Download ECONOMICS & THE BUSINESS ENVIRONMENT FORMATION 1 EXAMINATION - APRIL 2009 NOTES:

ECONOMICS &
THE BUSINESS ENVIRONMENT
FORMATION 1 EXAMINATION - APRIL 2009
NOTES:
You are required to answer Question 1. You are also required to answer any three out of Questions 2 to 5.
(If you provide answers to all of Questions 2 to 5, you must draw a clearly distinguishable line through the answer
not to be marked. Otherwise, only the first three answers to hand for Questions 2 to 5 will be marked.)
TIME ALLOWED:
3 hours, plus 10 minutes to read the paper.
INSTRUCTIONS:
During the reading time you may write notes on the examination paper but you may not commence
writing in your answer book.
Marks for each question are shown. The pass mark required is 50% in total over the whole paper.
Start your answer to each question on a new page.
You are reminded that candidates are expected to pay particular attention to their communication skills
and care must be taken regarding the format and literacy of the solutions. The marking system will take
into account the content of the candidates' answers and the extent to which answers are supported with
relevant legislation, case law or examples where appropriate.
List on the cover of each answer booklet, in the space provided, the number of each question(s)
attempted.
The Institute of Certified Public Accountants in Ireland,17 Harcourt Street, Dublin 2.
ECONOMICS &
THE BUSINESS ENVIRONMENT
THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND
FORMATION I EXAMINATION – APRIL 2009
Time allowed: 3 hours, plus 10 minutes to read the paper.
You are required to answer Question 1. You are also required to answer any three out of Questions 2 to 5.
(If you provide answer to all of 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:
2.
(a)
(i)
(ii)
(iii)
(iv)
(v)
(b)
3.
4.
(a)
(b)
(a)
(b)
5.
(a)
(b)
Characteristics of Economic Goods.
Law of Diminishing Marginal Returns.
Economic Rent.
Distinguish between National Income and Gross Domestic Product (GDP) at Current Market Prices.
Fixed Exchange Rates.
(4 x 10 marks each)
[Total : 40 Marks]
Explain the factors that influence the level of remuneration paid to an employee. In the course of your
answer indicate what determines (i) the upper limit and (ii) the lower limit to the salary/wages paid.
(10 marks)
As an employee, would you prefer to be employed by a monopolist or by a firm, in a perfectly competitive
form of market structure? Justify your choice.
(10 marks)
[Total : 20 Marks]
Write an explanatory note on 'Entrepreneurship' as a factor of production.
(10 marks)
Explain the type of problems that may arise when the managers of the day-to-day operations of an
economic enterprise are not the owners (i.e. The Principal/Agent problem). (You may assume that the
owners wish to maximise their profit/return).
(10 marks)
[Total : 20 Marks]
Explain the (likely) impact on the national economic objectives if the economy goes into recession.
(10 marks)
Trace the (likely) effects over the period of the economic cycle if the government adopts a 'payback'
approach (i.e. Injecting money into the economy when government revenue is buoyant).
(10 marks)
[Total : 20 Marks]
Explain how it is possible for commercial banks to create purchasing power.
(10 marks)
Explain, in general terms, what caused the 'credit crunch' that occurred in the Irish economy and the
significance of this occurrence for the rest of the economy.
(10 marks)
[Total : 20 Marks]
END OF PAPER
Page 1
SUGGESTED SOLUTIONS
ECONOMICS &
THE BUSINESS ENVIRONMENT
THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND
FORMATION I EXAMINATION – APRIL 2009
SOLUTION 1
(i)
In the study of economics we are concerned with goods which are capable of being bought and sold, such goods
are known as economic goods and their characteristics are:
•
Utility. Utility refers to the ability of a good to give satisfaction or satisfy a need or want, it is this ability
which renders goods desirable. Thus since goods must be desirable if they are to be bought it is a
characteristic of economic goods that they possess utility. It would be futile to attempt to sell something
which is a nuisance or irritant and has no utility.
