
(3 marks)

(b) In what way(s) is such an increase likely to impact on our balance of (international) trade? (8 marks)

(c) Detail other ways in which such an increase would (likely) impact on the Irish economy. (9 marks)

[Total: 20 Marks]

END OF PAPER

Page 2
SUGGESTED SOLUTIONS

ECONOMICS &
THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND

THE BUSINESS ENVIRONMENT


FORMATION I EXAMINATION – APRIL 2008

SOLUTION 1
The format and nature of this question is to acquire an indication of the studentʼs 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) Opportunity cost is the cost of anything in terms of alternatives foregone and as such it includes explicit cost
i.e. the price which I pay for an item and implicit cost i.e. any other cost even if it does not include the paying
out of money. Since opportunity cost is defined as the cost of anything in terms of alternative foregone it is
usually measured in terms of explicit cost i.e. the price paid for the item. The price which I pay for an item
represents the sacrifice which I must make in order to acquire the item e.g. the time which I must work to
earn the money to buy the item or alternatively all the other items which I now must do without since I cannot
afford to buy them having bought the item in question. Very often this money cost (price) measures
opportunity cost to an adequate degree of accuracy. However, just to show that opportunity cost is never
less than the money cost it should be realised that buying an item also entails implicit costs such as the
search costs in acquiring information regarding the availability and qualities of the good, the cost of the time
spent travelling to where the good is to be purchased; and additional implicit cost may also be relevant if,
for example, there is wear and tear on the motor car in travelling to buy the good. The opportunity cost
concept is still appropriate even when no money is involved e.g. the opportunity cost of investing your own
money and time in a business is the interest and wages which could have been earned if you had have
worked elsewhere for a wage and invested your money elsewhere. Similarly the opportunity cost of
watching a television programme is all of the other activities which you are precluded from undertaking as
a result of watching the television programme.

(ii) Price elasticity of demand measures the responsiveness of demand to a change in its own price. The
formula for price elasticity of demand is the percentage change in quantity demanded divided by the
percentage change in price. The answer will usually be negative since price and quantity demanded
normally move in opposite directions as illustrated by downward sloping demand curves. If the answer
derived from the application of the formula is greater than unity in absolute terms then demand is said to be
price elastic, if it less than unity in absolute terms it is said to be inelastic and if equal to unity in absolute
terms it is said to be of unit elasticity. Total revenue and price will move in the same direction for inelastic
goods, e.g. if the price of such a good is increased then total revenue received from the good will increase
and if the selling price of the good is reduced then the total revenue received from the sale of the good will
fall. The opposite outcome occurs in respect of elastic goods, demand for such goods is particularly
responsive to a change in price so that total revenue from their sale falls when their price is increased and
rises when their price is reduced i.e. total revenue from the sale of such goods and changes in their selling
prices move in opposite direction. For goods of unit elasticity any change in price is matched by an equal
percentage change in demand in the opposite direction so that total revenue from the sale of such goods
remains unchanged in response to a change in their selling price.

The greatest single factor which affects price elasticity of demand for a good is the availability of close
substitutes at competitive prices. Goods are purchased because they provide utility, if other goods at
competitive prices provide more or less the same utility consumers will switch to the purchase of these
substitute goods in response to an increase in the selling price of the good in question. The extent of the
switch, i.e. price elasticity of demand for the good, depends on the closeness of the substitutability.

Page 4
(iii) The level of output, which it is possible to produce in the Irish economy, is determined by the quantity and
quality of factors of production within our economy together with the state of technology, which exists in (or
is available to) the Irish economy. This level of output is referred to as the potential level of GDP. However
while this potential level of GDP places an upper limit to the amount of goods and services which it is
possible to produce in Ireland the actual level of national output or aggregate demand is determined by the
level of demand within the economy. In relation to a small open economy such as the Irish economy demand
is usually categorised as consumption, investment, government expenditure and net exports and this
relationship is usually depicted as Y = C + I + G + (X-M) where each of these symbols have their usual
meaning. Often this relationship is illustrated with a diagram of the circular flow of income where
consumption, investment, government expenditure and exports are shown as injections into the economy
and consequently these forces create the demand which culminates in the actual aggregate level of
economic activity. In this circular flow of income diagram savings, taxation and imports are shown as
withdrawals from the circular flow and consequently, of themselves, are depicted as reducing the level of
aggregate demand.

