ECONOMICS &

THE BUSINESS ENVIRONMENT

FORMATION 1 EXAMINATION - AUGUST 2006

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

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.

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 I EXAMINATION – AUGUST 2006

Time allowed: 3 hours, plus 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 are allocated 20 marks.

1. Write a note on four of the following:

(i) Perfect Competition.
(ii) The Law of Comparative Advantage (in international trade)
(iii) Law of Equi-marginal Returns
(in relation to utility maximising behaviour by a consumer)
(iv) Economies of Scale.
(v) Explain the functions of money.
[40 Marks]

2. (a) Cross Elasticity of Demand between good A and these other goods is as follows:
Between good A & good B (minus) - 1.2
Between good A & good C (plus) + 0.4
Between good A & good D (plus) + 1.5
Between good A & good E (minus) – 0.6

State, giving reasons,

(i) Which of these goods is/are a substitute for Good A? (4 marks)

(ii) Which of these goods is considered to be the best substitute for good A?
(4 marks)

(b) A consumer spends 80% of her income on Good X and the remainder on Good Y. (they are both
normal goods but they are not complementary goods). If the price of good X is reduced explain the
likely effect on this consumer's demand for each of the goods (i) if the consumer's money income
remains unchanged, (ii) if the consumer's money income is adjusted so that her real income remains
the same
(12 marks)

[Total: 20 Marks]

3. (a) Distinguish between Opportunity Costs & Money Costs and give one example where opportunity cost
would be zero (or less than money costs).
(6 marks)

(b) State, giving reasons, if you agree with the following statements:
(i) 'If a firm seeks to maximise its profits then it should always expand production if unit costs of
production are falling’
(7 marks)
(ii) ‘If wage costs are rising then unit costs of production must be rising’.
(7 marks)

[Total: 20 Marks]

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4. (a) In circumstance where the Marginal Propensity to save = 0.2; Marginal Propensity to Import = 0.2 and
Marginal Propensity to pay Tax = 0.1 calculate the net change in the Balance of Payments if our
exports increase by €10milliion.
(6 marks)

(b) Why is the value of our imports likely to increase if there is an increase in the value of our exports?
(9 marks)

(c) What do you understand by ‘a deficit on our Balance of Payments’?

(5 marks)

[Total: 20 Marks]

5. (a) What action(s) could the European Central Bank (ECB) take if wished to increase the foreign
exchange value of the Euro? Explain how such action(s) would have the desired effect.
(10 marks)

(b) Trace the likely impact of such action(s) on the Irish economy. (10 marks)

[Total: 20 Marks]

END OF PAPER

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 SUGGESTED SOLUTIONS

ECONOMICS &
THE BUSINESS ENVIRONMENT
FORMATION I EXAMINATION – AUGUST 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 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 other subjects. 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) Perfect Competition is a form of market structure which is characterised by the following conditions:

• Each firm is selling a homogeneous product i.e. there is no distinguishable difference between the
products on offer by different firms.

• There are many competitive sellers in the market none of whom produces a quantity sufficiently large
to influence, by their own actions, the price at which the good is sold i.e. firms are price takers.

• There are a large number of buyers so that no individual buyer has a sufficient market share to enable
them to influence by their own actions the market price of the goods.

• There is no collusion between buyers of the goods or sellers of the goods.

• There is freedom of entry into, or exit from, the industry.

• Firms are profit maximisers.

• Everyone involved in the market has perfect knowledge as to all facts which influence their decision
making.

As a consequence of these conditions the market price is a given to firms i.e. they are price takers. A firm
can sell any quantity it wishes at the ruling market price so that the profitability of the firm is determined by
its costs and a profit maximising firm at long run equilibrium will be producing a level of output at which its
unit costs are at a minimum --- profit maximisation equates to the minimisation of unit costs. Because of
freedom of entry only Normal Profit will be earned in the long run.

(ii) The Law of Comparative Advantage which is known also as the Law of Comparative Cost states that a
country should concentrate on the production of those goods in which it has the greater comparative
advantage i.e. in the production of which it is relatively more efficient. Thus even though country A may be
able to produce each of two goods using less resources than country B requires in order to produce them
then it is still advantageous to country A to concentrate on the production of the good at which they are
relatively more efficient. Based on this notion countries often import goods which they are capable of
producing in their own domestic economy. The concept is analogous to the division of labour at the micro
level where factors of production concentrate on those tasks at which they are relatively more efficient and
purchase their other requirements. The law concentrates on the gains which are possible from trade when
countries concentrate in this manner however the terms of trade or the rate at which the goods are
exchanged determine whether or not trade is beneficial to both parties.

