THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND

ECONOMICS &
THE BUSINESS ENVIRONMENT
FORMATION I EXAMINATION – APRIL 2006

Time allowed: 3 hours and 10 minutes to read the paper Answer 4 questions, question 1 which is compulsory
and any 3 other questions
Question 1 is allocated 40 marks and each
of the other questions is allocated 20 marks.

1. Write a note on four of the following:

(i) Law of Diminishing Marginal Returns.

(10 marks)

(ii) The factors which influence demand for a good (or service).
(10 marks)

(iii) The Entrepreneur (as a factor of production).

(10 marks)

(iv) Automatic Stabilisers (in relation to fiscal policy).

(10 marks)

(v) Advantages and Disadvantages of Indirect (Sales or Expenditure) form of taxation e.g. VAT.
(10 marks)

[Total: 40 Marks]

2. An Irish firm that seeks to earn maximum profits produces one type of product which it sells in the domestic
(Irish) market and in the European market. The firm is a monopolist in one of these markets and experiences
perfect competition in the other.

(a) State, giving reasons, in which market you think the firm is a monopolist.
(2 marks)
(b) In respect of each of these markets explain the affect(s) on this firm of:
(i) an increase in wage costs in the Irish economy;
(ii) if OPEC increases the selling price of petroleum products.
(8 marks)
(c) Explain, using a diagram, long run equilibrium of a profit maximising monopolist.
(10 marks)

[Total: 20 Marks]

Page 1
3. (a) Explain the factors that determine:
(i) the upper limit; (3 marks)

(ii) the lower limit to the level of wages that will apply to a particular job. (3 marks)

(b) Two individuals A & B are employed in similar work and are in identical situations in terms of
allowances etc. for the purpose of income tax. A is employed in the public sector and B in the private
sector. In your opinion should A & B have the same amount of take-home pay from their employment?
(7 marks)

(c) Why is there (usually) a numerical difference between the potential level of Gross Domestic Product
(GDP) and the actual level of GDP?
(7 marks)

[Total: 20 Marks]

4. (a) How is the rate of inflation calculated (or measured)?

(3 marks)
(b) Why is inflation considered to be undesirable?
(8 marks)
(c) Are there any limitations on the power of commercial banks to create purchasing power?
(9 marks)

[Total: 20 Marks]

5. (a) Explain why the European Central Bank (ECB) might decide to increase interest rates.
(8 marks)

(b) Trace the various ways in which an increase in interest rates could impact on the level of economic
activity in Ireland.
(12 marks)

[Total: 20 Marks]

END OF PAPER

Page 2
 Suggested Solutions

ECONOMICS &
THE BUSINESS ENVIRONMENT
FORMATION I EXAMINATION – APRIL 2006

SOLUTION 1
The format and nature of this question is to acquire an indication of the student’s overall understanding of the
subject. It not only permits the exam paper to reflect more accurately the comprehensive nature of the syllabus
but it also improves 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) 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. In the table illustrating the law which is set out below land is considered to be the
fixed factor of production and labour is the variable factor and in this example diminishing marginal returns
set in with the employment of the fifth person. 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.

Land No. of men employed Total output Marginal output

1 1 10 -
1 2 24 14
1 3 40 16
1 4 58 18
1 5 73 15
1 6 86 13
1 7 98 12

(ii) The principle factor which affects the demand for a good is its own price, generally speaking if the price of
a good increases the demand for it falls and conversely if the price of the good is reduced then the demand
for it increases - always on the assumption that nothing else changes. The price of substitute goods also
affects the demand for a good, if a substitute good increases (falls) in price then the demand for the good
in question would increase(fall). Whereas if the price of a complementary good increases (falls) in price then
the demand for the good in question would fall (increase). The general level of real income is another factor
which has an influence on the demand for a good. For most goods if real income is increased the demand
for the good in question increases, in fact goods which are subject to this positive income effect are known
as Normal Goods. If the opposite occurs i.e. goods the demand for which falls when income rises, such
goods are known as Inferior Goods. Taste or fashion also influences the demand for a good as does
expectations as to future changes in prices or expectations as to the future availability of the item.

