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Mechanics of economics

CIMA provides answers to its May 2000 (Stage 1) paper on economic environment

ANSWER all fourteen sub-questions in Section A (28 marks). Each of the sub-questions numbered from 1.1 to 1.14 inclusive, given below, has only one right answer.

1(1) In a market economy, the price system provides all of the following except which one?

a) Signals to consumers; b) incentives to producers; c) a means of allocating scarce resources; d) a store of value.

1(2) The main benefit of specialisation of labour to a company is that it: a) creates economies of scale; b) raises the productivity of labour; c) reduces the boredom involved in manual work; d) generates product differentiation.

1(3) When diminishing returns begin to operate, the total variable cost curve will start to: a) fall at an increasing rate; b) rise at a decreasing rate; c) fall at a decreasing rate; d) rise at an increasing rate.

1(4) Which one of the following is most likely to lead to an increase in labour productivity?

a) An increase in the rate of technical innovation; b) an increase in the quantity of labour employed; c) the purchase of cheaper raw materials; d) a fall in the stock of capital goods.

1(5) The price elasticity of supply means the: a) change in supply divided by price; b) responsiveness of the quantity supplied to a change in price; c) responsiveness of the quantity supplied to a change in demand; and d) time taken for supply to adjust to a change in price.

1(6) The term economic scarcity means that goods are: a) very few in number; b) not currently available; c) limited in supply; and d) sold above the market equilibrium price.

1(7) Which one of the following is not a feature of profit?

a) a reward for bearing risks; b) the price of capital; c) a return to entrepreneurs; d) an incentive to entrepreneurs.

1(8) The imposition of an indirect tax on a good would have most effect on price when the demand for the good: a) is price inelastic; b) is price elastic; c) has unitary price elasticity; and d) is income elastic.

1(9) Which of the following help to explain the survival of small firms?

i) The benefits of regional specialisation; ii) imperfect consumer knowledge; iii) diseconomies of scale; and iv) localised markets.

A) (i), (ii) and (ill) only; B) (i), (iii) and (iv) only; C) (ii), (iii) and (iv) only; and D) (i) and (iv) only.

1(10) The pursuit of profit will ensure that business organisations are efficient provided: a) they operate in competitive markets; b) they produce at the profit-maximising level of output; c) prices are set where demand and supply are equal; and d) exce ss profits are reinvested in the businesses.

1(11) All of the following are examples of anti-competitive behaviour by manufacturing companies except which one?

a) Price fixing agreements; b) minimum price contracts with retailers; c) exclusive contracts with retailers; and d) the heavy use of advertising.

1(12) The essential condition for an asset to act as money is that it is: a) legal tender; b) generally acceptable; c) backed by gold or foreign exchange; and d) a physical commodity.

1(13) Which of the following would normally result from an increase (appreciation) in a country's exchange rate?

i) A fall in the country's rate of inflation; ii) a rise in the volume of its exports; iii) an improvement in its terms of trade; and iv) a surplus on its current account.

a) (i), (ii) and (iii) only; b) (ii), (iii) and (iv) only; c) (i) and (iii) only; and d) (ii) and (iv) only.

1(14) If a country has a floating (flexible) exchange rate, which one of the following would lead to a fall (depreciation) in the rate of exchange for its currency?

a) A rise in capital inflows into the economy; b) an increase in the country's exports; c) an increase in the country's imports; and d) a fall in the country's rate of inflation.

Section B (24 marks): Answer one question only (either 2 or 3)

2) The following passage is based on newspaper articles and refers to the market for coffee:

Supermarkets recently ended 10 years of cheap coffee when some raised the price of their own brands of instant coffee by up to 12 per cent. Major producers of ground coffee said that their prices would also increase, but probably not for some weeks.

Reports of severe frost damage to Brazilian coffee plantations sent the open market price of coffee beans for September delivery up from $3,100 a tonne to $4,000 a tonne - the highest level since 1986. The price has risen five-fold since 1993. Even before the frost damage, the price had been rising because some coffee farmers, discouraged by the previous low price of coffee, had moved to other, more profitable crops. The depressed price of coffee before 1993 was partly due to the co llapse of the International Coffee Agreement. This Agreement, effectively a cartel, had kept prices artificially high. When the Agreement broke down, supplies flooded into the market and the price of coffee fell.