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(iii) The Law of Equi-marginal Returns states that a consumer will enjoy maximum satisfaction when the ratio of
marginal utility to price is the same for all of the different types of goods which she buys i.e.

MU1 MU2
= ETC
P1 P2

This law may also be expressed in terms of a consumer adjusting her purchasing pattern so that she gets
the maximum return for the last pound spent on each of the goods chosen. For example if there are two
items which can be purchased for 50c, say an apple from which the consumer gets 17 units of satisfaction
and a bar of chocolate from which the consumer gets 12 units, the consumer will purchase the apple
because she gets more satisfaction from it and they both cost the same price. Suppose the price of the
apple increased to €1 while the price of the chocolate remains at 50c then the consumer would buy the bar
of chocolate rather than the apple not because her preference has changed but simply because she gets
more utility from 2 bars of chocolate than she does from an apple which costs her the same as the two bars
of chocolate. The foregoing example refers to a change in purchasing behaviour in response to a change in
the relative prices of the goods, in a similar fashion the consumer would change her purchasing behaviour
in response to a change in her taste i.e. the amount of utility she derives from the goods. By concentrating
on the ratio between marginal utility and price, i.e. the marginal utility per 50c spent, and adjusting her
purchasing pattern accordingly, the consumer gets maximum satisfaction. When the ratio of marginal utility
to price is the same for all of the different types of good which she purchases, there is no way that the
consumer can change her purchasing behaviour and increase her total utility. When such a circumstance
pertains the consumer is said to be at equilibrium.

(iv) Economies of Scale is the term applied to reduction in unit costs of production that occur as the scale of
operations of the firm increases. They are often analysed in terms of internal economies of scale and
external economies of scale. Internal economies of scale are economies or benefits which accrue to an
individual firm as its scale of operation increases: as the benefits accrue to that firm alone they are referred
to as internal economies of scale. Economies of this nature are usually classified as technical, marketing
and financial economies of scale. The more extensive use of specialised machinery; a greater degree of
specialisation by workers and economies of construction are examples of technical economies of scale. Bulk
buying and economies in distribution are examples of marketing economies while financial economies of
scale arise from such firms having access to more extensive sources of funds together with the improved
negotiating strength which larger firms enjoy in raising loans or seeking financial accommodation. External
economies of scale are so called because the source of these benefits is external to any individual firm; they
are benefits which accrue from the growth of an industry and thus they may be availed of by all firms in the
industry. The growth of sub-supply industries or the benefits of industry clustering would be examples of
external economies of scale.

(v) The roles which money plays in an economy are:

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

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SOLUTION 2.
This question is drawn from section 1 of the syllabus and examines the relationship between the interactions of
variables which form the elements of demand. It has links with management & strategy.

(a) Cross elasticity of demand measures the sensitivity of change in demand for a particular good when the
price of some other good changes. The formula for the calculation of cross elasticity of demand is the
relative change in demand for good A divided by the relative change in the price of good B. If the calculation
results in a positive answer then the change in demand and the change in price are positively correlated i.e.
the direction of change in price of good B results in a movement in the same direction for good A. This would
indicate that an increase in the price of good B resulted in an increase in demand for good A: this means
that the goods stand in a substitute or competitive relationship to each other. The opposite to the foregoing
applies in relation to complementary goods which would have negative cross elasticity of demand indicating
that if the price of one of the goods is increased than the demand for the other good would fall. If the answer
is zero then the goods are independent of each other.

The larger the figure, in absolute terms, which results from the application of the formula then the closer the
relationship between the goods thus +1.5 indicates a closer substitute good than does +0.4; applying similar
reasoning minus 1.2 is a closer complementary relationship than is minus 0.6.

Applying the above:

(i) Goods C & D are substitutes for good A
Goods B & E are complements of good A
(ii) Good D is the closest substitute for good A.

(b) If the price of good X is reduced then this has two effects on the consumer there is an increase in the real
income of the consumer as the price of one of the goods is reduced (the income effect) and in addition there
is a change in the relative prices of the goods that she is buying (which gives rise to a substitution effect).
i.e. the good which has become relatively cheaper will be substituted for the other good which has now
become relatively dearer.