•
Scarcity. Economic goods are scarce in relation to the demand for them. The concept of scarcity as used
here means that there is not enough of the good to satisfy the demand of all those who want it; this is why
people must pay a price in order to acquire it. Thus in this country fresh air would not be an economic good
because even though it provides utility it is not scarce in relation to the demand for it.
•
Transferable.Economic goods must be capable of being passed from one person to another i.e. they must
be transferable. People are unable to sell what they cannot pass to the buyer and people won't buy what
they cannot receive or control. It is because they do not satisfy this criterion of transferability that good
health, pleasant disposition, beauty and intelligence are not economic goods even though they satisfy the
first two criteria of possessing utility and are scarce in relation to the demand for them in the sense that not
everybody has them though all desire them.
(ii)
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 margin 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 i.e
the additional returns begin to decline. 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.
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.
Land
No. of men employed
Total Output
Marginal Output
1
2
24
14
58
18
1
1
1
1
1
1
10
3
40
4
5
73
6
86
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16
15
13
(iii)
The supply price of a factor of production is the sum of money which must be paid in order to acquire the use of
that factor. Economic Rent is any payment to a factor of production in excess of its supply price.
The supply price of the factor of production labour is the transfer earnings of the factor i.e. the payment (or net
benefits) which it can earn in the next best situation available so that if a firm employs a plumber at a wage of
£400 and the transfer earnings of the plumber is £330 then in this instance the plumber would enjoy an Economic
Rent of £70.To the extent that workers would be willing, if necessary, to continue working in their present jobs
even if their wages were reduced then they are certainly earning some Economic Rent. In general, the existence
of Economic Rent may also be deduced if there are workers of similar ability employed elsewhere and yet seeking
the employment in question. One of the reasons why workers might enjoy an Economic Rent could be due to the
existence of a trade union in the particular job.
(iv)
(v)
Since Economic Rent is a payment in excess of the supply price i.e. in excess of the transfer earnings of a factor,
then the more narrowly defined the occupation the lower will be the Economic Rent. For example if the
occupation of a person is "a CPA in firm A" then his Economic Rent may be close to zero since he might be able
to earn virtually the same salary as "a CPA in firm B". However if the individual's occupation is defined as "an
accountant" then the next best job available to him may be as a general clerk with considerably lower earnings,
in which case there would be an element of Economic Rent. In relation to entrepreneurs Normal Profit is
considered to be the supply price of entrepreneurs so any payment in excess of this amount viz: Supernormal
Profit would be considered a form of Economic Rent.
National Income is defined as the income that accrues to the permanent residents of the country from current
economic activity in the production of goods and services during a specified period. It does not matter in what
country the economic activity takes place provided that the income is received by Irish people.
Gross Domestic Product @ Current Market Prices is the value of the output produced by factors of production
in the domestic economy valued at the price that is paid for the goods and services. It does not matter whether
to factors of production are owned by Irish people or foreigners provided the output is produced in Ireland. Since
National Income refers to the value of output produced by Irish owned factors of production and GDP includes
production by foreign owned factors of production in order to reconcile the two concepts some allowance must
be made for income earned in Ireland by foreign owned factors of production and income earned abroad by Irish
owned factors of production: this net figure is termed Net Factor Income from the Rest of the World. Similarly
allowance must be made for Depreciation and Net Expenditure Taxes.
The absence of a single international currency and the possibility of fluctuations in exchange rates create a risk
that the real value of the price received for goods being sold to purchasers in a different monetary zone may vary
from that intended when the price for the transaction was struck. Stable exchange rates eliminate risks of that
nature and thus assist in the development of trade and commerce between nations and permit future
commitments to be entered into with a lower degree of financial risk. This financial risk arises from the fact that
the period between the striking of a price and the receipt of payment is longer in international trading than it is
when trading takes place within the confines of the domestic market (or single monetary zone). Rather than permit
exchange rates to continually fluctuate in order to reflect transitory fluctuations in supply and demand for a
currency, the monetary authorities may adopt a policy of maintaining the exchange rate at its trend value by
pursuing a fixed exchange rate policy for its currency. By utilising its holding of foreign currencies the Central
Bank may buy or sell its own currency in order to maintain the foreign exchange value at the target level. A Central
Bank’s holding of foreign currencies is not infinite so that a fixed exchange rate policy is merely a smoothing
operation around the trend value of the currency. Over the longer tem the market determines the true value of a
currency.