Page 3
(iii) The entrepreneur is the person (or persons) who bear the risks against which a business cannot insure.
Some examples of risks against which insurance policies are not available are:
l The possibility that new products may not sell at the price and in the quantity required to generate
an adequate profit.
l The risk that competitive strategies by competitors will render your business unprofitable.
l The possibility that unforeseen developments may affect the profitability of the firm.
l Industrial Disputes
l The entry of new firms into the industry.
l The emergence of international trade agreements which increase competition.

It is sometimes thought that directors, top management or decision makers in a firm are the entrepreneurs
though this is not necessarily so. If such people are employed by the firm and they receive a salary for their
efforts on the firm's behalf then they are merely a form of the factor of production labour. The return to the
entrepreneur is known as profit and this form of return is different to the return to other factors of production
in that it is a residual rather than a specified amount, in addition to which is likely to be subject to
considerable variation from one period to another. The return to the entrepreneur is unique also in that it
may be a negative return in circumstances where the firm suffers a loss; such an outcome is not
conceivable in respect of any of the other categories of factors of production.

(iv) Automatic (or Built-in) Fiscal Stabilisers. Tax revenue that rises and government expenditure that falls as
National Income rises are known as automatic stabilisers, Automatic stabilisers have the effect of
dampening fluctuations in the trade cycle; they dampen oscillations around the trend growth path. If there is
an injection of income into the economy then the subsequent leakage of part of this money through the
payment of taxes lessens the impact of the injection on the level of aggregate demand. The main advantage
of automatic stabilisers in controlling aggregate demand is the fact that they operate instantaneously - as
soon as aggregate demand fluctuates this stabilising process comes into play. This stabilisation process is
extremely beneficial when an economy is operating at a desired level, in which circumstances the
stabilisation process ensures that there are no major deviations from an acceptable level of economic
activity. However, if the economy is under-performing the operation of automatic stabilisers still applies and
in these circumstances they hold back the economy through lessening the impact of any demand stimulus
to which the economy might be subject. In such a circumstance the term fiscal drag is often applied. Social
welfare payments are another source of automatic stabilisers since the number of people eligible for such
payments varies inversely with the state of the economy so that the government spends more money on
such payments in a downturn and less money on payments of this nature in a buoyant economy.

(i) Advantages of Indirect (or Expenditure )Taxes.

l They are productive of considerable revenue particularly when imposed on goods which enjoy
a relatively inelastic demand.
l They are equitable. In contrast to direct taxes which are imposed on income which it is often
difficult to determine precisely indirect taxes are imposed on expenditure which will be closely
related to a person's income and standard of living.
l Payment of indirect tax is convenient to the taxpayer as it is paid at the time of purchasing the
goods and thus the tax is a factor in deciding whether or not to purchase the item.
l Indirect taxes do not constitute a disincentive to effort since they are based on expenditure
rather than income.
l They have a stabilising effect on the level of economic activity through their influence as
automatic stabilisers.

Disadvantages of Indirect Taxes.

l They may be regressive if they are levied on goods which are bought in more or less the same
quantities by rich and poor alike.
l They may be inflationary because they increase the selling price of goods and services.
l They discriminate between individuals of the same economic standing when they are imposed
on specific goods rather than in a general way on all goods.

Page 4
Solution 2
This question is drawn from sections 1 & 2 of the syllabus. It relates to aspects of the course that have strong
linkages with Management Accounting and Financial Management. The question is so structured as to draw the
student through the salient points to be covered.

(a) The firm is more likely to be a monopolist in the domestic market and to be subject to perfectly competitive
conditions in the export market as the falling comments indicate.
l Because the Irish market is relatively small it is possible that foreign firms supplying competitive
items might not consider it to be economically worthwhile to enter the Irish market.
l If the Irish firm was subject to perfectly competitive conditions in the domestic market it is unlikely to
build up the resources necessary to enter the export market. The usual situation is for a firm to
develop its business expertise to acquire a relatively dominant position in the domestic market and
then use this as a springboard into exporting.
l It is an unlikely scenario that firms would be price-takers in the domestic market and that one of these
price-taking firms would enter exports markets without others following suit.