(i) For normal goods a person buys more of the good as their real income increases so that if the
person’s money income remains unchanged then the person will buy more of good X because the
person is now better-off i.e. their real income is increased. Also there is an additional reason to buy
good X because good is now better value because it is relatively cheaper. As the person’s real income
has increased there are also in a position to buy more of good Y. Thus in this case the consumer will
buy more of each of the goods.

(ii) In this case the person’s money income has been reduced so that the consumer’s real income doesn’t
change. Arising from this the consumer will buy more of good X because it is better value (the
substitution effect). However as there is no real income effect less of good Y will be purchased.

Page 5
SOLUTION 3.

This question is drawn mainly from section 2 of the syllabus. It has links with the syllabus for strategic
management accounting and the syllabus for management & strategy.

(a) Money cost is the nominal cost or the actual amount of money paid for an item. Opportunity cost is the cost
of an item in terms of the opportunities which must be foregone when one item or course of action is chosen
rather than another. Though in some cases there may be no difference between money cost and
opportunity cost, the latter concept is the more comprehensive and is more suitable for decision making.
For example if an employee who is paid a weekly fixed sum as a salary is given an additional task to do, if
the employee performs this task without cutting back on any of the other tasks which he/she is required to
carry out, then the opportunity cost to the employer in respect of wages for this job is zero. Similarly it will
be noticed that sunk cost is not a current opportunity cost.

(b) (i) The first condition for profit maximising behaviour is that the firm will be at equilibrium at the level of
output at which marginal cost is equal to marginal revenue. It is this relationship between the costs of
undertaking an action and the revenue (or benefit) accruing from the action that is the basis for
decision making in determining profit maximising behaviour. In the perfectly completive form of
market structure the firm can sell any quantity it wishes at a constant price. In such circumstances
profit maximising behaviour dictates that since profits are maximised when costs are minimised a firm
in such should expand output when unit costs of production are falling. In the forms of market
structure where it is necessary for a firm to lower its price in order to sell an increased output, firms in
such markets who are seeking to maximise profits must consider not only cost considerations as they
expand output but also the impact on their revenue, i.e. their marginal revenue, as they seek to sell
increased levels of output. Even if unit costs would be lower at increased levels of output, it may be
that marginal revenue as the firm seeks to sell the increased output is less than the marginal cost of
producing the extra output. In such a case a profit maximising firm should not expand production even
if unit costs of production are falling.

(ii) One must distinguish between wage costs, i) wages ii) costs per unit produced and iii) unit costs of
production. Wage costs are just one element, though a significant element, in unit costs of production.
Though wage costs are rising it is possible that productivity is increasing at a faster rate in which case
unit labour costs would be falling. Alternatively wage costs might be rising but other costs associated
with production might be falling and the net affect could be a reduction in unit costs of production. It
is also possible that fixed costs are being spread over a greater volume of output so that unit fixed
costs are falling at a greater rate than wages are rising. The advantages of specialisation and the
various sources of economies of scale are other possible reasons why wage costs may rise without
causing an increase in unit costs of production.

Page 6
SOLUTION 4.

This question which is drawn from section 6 of the syllabus has links with the syllabi of management & strategy

1 1
and financial management.

(a) The multiplier is equal to mps + mpm + mpt , in this instance this is equal to 0.2 + 0.2 + 0.1 which is
equal to 2.. thus if there is an increase in injections into the economy through an increase of €10 million in
exports then the increase in aggregate demand will be equal to €10 million X 2 which is equal to €20 million.
Since the marginal propensity to import is 0.2 then from this increase of €20 million in aggregate demand
imports will increase be €20 million X 0.2 which is equal to €4 million. With an increase of €20 million in
the level of exports and a consequent increase of €4 million in the level of imports the net effect will be an
improvement of €16 million in our Balance of Payments.

(b) The value of our imports is likely to increase if there is an increase in the value of our exports because an
increase in the level of exports constitutes an injection into the circular flow of income. This injection will, in
turn, be subject to the multiplier which will magnify the increase in the level of income enjoyed in the
economy. This increased purchasing power in the economy will impact on the level of imports in the
following manner.
(i) Firms that are producing the extra goods that are being exported will have to import some of their raw
materials and they will have increased demand for energy requirements which are of an imported
nature.
(i) The increased purchasing power in the economy will cause an increase in the purchase of foreign
goods and service to an extent that depends on our marginal propensity to import.
(ii) Some of the increase in purchasing power will be spent on domestically produced goods. To the
extent that such good use imported raw materials there will a further rise in our level of imports.

