ECONOMICS &

THE BUSINESS ENVIRONMENT

FORMATION 1 EXAMINATION - APRIL 2005

NOTES
Answer four questions,
question I which is compulsory
and any 3 other questions.

TIME ALLOWED:
Three hours and 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 1 EXAMINATION - APRIL 2005

Time allowed: 3 hours and 10 minutes to read the paper. Answer four questions; question 1
which is compulsory and any 3 other questions.

Question 1 is allocated 40 marks and each of the

other questions is allocated 20 marks.

1. Write a note on four of the following:

(i) Cross Elasticity of Demand.

(ii) The market conditions (or circumstances) that prevail when a firm is a price taker in that market.
(iii) Fiscal Drag.
(iv) Economies of Scale.
(v) Incidence of a Tax.

[Total 40 Marks]

2. (a) Draw a short run average (or unit) cost curve and justify the shape you have drawn.
(6 marks)

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

(c) A firm that seeks to make the maximum possible level of profit is contemplating taking on an additional
product line. Set out the economic (or financial) information that you would require (or seek). Explain
your approach.
(10 marks)

[Total 20 Marks]

3. (a) Explain the factors that determine the rate at which it is possible for the Irish economy to grow (i.e.
the potential growth rate).
(7 marks)

(b) Explain the factors that determine the rate at which the Irish economy actually grows.
(8 marks)

(c) Explain the statistic (or information) that is used to measure the actual rate of growth in the Irish
economy between any two periods.
(5 marks)

[Total 20 Marks]

Page 1
4. (a) Explain the functions of money. (8 marks)

(b) Does the fact that banks create purchasing power mean that they may not have enough money for
depositors who seek access to their cash? Explain your answer.
(12 marks)

[Total 20 Marks]

5. (a) Explain the effect(s) that a Budget Deficit would have on the objectives of national economic policy.
(8 marks)

(b) Has membership of the European Union been beneficial to the Irish economy? Explain your answer.
(12 marks)

[Total 20 Marks]

END OF PAPER

Page 2
SUGGESTED SOLUTIONS

ECONOMICS & THE BUSINESS

ENVIRONMENT
FORMATION 1 EXAMINATION - APRIL 2005.

SOLUTION 1

(i) Cross Elasticity of Demand measures the responsiveness of demand for a commodity in response to a
change in the price of another commodity. The formula for calculating cross elasticity of demand is the
proportionate change in the quantity demanded of one good (good X) divided by the proportionate change
in the price of another good (good Y). If the answer obtained from the application of the formula is positive
this indicates that an increase in the price of one good brings about an increase in the demand for the other
good indicating that the goods stand in a substitute relationship to each other. The larger the numerical value
the closer the degree of substitutability. If the answer from the calculation is negative then the goods stand
in a complementary relationship to each other.

(ii) A firm is said to be a price taker when, acting alone, it is unable to influence market prices i.e. market price(s)
is a given and the firm has to make its business decisions within the constraint of this reality. Typically such
a situation pertains when a firm is a small player in the market and the product that the firm is selling is
homogeneous so that there is no marketable difference between the items produced by different suppliers.
Because the product is no different from the offerings of competitors it is not possible for the firm to sell at
a higher price than competitors, while on the other hand there is no incentive for the firm to sell at a lower
price. The demand curve facing the individual firm in such circumstances is a horizontal demand curve at
the market price. The horizontal demand curve reflects the fact that there is no demand for the product of
the firm at any higher price and there is no incentive for the firm to sell at a lower price since due to the small
scale of its operations it can sell its entire output without affecting market price(s). All of this is captured in
the depiction of the representative firm in a perfectly competitive form of market structure. The viability and
the profitability of such firms is determined by their cost base and if an individual firm suffers from some
cost disadvantage it is not possible to recoup this additional cost through increasing prices. It is not unusual
for Irish firms competing against large firms in export markets to see themselves as price takers and in the
light of the foregoing comments such firms are particularly vulnerable if they are subject to cost pressures
that are not being experienced by firms in other member states.

(iii) 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 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 which term is rather 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 would be experienced if the economy became more buoyant than was envisaged
at budget time. For example 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 development which is referred to as
fiscal drag.

Page 3
(iv) Economies of scale are cost reducing benefits which accrue to a firm as a result of an increase in the scale
of output. They are sometimes analysed in terms of internal economies of scale which are applicable to a
particular firm as its level of production increases and external economies of scale which accrue from the
growth of an industry and these external economies may be availed of by all firms in the industry. Internal
economies of scale are usually categorised as technical economies, marketing economies and financial
economies.

• Technical economies are one source of reductions in unit cost as the level of production increases,
for example increased use of machinery becomes possible, the use of specialised machinery
becomes feasible and economical, the cost of overheads does not grow pro rata with increases in
production, and a more economical linking of the processes of production becomes possible.