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SOLUTION 2
This question is drawn from information set out in sections 1 and 2 of the syllabus. Section (a) seeks an
awareness of the various elements that contribute to wage costs and the economic realities that determine the
negotiating limits to wage negotiations. Section (b) of the question focuses on factors influencing the firm’s cost
structure and the manner in which the competitive environment circumscribes the actions of a firm and influences
its profitability. Both sections (a) & (b) of the question have relevance to the current debate regarding wage costs
in the public sector. The knowledge being tested in the question has relevance to the management accounting
and strategic performance management courses.
(a) 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
marginal revenue productivity because this would imply a reduction in the profits of the firm from such
employment. Where marginal revenue productivity is difficult to calculate traditional relativities and differentials
may emerge.
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 available to them.
The actual level of wages 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.
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.
(b)
Thus comparisons between different forms of employment should be based on the net advantages associated
with each. As the 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.
If a monopolistic firm is enjoying an ‘economic rent’ in the form of supernormal profits then it is possible for the
workers to seek to capture some portion of that economic rent in the form of increases in wages.
Whether wages increases are the result of national wage negotiations or are due to local demands, a monopolist
is better positioned to recoup any cost increases through increasing selling prices.
To the extent that the market is devoid of competitive pressures a monopolistic firm is more durable and thus
workers in such an enterprise are likely to enjoy enhanced job security.
Thus it is better for an employee if they are employed in a firm that enjoys monopolistic powers compared to being
employed by a perfectly competitive firm but it should be noted the market power of the monopolistic firm depends
on the price (in)elasticity of demand for the output of the firm.
The situation may be captured by considering individuals employed in the public sector.
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SOLUTION 3
This question introduces a new aspect of the course which is set out in section 4 of the syllabus: section 5 of the
syllabus forms the basis for part (a) of the question. Risk-taking and the volatility of profitability and returns on
investments are very current topics as our economy seeks to encourage entrepreneurial flair. Section (b) of the
question is concerned with another aspect of the same mindset and focuses on the reality that in many sectors
of the economy ownership is divorced from day-to-day management. This form of business model has
implications for decision making within modern businesses and it is desirable that students be aware of the
courses of action arising therefrom. The information on which the question is based has relevance to strategic
corporate finance, managerial finance, strategic performance management, strategy leadership and knowledge
management.
(a)
The entrepreneur is the person (or persons) who bears the risks against which a business cannot insure. Some
examples of risks against which insurance policies are not available are:
•
The possibility that new products may not sell at the price and in the quantity required to generate an
adequate profit.
•
The risk that competitive strategies by competitors will render your business unprofitable.
•
The possibility that unforeseen developments may affect the profitability of the firm.
•
Industrial Disputes
•
The entry of new firms into the industry.
•
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 as a result receive a salary for their efforts
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.
(b) A Principal is a person who hires an agent to undertake work on their behalf. It is possible that the interests
of the principal and the agent may differ, since while owners seek to maximise their return from the enterprise,
managers may pursue an agenda that does not exactly reflect the same order of priorities. One of the first
problems that is manifest is in relation to the time period over which results should be assessed managers tend
to be judged (and incentive bonuses based) on performance during an annual or short term period and this may
not necessarily be consistent with the maximisation of returns in the longer term – there are many examples of
this in professional sport and in recent developments in high profile business enterprises.
Another problem arises in determining what precisely is an optimum attainable or maximising level in relation to
any specified objective. A consequent of this dilemma is the emergence of a form of satisficing behaviour whereby
managers seek to ensure that the returns to the owners are sufficient to leave them (the owners) satisfied with
the stewardship of the manager. Such satisficing behaviour may result in the setting of sub-optimal operational
targets against which the performance of the enterprise (and thus the manager) will be judged.