(c) International trade inevitably gives rise in indebtedness between people in different countries. The record of
economic transaction with the rest of the world is conventionally known as the Balance of Payments this
might be more accurately entitled the Balance of International Payments. Since the Balance of Payments is
a financial statement if a country’s financial affairs arising from international transactions it is a nook-keeping
exercise and consequently it must balance in the double-entry book-keeping sense that total credits must
equal total debits. When reference is made to deficits or surpluses in the balance of Payments it is usually
a reference to a deficit or surplus on the current account section of the Balance of Payments. Such
imbalances of the current account section of the Balance of Payments occur when there is an imbalance
between the value of exports and the value of imports. A deficit being the term to indicate the value of
imports being greater and a surplus when the opposite applies. Because some inflows of capital may occur
to order to finance a goods being imported a more insightful analysis of the Balance of Payments may be
conducted through examining changes in the level of our external reserves. In this case there is said to be
a deficit on the Balance of Payments when the combined effect of current and capital transactions causes
a fall in the level of our external reserves.

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 value of a currency on foreign exchange markets depends on the supply of, and demand for, the
currency. Thus on the trading side a reduction in the supply of the currency through some form of taxation
regulation of imports would achieve an increase in the value of the currency as would an increase in the
demand for the currency through an improvement in the international competitiveness of our exports.
However, not only is the possibility of such initiatives on imports constrained by international trade
agreements but the ECB’s area of control is in the financial or monetary nature so that these trading matters
are outside its direct area of control.

The manner in which the ECB could increase the value of the euro would be (i) through using some of its
holdings of external reserves to buy its own currency; such an action would simultaneously increase the
supply of foreign currencies on the market and reduce the supply of the domestic currency However, the
ECB’s holdings of foreign reserves is not infinite so that actions of this nature could only be of short-term
or ‘smoothing’ nature. (ii) Another action available to the ECB would be to increase interest rates. This
action would encourage a movement of funds into the Euro and this increase in demand would support the
currency and increase its value on foreign exchange markets.

(b) An increase in the level of interest rates would impart a deflationary impulse to the Irish economy. The
business sector would be inclined to reassess the risk return on their investment plans which are now more
costly as a consequence of the increase in financing costs. Some of their proposed expansionary plans may
be postponed as they may not be viable at the higher rates of interest. Not only will higher rates of interest
increase the cost structure of firms and impact on their international competitiveness but to the extent that
the increase in interest rates reduces the real income of their customers it will depress demand for their
output and further impact on estimates of the viability of proposed investment and expansion plans.

There would be a reduction in the demand for consumption goods bought on credit since the total cost of
purchasing such goods would increase l in line with the increase in credit charges. The construction industry
in particular could face a significant reduction in demand due to an increase in the cost of mortgages. The
demand for motor cars and consumer durables, which are normally financed by some form of credit
purchase, would experience a similar depression in demand. There would also be a spill-over effect into
demand in general as the general public suffers a reduction in real income arising from the upward drift in
the cost of mortgages and their other existing forms of credit commitments.

The government finances will also be affected as at lower levels of Economic activity the operation of
automatic fiscal stabilisers would reduce their taxation receipts and increases their welfare payments. Also
in a higher interest rate environment the financing of the national debt will become more onerous.

The net effect of the higher interest rates on the Balance of Payments depends on the one hand to the effect
of increased costs on the price competitiveness of our exports against non-euro zone competitors and on
the other hand to the extent that demand for our exports to other euro zone countries is affected as the
increase in interest rates bites into their real income.

The level of discretionary savings would increase as their attractiveness increases with the higher return on
such savings.

Page 8
 ECONOMICS &THE BUSINESS ENVIRONMENT.
MARKING SCHEME--- AUGUST 2006.

Q1. 10 marks for each of 4 satisfactory answers. 40 marks.

Q.2. (a) (i) 2 substitutes named @ 2 marks each 4 marks.

(ii) Correct choice of closest substitute. 4 marks.

(b) (i) Effect with unchanged money income. 6 marks

(ii) Effect with adjustment of money income. 6 marks

Q.3 (a) Distinction between the two terms 3 marks

One correct example. 3 marks
(b) (i) Understanding of profit maximising condition 7 marks
(ii) Distinction between wage costs & unit costs 7 marks

Q.4. (a) Correct calculation 6 marks

(b) 3 reasons @ 3 marks each 9 marks
(c) Understanding of deficit. 5 marks

Q.5. (a) 2 possible actions @ 3 marks each 6 marks

Transmission mechanism of actions 4 marks
(b) 5 effects @ 2 marks each 10 marks

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