(b) (i) If there is an increase in wages in the Irish economy then this Irish firm suffers an increase in its
costs.
l As the firm is a monopolist in the domestic market it is likely to pass all or part of the increase
in wages on to the selling price of the goods.
l The precise distribution of the cost will depend on the relative elasticities of supply and
demand in the market.
l The foreign firms that are competitors of the Irish firm in the perfectly competitive export
markets have not suffered this increase in costs so the Irish firm would not be in a position to
reflect the increased cost in the selling price of the goods on the export market.
l There may well arise a question as to the economic viability of continuing to compete in the
export market.
(ii) In the event of an increase in the prices of petroleum products. In addition to increasing the costs of
the Irish firm this will also affect not only the cost structure of the Irish firm but also the cost structure
of that firm’s competitors in the export market. Thus there will be an opportunity for the Irish firm to
recoup these increased costs in the export market as well as in the domestic market.

(c)

Supernormal profit

quantity

Long run equilibrium of a monopolist.

The following points covered:

(i) The firm faces a downward sloping demand curve.
(ii) The firm produces the level of output at which marginal cost is equal to marginal revenue (and at that
level of output marginal cost is increasing at a faster rate than marginal revenue.)
(iii) At equilibrium the firm is earning supernormal profit (i.e. average cost is lower than average
revenue).

Page 5
Solution 3
Parts (a) & (b) of the question which are taken from section 3 of the syllabus have links with the syllabus for
management & strategy: part (c) of the question is taken from section 5 of the syllabus. The question relates to
material currently under general public discussion.

(a) (i) The upper limit to the level of wages that will be paid by a profit maximising firm is determined by the
increase in revenue accruing to the firm that is directly attributable to employing the person i.e. the
marginal revenue productivity of the employee. The actual value of marginal revenue productivity is
a combination of the actual increase in total production – marginal physical productivity and the
increase in total revenue as a result of selling the additional output. A strong trade union may ensure
that employees are paid up to their marginal revenue productivity but no trade union, no matter how
strong their negotiating power, can extract wage levels higher than the marginal revenue productivity
of the employee because this would imply a reduction in the profits of the firm from such
employment. Where marginal revenue productivity is difficult to calculate traditional wage relativities
and differentials may emerge.
(ii) The lower limit to the level of wages that a person will accept is determined by the transfer earnings
of the employee i.e. what they could earn in the next best area of employment.
The actual level of wages paid will lie between the marginal revenue productivity and the transfer
earning. The precise level of wages depends in the relative negotiating strength of the two parties to
the contract.
(b) Money wages are not the only form of benefit associated with a job, there may be other forms of monetary
benefits as well as non-monetary benefits. Thus it is more meaningful to consider the net advantages
associated with particular forms of employment. Pension rights, expense accounts, loans at preferential
rates, subsidised housing, allowances for children and other forms of benefits-in-kind are examples of non-
wage monetary benefits. Forms of non-monetary benefits are job security, socially attractive working hours,
opportunities for career development and promotion, congenial working environments, employment
located in areas with a good social infrastructure.

Thus comparisons between different forms of employment should be based on the net advantages
associated with each. Both monetary non-wage benefits and the non-monetary benefits tend to be greater
in the public sector then the only way that net advantages would be equalised for similar work would be if
wages in the private sector had some compensatory element.

(c) The potential level of GDP is the value of the output of goods and services that the resources of the
economy are capable of producing if they are being fully utilised. Whereas the potential level of GDP is a
function of the physical stock of factors of production and their efficiency the actual level of GDP is the
value of the production in the economy during a specified period – usually a year. The potential level of
GDP is the upper limit to what the actual level of output might be. While the potential level of GDP depends
on the stock & efficiency of factors of production the actual level depends on the level of demand being
experienced for the goods and services that we are capable of producing. The elements of this demand
are consumption, investment, government expenditure of domestically produced goods and services and
net exports i.e. exports minus imports.

Page 6
Solution 4
This question is based on sections 5 & 7 of the syllabus. It examines knowledge of a topic that is of particular
relevance to the Irish economy given our international economic liaisons and our loss of economic sovereignty/

(a) The rate of inflation in Ireland is measured by reference to the Consumer Price Index which is compiled by
the Central Statistics office. This index is designed to measure the change in the average level of prices
(inclusive of all indirect taxes) paid for consumer goods and services by all private households in the
country and by foreign tourists holidaying in Ireland. The CPI measures in index form the monthly changes
in the cost of purchasing a fixed representative ‘basket’ of consumer goods and services thus it is
essentially a weighted average of the price changes occurring in respect of a representative basket of
goods. The representative share of each item in this basket is proportional to the average amount
purchased by all households in the country as determined by the Household Budget Survey and by
surveys relation to tourists, expenditure. An EU-Harmonised Index of consumer Prices is now calculated
in each Member State of the European Union. The purpose of this index is to allow a comparison of
consumer price trends in the different Member States.