Thus potential level of GDP is what the economy is capable of producing when there is full employment of
all the factors of production whereas actual level of GDP is the recorded level of economic activity in the
Irish economy. The quantity and quality of economic resources determines the potential GDP and the level
of demand determines the actual level of GDP subject to the upper limit which the potential imposes.

(iv) Regressive taxes are taxes which take a higher proportion of income from a poorer person. The possibility
of taxation being of a regressive nature arises in the case of taxes on expenditure such as VAT. Where such
taxes are levied on goods which are bought by rich and poor in quantities which don't vary significantly with
levels of income e.g. vat on necessities or a TV licence, they constitute a regressive form of taxation. In
circumstance where rich and poor pay the same amount of tax then this still constitutes a regressive form
of taxation because the amount of tax being paid constitutes a larger proportion of the income of a poorer
person. Thus regressive taxation contravenes the canon of taxation which state that the amount of tax paid
should be related to the individual's ability to pay which implies that taxation should be equitable in that it
should be 'from each according to their means'. Regressive taxation does not arise in the case of taxes
which are levied on income since the liability in respect of such taxes is calculated specifically in respect of
the economic circumstances of each individual and the amount of tax levied is based on the individual's
income i.e. 'from each according to their means'

(v) The Multiplier is a concept developed by the famous economist, John Maynard Keynes, to define the total
increase in national income which results from a given increase in injections into the circular flow of income.
Any injection into the circular flow of income will continue to add to the level of domestic demand until there
is an increase in leakages (viz.: imports, savings, taxation) which is equal to the amount of the original
injection into the economy. Thus it is the various marginal propensities to leak which determine the
magnitude of the multiplier. The formula for the Multiplier in an open economy with a government sector is:
where mps is the marginal propensity to save; mpm is the marginal propensity to import and mpt is the
marginal propensity to pay taxes. Thus it will be noted that the multiplier is greatest in a closed economy
which has low taxes and that the multiplier will be relatively small in a high taxed open economy. The
multiplier also operates in a deflationary manner so that if there is a reduction in the level of injections then
this reduction in demand will continue to be reflected throughout the economy until such time as a new lower
equilibrium is reached; at this new lower equilibrium level of output the magnitude of the change (reduction)
in leakages will be equal to the magnitude of the change (reduction) in injections

Page 5
SOLUTION 2
This question is drawn from information set out in sections 1 and 2 of the syllabus. The question directs attention
to the fact that it is the twin aspects of cost (efficiency) and revenue (market conditions) that determine the
profitability (viability) of the enterprise. and thus its very existence. The information being sought in the question
has relevance to the management accounting and strategic performance management courses.

(a) A cost of production is a cost that is necessarily incurred in bringing a product (or service) into existence, If
the revenue realised by the sale of the product in question is insufficient to pay the wages, rent and rates,
the raw materials and all the other expenses incurred in producing the product then production of the item
would not continue and the good would cease to be produced. If the cost to you of producing good in terms
of wages paid to employees, the purchase of raw materials and the payment of other expenses such as
rent, electricity etc came to €1000 and you could sell that item for €1000 would you produce it?. The answer
is no because there is no reward or return for you in this transaction. If with the same level of costs you could
sell the item for €1000 and 1 cent, you are still unlikely to produce the item since you would consider the
return to you of 1cent as being derisory and not a worthwhile return for the effort and risk that you have
undertaken. However there is some price that will provide you with the minimum amount that you must
receive if you are to be involved in the production of this good. Let us say that €1140 is the minimum selling
price for this good that would provide you with the return that you require and in the absence of this level of
return you would not engage in the production of the good, then in this case €140 (€1140 - €1000) is the
minimum payment (or profit) that would require if you are to produce this good:. thus €140 is a cost of
production because it is a payment that must be available if production is to take place and production will
not take place if this minimum amount of profit is not received. This minimum amount of profit is known as
Normal Profit and it constitutes a cost of production, it is the supply price of entrepreneurship and in
economics normal profit is always included as an element of cost.