Also it is possible that mangers may pursue objectives other than profit maximisation. Managers may pursue
objectives such as the maximising the level of sales or the rate of growth of the enterprise even though it is
possible that the attainment of these objectives may not be consistent with profit maximisation. However, since
the achievement of objectives of this nature reflect well on the manager and are often the criteria, on which the
performance, salary and career prospects of managers are based, these targets may be prioritised by the
manager.
It is possible that managers may have a proclivity towards expense preference behaviour. The consumption of
perquisites, e.g. expensive cars, lavish entertainments expenses, may be important to a manager even though
they add little to the profitability of the enterprise or the benefits of owners/ shareholders.
In an effort to minimise Principal/Agent problems stock options and profit sharing schemes have been introduced
to align more closely the interest of owners and managers.
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SOLUTION 4
This question relates to sections 7 of the syllabus and illustrates the interrelationships between economic cycles
and national economic objectives. 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. Section (a) of the questions alerts the student to current business and
economic climate while section (b) of the question directs the students attention to the circumstances that
contributed to the present situation ---’those who do not understand history are doomed to repeat it’. In this way
the question seeks to contribute to the strategic performance management and the strategy, leadership and
knowledge management courses.
(a)
The national economic objectives are (i) Fiscal Rectitude, (ii) Full Employment, (iii) Economic Growth &
Development, (iv) Control Inflation, (v) Balance of Payments Equilibrium, (vi) Balanced Regional Development,
(vii) Optimum Distribution of National Income.
Below is set out the manner in which a period of recession is likely to impact on each of these objectives.
(i)
(ii)
(iii)
(iv)
(v)
(vi)
(b)
Fiscal Rectitude. The burden of the National Debt is expressed as the ratios of the National Debt to GDP.
If GDP is not increasing then unless government spending does not increase, the cost of servicing the
National Debt will increase. All current projections for the Irish economy predict an increase in the ratio of
National Debt to GDP. Any reduction in tax revenues and increases in demand for the various forms of
welfare payments would further increase the pressure for borrowing for current purposes.
Levels of employment will fall in response to the reduced demand for goods and services.
By definition no economic growth is being experienced.
A sustained period of little or no economic growth will mean that no inflationary pressures are being
experienced in the economy. If the downturn is severe then the general price level may actually fall.
The Balance of Payments would not be under any pressure. Low levels of demand in the domestic
economy would translate into low levels of demand for imported petroleum products and imported raw
materials. In addition a recession and the economic conditions that this engenders in the domestic
economy would probably improve the competitiveness of our exports; the actual outcome in terms of
relative competitiveness depends on what is happening in the domestic economies of our international
competitors.
A recession and its affect on the national finances means that there is unlikely to be any improvement in
the circumstances of the economically disadvantaged. If the recession is severe it may well be a case of
retaining existing benefits.
Periods when the finances of the state are in a healthy condition and in the terms of the question the state has
'money to spend' will tend to coincide with periods of high levels of aggregate demand in the economy as
exemplified by the Irish economy in recent years. Such periods tend also to coincide with periods of high levels
of employment and in such an economic environment the most likely problem on the national economic horizon
is inflation. So that, in these circumstances if state spending is increased the economy is being subjected to
additional undesirable inflationary pressure. It should also be noted that the state will derive less value in real
terms for any spending that it undertakes during periods of inflation; witness the reduction in the number of
kilometres of roads which the government got for its spending on the road infrastructure due to increases in the
level of inflation during the period of the national development plan. There are also implications for the private
sector which finds itself bidding against the state for economic resources in tight market conditions.