(b) l Exports constitute a very significant source of demand in the Irish economy. If our rate of inflation is
greater than that being experienced by our trading partners then our exports will become
uncompetitive with a consequent depressing effect on the level of our GDP.
l With rising prices being experienced in the domestic economy imports will become more competitive
as a result of which imports will gain market share.
l Direct foreign investment into the Irish economy will become less attractive on two accounts. Firstly
there will be an increase in costs of doing business in the host country and secondly when profits
are being repatriated they will be worth less when converted into the currency of the investor if our
exchange rate has worsened to reflect our inflation.
l Inflation increases uncertainty and thus business risk which worsens the trading climate.
l During a period of inflation borrowers tend to gain at the expense of lenders. This may encourage
further borrowing thus adding further to inflationary pressure.
l In the absence of the indexing of tax allowances or credits there is a transfer of resources to the
exchequer.
l There is a redistribution of income within the State. Those on fixed incomes and the economically
vulnerable tend to suffer most.
l Business planning becomes more difficult in the uncertain inflationary climate.
l Cash flow problems may emerge and historical depreciation may be inadequate as assets being
replaced are subject to the increased prices.

(c) The fundamental consideration in determining the scale of bank lending is their ability to attract deposits.
Their ability to create money stems from the general acceptability of cheques and other bank generated
non-cash methods of payment for goods and services. However, money still has an important role to play
and banks must ensure that they have available sufficient cash to meet the liquidity requirements of their
depositors. The proportion of their reserves that they must hold in cash form is known as their liquidity ratio.
It is these two elements – their deposit base and their liquidity ratio - that determine the amount of
purchasing power that it is possible for banks to create. Subject to the upper limit imposed by these
considerations the level of purchasing power that is actually created depends on the level of demand from
those who constitute an acceptable risk. Thus the limitations on the power of commercial banks to create
purchasing power are:
l The banks, ability to make loans is dependent upon their ability to acquire lodgements.
l The must retain sufficient liquidity in order to satisfy the demands of its customers for cash.
l On the demand side of the equation the number and value of loans depends on the number of
suitable applicants.

Page 7
Solution 5
This question is taken from section 8 of the syllabus and has links with the Legal Framework syllabus. Questions
on the European dimension of the subjects are set in order to emphasise the significance of our membership of
European economic institutions and the shifting sands of economic sovereignty. The question highlights the
manner in which actions of the ECB can impact on the well-being of the Irish economy.

(a) The European Central Bank (ECB) would increase in interest rates if it wishes to deflate economic activity
in the Euro zone The ECB is the central bank for the entire Euro zone so that it controls the level of interes
rates within the system. If it were to increase the rate at which it lends to the banking system then this
would result in all the banks in the euro zone increasing the rate of interest they charge. The principal
objective of the ECB is safeguarding the integrity or stability of the currency this translates into ensuring
that there is no inflation. The recipe for tackling inflation is to deflate the economy. Thus one of the
circumstances which would precipitate an increase in interest rates would be if there was an inflationary
threat. The manner in which the increase in interest rates is transmitted throughout the economy is set out
section (b) of this question.
Another reason why interest might be increased would be if the ECB wished to prevent any downward float
in the value of the euro on foreign exchange markets. An increase in interest rates would stimulate demand
for the currency and thus either increase its value or prevent its value falling on foreign exchange markets.

(b) 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 experience, the components of demand are
consumption, investment, government expenditure and net exports; 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 and
development that will have with considerable knock-on effects throughout the
economy. Firms will postpone expansion plans because of the increased cost of
financing and also with lower levels of demand throughout the economy there may
wait for more propitious trading 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 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
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 and may adopt a wait-and-see
approach in their business affairs resulting in an additional downward impulse to
economic activity.

Page 8