(b) Marginal cost is the change in total cost when the level of output is changed by one unit, similarly marginal
revenue is the change in total revenue when the level of sales changes by one unit. If a firm seeks to earn
the highest possible level of profit then it will base its business decisions on the effect of such decisions on
costs and their effect on revenue i.e. decisions will be based on the relationship between marginal costs and
marginal revenue. If marginal cost from a course of action is lower than the marginal revenue then profit will
be increased from undertaking the course of action. Conversely if marginal cost is greater than marginal
revenue then profit will be increased by desisting from the action. Thus the only circumstance when a firm
would be at equilibrium is when marginal cost is equal to marginal revenue. In addition at the level of output
at which marginal cost is equal to marginal revenue marginal cost must be increasing at a faster rate than
marginal revenue so that a firm would reduce its profit if it either increased or decreased its level of activity.

(c) As illustrated in the answer to section (b) above, for profit maximising firms it is the relationship between
costs and revenue that form the basis of decision-making. While a firm would wish to produce the desired
level of output at the lowest possible price it cannot just consider the cost of producing varying quantities
without also considering the revenue which will be earned from the varying price/output combinations. Even
if a firm could produce extra output at lower unit cost if it has to lower the selling price in order to sell the
increased quantity then it must consider both aspects of the development. If the firm faces a downward
slopping demand curve for its output then its marginal revenue will be less than price so that even if unit
costs of production would be lower at increased levels of activity it is the relationship between marginal cost
and marginal revenue that is important.

In terms of market structures a profit maximising firm at long run equilibrium in a perfectly competitive market
will be producing at the lowest point on its average cost curve in other forms of market structure it will not.

Page 6
SOLUTION 3
This question introduces a new aspect of the course which is set out in section 4 of the syllabus and will be of
relevance to managerial finance and also all courses seeking to develop skill in business and strategic decision
making. Part (c) of the question relates to section 3 of the syllabus.
(a) Horizontal growth is the term applied to expansion at a singular or particular point on the value chain. It can
occur through organic growth, merger or acquisition.

(b) Examples of benefits attributed to horizontal growth include:


Organic horizontal growth may be engaged in as a firm seeks to exploit revenue opportunities. As
more consumers move into a market the firm could exploit increased revenue opportunities by

investing in more productive assets.


When a merger or acquisition occurs there is, by definition, a reduction in the number of competitors
in the market. Consequently there is a reduction in the availability of substitute goods so that there is

a reduction in price elasticity of demand for the firmʼs output.


Price wars are less likely to occur.
An increase in co-operative behaviour from firms is likely and cartel behaviour among firms may

develop.

If the nature of the business is characterised by a steep learning curve significant cost savings may
be achieved through horizontal growth.

(c) As indicated by the name oligopolistic markets are markets in which there are few sellers. The significance
of the paucity of sellers is that firms can identify their competitors and thus conceivably take into account
the possible reaction of rivals to any competitive initiatives that the firm may take.

Oligopolistic markets tend to be characterised more by non-price competition rather than significant price
flexibility and the kinked demand curve model is one example of a possible scenario. Recognition of market
territories and market shares together with various forms of collusive behaviour and/or agreements such as
cartels are also associated with oligopolistic markets.

Page 7
SOLUTION 4
This question relates to sections 7 of the syllabus and illustrates the interrelationships between different sectors
of the economy. This approach will assist a student in recognising precise linkages within the economic and
business environment and provides a form of template for analysing the effects of fiscal policy on the domestic
economic environment. In this way it contributes to the strategic performance management and the strategy,
leadership and knowledge management courses.

(a) A budget deficit refers to a situation in which the governmentʼs expenditure is greater than its revenue; the
shortfall on the revenue side being made up through government borrowing.

The following points are relevant when evaluating a considering a government decision to introduce a
budget deficit:

The use which is made of the borrowed funds. It may be self-liquidating form of borrowing in the sense
that the borrowed funds may be used in a manner that improves the productive capacity of the

economy e.g. improving the infrastructure of the economy.