• Marketing economies stem from a stronger position in negotiating the purchase of raw materials
together with reductions in relative ordering costs. Economies accrue also in distribution as large
scales of operation facilitate improved load factors in delivery vehicles together with the
implementation of more economical delivery schedules.

• Financial economies of scale accrue because large firms are generally considered to constitute a
lower financial risk in relation to borrowing and consequently enjoy more favourable borrowing terms.
In addition large firms may have access to sources of funds which are not available to smaller firms.

• Some examples of external economies of scale are the growth of specialised sub-contracting firms
and the development of a supporting economic infrastructure

(v) 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

Page 4
SOLUTION 2.
(a) Short run average cost refers to the effect on unit cost of production when there is an alteration in the level
of production in the short run i.e. while the supply of at least one factor of production cannot be altered.
Short run average cost curves are usually depicted as being U shaped as illustrated below.

decreasing unit cost

increasing returns due to
specialisation and better
spread of fixed costs
unit cost
increasing unit cost
decreasing returns due to
law of diminishing
marginal returns.

output per period

Short run average cost curve.

The downward section of the U curve is attributable to the following two reasons:
(i) As the level of production increases there is a sufficient volume of work to justify the employment of
specialists or to permit existing workers to concentrate on a narrow range of duties. Since workers
improve their productivity through concentration and specialisation, unit costs of production are
reduced.
(ii) As a firm expands its level of production, its costs of production do not increase pro rata e.g. fixed
costs are defined as costs which do not vary over a certain range of output, thus the spreading of fixed
costs over a larger volume of output reduces the fixed cost element in unit production costs and
consequently unit costs fall as output expands.

Despite the foregoing if the volume of production continues to expand unit costs will eventually increase due
to the coming into effect of the Law of Diminishing Marginal Returns. This law 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 where marginal returns begin to decline.

(b) Costs of production are all those expenses that must be recouped if production is to take place. If the
revenue realised on the sale of the goods is insufficient to cover the wages, rent, cost of raw material and
all of the other expenses then production would not continue. The entrepreneur is the person who mobilises
and organises the other factors of production in order to produce the goods and services which eventually
are offered for sale. Even if the other factors of production are available in the absence of the entrepreneurial
function the production would not take place and unless there is a return, or an acceptable likelihood of a
return, the entrepreneur has no incentive to get involved. Normal Profit is the minimum return that the
entrepreneur requires if he/she is undertake the entrepreneurial role and in the absence of such a rate of
return the envisaged economic activity would not take place. Therefore Normal Profit is a cost of production
because if the enterprise does not generate a return sufficient to enable the entrepreneur to earn Normal
Profit then the economic activity will cease or will not be undertaken in the first instance

(c) A firm that seeks to earn the maximum possible level of profits will base their decisions on the effect of
proposed actions on their bottom line . Accordingly the firm in question would calculate the various costs
that would be incurred if they expand into the additional product line. These additional costs of production
would be incurred under the usual cost headings viz: additional wages, raw material costs, energy costs etc.
Collectively they can be termed marginal cost. On the revenue side the firm will undertake research into
market conditions, extent of competition, possible reaction of market incumbents to the new entrants etc as
it attempts to estimate the increase in the revenue of the firm i.e. marginal revenue. If the marginal revenue
exceeds the marginal costs then profitability will be improved if the expansion takes place. There is one
important consideration in this type of decision. If general overheads do not increase when the contemplated
action is undertaken then marginal costs will consist entirely of the additional variable costs. This is usually
referred to in terms of analysing if the new activity will make a contribution towards the fixed costs (or
overheads) of the firm and is similar to the economic conditions for profit maximisation in the short run.

Page 5
SOLUTION 3

(a) The level of output, that it is possible to produce in the Irish economy, is determined by (i) the quantity and
quality of factors of production within our economy and (ii) the state of technology, which exists in (or is
available to) the Irish economy. The greater the stock of factors of production that is available the greater
the level of output that the economy is capable of producing i.e. the greater the potential level of national
income. A greater stock of factors of production is available in the USA compared with Ireland, consequently
the potential level of national income in that country is greater than ours .The quality or efficiency of these
factors of production is also a relevant consideration e.g. the fertility of the land, the economic quality of the
workforce, the efficiency of the infrastructure etc. The state of technology in an economy has such an
important bearing of the potential level of national income that it is considered to be the most important
determinant in the growth of an economy. One of the main reasons for the economic resurgence of Germany
despite its defeat in the Second World War was the level of technical knowledge and ability available within
that economy.

(b) While this potential level of GDP places an upper limit to the amount of goods and services that 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 a circular flow of income diagram savings, taxation and imports are shown as
withdrawals from the circular flow and consequently, of themselves, reduce the level of aggregate demand.
Exports are a very important element of demand for the Irish economy; so that if foreign purchasers of Irish
merchandise and service are experiencing economic buoyancy in their domestic market this will stimulate
their demand for our exports and consequently our actual level of 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
economy.