If the state pursues a policy of spending when they have the money, then obviously they will have to retrench
during period of economic downturn, since it is in such periods that the state finances will not be buoyant and
funds of the required magnitude will not be available without borrowing. The retrenchment which will be required
entails cutting back government expenditure in real terms when the economy is in a downturn thus aggravating
the downward spiral. In the circumstances being discussed there are likely to be closure of some firms with
consequent unemployment; if the state is cutting back its expenditure it may well be that there will be cutbacks
in the funds allocated to the state's job creation agencies such as Fás, Enterprise Ireland etc. at the very time
when the job creating activities of these agencies are most necessary. Also it is during economic downturns that
more people become eligible for various forms of welfare payment so that there will be increased demands on
the public purse arising from this development. In this scenario it will be difficult to avoid increased demand for
increased expenditure under the social welfare heading never mind attempting to implement actual reductions
Page 7
Economic behaviour of the nature envisaged in the question is cyclical in that it is positively correlated with the
economic cycle as a result of which it adds to inflationary pressures during periods of economic buoyancy and
aggravates economic downturns during deflationary periods. Thus it is the direct opposite to the policy when is
recommended for demand management. Demand management fiscal policy is meant to be counter cyclical in the
sense that budget surpluses are seen as the appropriate response during periods of economic buoyancy and in
this way inflationary pressures in the economy can be lessened. Conversely budgetary deficits may be tolerated
during recessions in order to provide an economic stimulus to the economy.
SOLUTION 5
The material for this topic is contained in sections 8 & 9 of the syllabus and is particularly relevant in the
circumstances currently pertaining in the Irish economy Exam questions based on new circumstances arising
from the globalisation of the macroeconomy help to develop students’ understanding of the changed and
changing business environment and the economic discipline, threats and opportunities that this implies. This area
of study 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.
(a)
(b)
Because banks operate on a fractional reserve system it is possible for them to loan out a multiple of the amount
of cash which is deposited with them. Thus the banking sector in the conduct of its day-to-day operations creates
purchasing power rather than merely transferring the value one person's savings into another person's spending.
The basis which renders it possible for the banks to create purchasing power is the fact that when a cash deposit
is made into a bank the person doing so normally does not seek the return of this lodgement entirely in a cash
form. The person will use cheques, direct debits, standing orders, credit cards and other forms of banking
instruments in order to pay for their purchases. Arising from this, banks have discovered that their customers will
require to access only (say) 10% of the amount of cash deposits and loans granted in the form of actual cash.
This 10% is known as the bank's liquidity ratio (or the bank's cash ratio). If the bank's liquidity ratio is 10% then
a cash lodgement of €100 would support liabilities (in the form of customers' loans) to a value of €1000. This
process gives rise to the concept of the money multiplier --- which is also referred to as the credit multiplier. The
formula for the money multiplier is 1 divided by the liquidity ratio. Thus if the required liquidity ratio is 10% the
money multiplier is 10 and if the required liquidity ratio was 20% the relevant multiplier is 5. On the basis of a
liquidity ratio of 10% if €1000 cash is lodged in a bank it is possible for the banks through giving loans to create
purchasing power to the value of €10,000. From this it can be seen that the amount of purchasing power which
it is possible for banks to create depends on the amount of cash lodged with the bank and the liquidity ratio which
the bank requires. While this ratio determines the amount of purchasing power which it is possible for the banking
sector to create the actual increase in purchasing power depends on the level of demand for such loans from
individuals (or firms) that the bank considers to be credit worthy.
Many borrowers from banks wish to extend the term of their loan over a relatively lengthy period whereas the
depositors generally wish to have access to their funds over a shorter period of time. Because banks are
continually accepting deposit the influx of fresh funds ensures that the required amount of money is available
depositors to access their funds as they wish. This maturity transformation enables short term deposits to be
converted into longer term loans.
Inter-bank borrowing is availed of to cover any short term mismatching of deposits and loans. The security for
such inter-bank borrowing is the asset holding (the secured loans) of the borrowing banks. In the current financial
climate there is a doubt over the real value of such securities and where such loans constitute a major share of
a bank’s portfolio there may even be doubts about the financial security of the bank itself. Because of doubts of
this nature and the corresponding uncertainty there is an increase in the risk attaching to loans secured by the
value of such securities with the result that banks are less willing to engage in inter-bank lending. The drying up
of this source of funds means that no only are banks unable to create loans at its previous rate in response to
inflows of new deposits but also the current economic volatility means that loans given out by individual banks to
depositors carry a higher degree of risk.
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