It may be part of a countercyclical macroeconomic policy so that the government has budget deficits
when the economy is working below capacity and runs surpluses in buoyant times to pay back the

borrowing.
The cost to the State of undertaking necessary public works will be lower when the economy is
somewhat flat.

In contrast to the foregoing points it would be a bad strategy in run a budget surplus when the
economy is already buoyant.

If the National Debt is at a very low level then the servicing of the borrowing may not impose too heavy
a burden on the economy.

(b) Possible effects of a budget deficit on other objectives of national economic policy.
As already mentioned a budget deficit adds to the National Debt .
A deficit budget is expansionary and thus it stimulates economic growth.

It results in increased levels of employment.


It may cause some problems on our Balance of Payments in the sense that increased purchasing

power within the economy will stimulate demand for imports.


The effect on inflation depends on the stage of the cycle that is being experienced. If a deficit budget
was introduced when the economy was inherently buoyant then inflationary pressures would be

intensified.
It may assist in facilitating a more equitable distribution of National Income.
Depending on the detailed use of the funds it may assist balance regional development.

Page 8
SOLUTION 5
The material for this topic is contained in section 9 of the syllabus. It has links with the legal framework syllabus
and also is complementary to aspects of the strategic performance management and the strategy, leadership and
knowledge management courses. Exam questions based on new circumstances arising from the shift of
macroeconomic decision-making to European institutions help to develop studentsʼ understanding of the changed
and changing business environment that applies to Irish firms and institutions.

(a) The prime objective of the European Central Bank is the safeguarding of the integrity (or value) of the Euro
currency. Since the value of money is its purchasing power, or the rate at which it exchanges for goods and
services, if there is inflation in the economy then the value of a unit of the currency is lessening in value.
The ECB has declared its target rate of inflation to be 2% so if inflation is in danger of going above this level
then the ECB is likely to deflate economic activity within its area of influence through increasing its interest
rate.

(b) One of the ways in which an increase in interest rates would impact on the level of activity in the Irish
economy is through the effect of such action on the value of the Euro. An increase in interest rates within
the euro zone would cause an inflow of international funds into the area and a consequent increase in the
foreign exchange value of the Euro. This appreciation in the value of the Euro makes our exports to non-
eurozone countries more expensive and imports from those areas cheaper relative to domestically produced
competitive goods.

The upward pressure on costs in the economy arising from the increase in interest rates would put further
pressure on our efforts to retain competitiveness against competitors from outside the Euro zone. Thus,
imports for these areas may enjoy price advantages against domestic products.

Obviously the precise effect of these developments on our balance of (international) trade depends on (i)
the proportion of our international trade which takes place outside the euro zone, (ii) the extent to which our
international competitors have not been subject to same economic developments, (iii) the price elasticity of
demand for our exports and (iv) our price elasticity of demand for imports.

(c) As already mentioned an increase in interest rates gives a downward thrust to economic activity. The level
of economic activity depends on the level of demand being experienced, the components of demand are
consumption, investment, government expenditure and net exports and the level of demand attributable to
each of these sources is reduced as a result of an increase in interest rates.

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

Investment. Investments are invariably financed by some form of credit which will lessen the level of
demand. The construction sector will experience a fall-off in demand, a development that will have with
considerable knock-on effects throughout the economy. Firms may postpone expansion plans because of
the increased cost of financing and also with lower levels of demand throughout the economy such firms
may wait for more propitious circumstances. All stock- carrying expenses increase resulting in a probable
lowering of current production to the level of sales being experienced.

Government Expenditure. With lower levels of economic activity government finances will come under
pressure as reductions in the levels of income and expenditure taxes reflect the lower level of aggregate
demand in the economy. The government expenditure on various forms of welfare payments will increase.
The financing of the National Debt will increase adding further to difficulties the government might have in
attempting to implement any form of counter-cyclical macroeconomic policy.

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

Expectations. Economic agents may incline towards a view that the increase in interest rates being
experienced may be just the first of a series of such increases and accordingly may adopt a wait-and-see
approach in their business affairs resulting in an additional downward impulse to economic activity.

Page 9