(c) Our Gross Domestic Product is a measure of the total value of goods and services produced in the Irish
economy, thus a comparison of GDP for different years would indicate the rate of growth experienced
between the two periods. Care would have to be taken if using GDP at current market prices since
expenditure taxes and/or subsidies might have changed in the intervening period. Using GDP @ factor Cost
would obviate this problem. An allowance for inflation would also be relevant and the case could be made
for including provision for depreciation.

Page 6
SOLUTION 4.

(a) Money is anything which is generally acceptable in payment for goods and services. Whatever is chosen to
be used as money must be capable of fulfilling the following roles, which are known as the functions of
money. If circumstances develop which inhibit the ability of money to effectively fulfil these functions e.g.
during a period of inflation, then money loses its effectiveness and either some other currency or item is
used to replace it or there is a reversion to a system of barter. Accordingly the functions of money are;

• To act as a medium of exchange. This is the most important function of money and it fulfils this role
when a person exchanges the good or service which they own for money and then use the money (or
some of it) to purchase the good or service which they require. Rather than suffering the draw backs
inherent in a situation where people attempt to satisfy directly all their own need this quality of money
facilitates the division of labour since it enables people to specialise and use the money thus obtained
to purchase their requirements.

• To constitute a store of value. It is this quality of money which enables a person to sell the goods
and services which they own at a time which is most beneficial to them and use the money thus
obtained as a store of value which can be used whenever they decide to purchase their requirements.

• To be a measure of value/unit of account. Money is the common denominator which we use to

measure and express value. It is the unit in which prices are quoted and accounts are kept.

• To provide a standard for deferred payments. It is this feature which makes possible credit trading
and drawing up of financial contracts with a money consideration being paid over at some future time.
All borrowing and lending is possible because of this. Transactions of this nature depend on being
able to express in money terms the price that must be paid at some future date.

(b) The ability of the banking sector to create purchasing power stems from the general acceptability of cheques
and other forms of non-cash in payment for goods and services. The actual amount of purchasing power
that it is possible for banks to create depends on the value of its cash holdings and the required liquidity
ratio e.g. if €1000 cash is lodged with the banks and if banking experience is that 10% of the value of
deposits needs to be held in cash form then the required liquidity ratio is 10% so that this lodgement would
support loans to the value of €10,000. Banks have learnt from experience the liquidity ratio that they require
in order to satisfy demands for cash so they are not very likely to be over extended on their loan portfolio.
However to the extent that they might be short of liquidity it is possible for them to borrow from other financial
institutions on the inter-bank market, they can also increase their liquidity by reducing the amount of their
overnight and on-call lending. In addition the central bank stands at the apex of the system in its capacity
of lender of last resort. To the extent that banks have underestimated their required level of liquidity, profits
are reduced through the bank having to seek short term external funding.

Page 7
SOLUTION 5.

(a) A budget deficit occurs when the revenue accruing to the national exchequer does not cover the expenditure
so that any shortfall has to be borrowed. The term is usually applied to the current section of the national
budget since as a book-keeping exercise total receipts plus borrowing must be equal to the total of current
and capital expenditure. The manner in which a budget deficit would impact on the objectives of national
economic policy is set out hereunder.

Unemployment would be less than would otherwise be the case because the injection of government
expenditure is greater than the leakage of demand that occurs through taxation.

Economic Growth would be stimulated through the expansionary budget.

National Debt would be increased through the borrowing that is necessary to make up the shortfall in
revenues.

Our Balance of Payments position is likely to worsen, at least in the short term, as the increase in purchasing
power stimulates an increased demand for imports.

Depending on the state of the economy the budget deficit may intensify inflationary pressures.

In the absence of precise taxation and spending details it is not possible to speculate on the likely effects of
the budget deficit on any national objectives regarding the distribution of national income or regional
development.

(b) A comparison of our economic well being at the present time with our economic circumstances at the time
of joining the then EEC would confirm that we are economically better off. While some might argue as to the
precise extent that this is attributable our membership of the European Union there is unanimity that
membership has been economically beneficial. European Funds have been made available to us to develop
our economic infrastructure. In addition we were a net beneficiary of funds through our participation in the
Common Agricultural Policy. Our access to European Markets has been enhanced and this is manifest in
the increase in our exports to, and imports from, these markets. It is worthy of note that were we not
members of the European Union we would be virtually excluded from such markets so that the possibility of
just continuing as we had been was not an option. The performance of the Irish economy has been boosted
by direct foreign investment and the attractiveness of our country to direct foreign investors is enhanced by
our membership of the European Union. Because of our membership Ireland provides for such investors a
gateway to EU markets. While there is no gainsaying the continuing importance of non-European markets
e.g. USA, a comparison of the changing geographical dispersion of our exports, and the new European
sourcing for many of our imports, illustrate opportunities that have accrued through membership. However,
there is no denying that membership has entailed some downsides and compromises. Some sectors of Irish
economic activity have been non-viable as a result of the creation of freer intra-European trade; in addition
the control of macroeconomic policy has to a large extent moved from the national to the Community level.

Page 8