The current price increases will end a golden age of cheap coffee for consumers. From 1986 to 1993, the retail price had fallen by more than 15 per cent; given that these years were ones of rapid inflation, the real price of coffee fell even more steeply . This caused a boom in coffee drinking and the sales of coffee in the UK exceeded those of tea. Now it looks as if there may be a switch back to tea. This may be similar to the switch to tea which happened in the 1970s - the last time when coffee prices rose sharply. During that period, many coffee drinkers, especially young people, switched their consumption to tea.Requirements: Using both your knowledge of economic theory and information in the passage:

(a)(i) Identify and explain two reasons why the price of coffee has risen recently, using an appropriate diagram; (4 marks)

ii) explain the concept of price elasticity of demand and show how it is important in determining the size of the rise in coffee prices; (4 marks)

iii)explain the meaning of the statement ``the real price of coffee fell even more steeply''; (2 marks)

b) explain the concept of cross elasticity of demand and use it to Explain the relationship between the level of coffee prices and the demand for tea; (7 marks)

c) Explain what is meant by a cartel, using an appropriate diagram, and show how a cartel might artificially raise prices. (7 marks)

(Or)

Background and guidance

Section A (compulsory): Question 1's fourteen multiple-choice sub-questions are designed to test knowledge of basic concepts and theories relevant to an understanding of the economic environment. They range across all sections of the syllabus.

Section B (one from two data response questions): These questions are designed to test knowledge and understanding of economic principles by requiring candidates to use them in relation to some numerical or written data concerning the economic environmen t.

Question 2 requires candidates to use supply and demand analysis to explain price changes in a commodity market. Candidates are required to demonstrate knowledge of the basic model, and an ability to use this to explain real-world events. In particular , candidates will need to use elasticity concepts to explain the impact of supply and demand shifts.

Question 3 uses macroeconomic data for the UK economy to highlight the relationship between the level of economic activity and the state of the government budget. Candidates are required to demonstrate knowledge of the nature of the variables especially the PSBR. Further, candidates are required to use economic theory to explain the changes in the variables shown and to discuss the relationships between them.

Suggested answers

Section A: 1.1 - (d); 1.2 - (b); 1.3 - (d); 1.4 - (a); 1.5 - (b); 1.6 - (c); 1.7 - (b); 1.8 - (a); 1.9 - (c); 1.10 - (a); 1.11 - (d); 1.12 - (b); 1.13 - (c); and 1.14 - (c).

Section B: 2(a)(i) The price of coffee is determined by the interaction of the supply and demand for coffee within world coffee markets. The supply of coffee had fallen for two reasons. First, because there had been severe frost damage to Brazilian coffe e plantations. Second, the low prices paid for coffee before 1993 had discouraged farmers from growing coffee. Instead. they had moved to more profitable crops.

ii) Price elasticity of demand (PE of D) measures the responsiveness of demand to changes in price. It is most commonly measured as:

PE of D = (Percentage change in quantity demanded / percentage change in price) =m AQ/Q.100 / mAP/P.100

PE of D is negative for all normal demand curves as a rise in price leads to a fall in quantity demanded and vice versa. The P.E of D will determine the extent of the rise in coffee prices resulting from any given reduction in supply. If demand is elasti c, the percentage rise in price will be small relative to the fall in the quantity demanded. If demand is inelastic, the percentage rise in price will be proportionally greater than the drop in the quantity demanded.

iii) The real price of any commodity is the price after an allowance has been made for inflation. Hence, the real price is the nominal price adjusted for the rate of inflation. As the period 1986 to 1993 was a period of rapid inflation, the real price o f coffee would have fallen more steeply than the reported fall in the nominal price of 15 per cent.

2(b) Cross elasticity of demand (C.E of D) measures the responsiveness of the demand for one good to changes in price of another. It is most commonly measured as:

CE of D = (Percentage change in quantity demanded of good A / percentage change in price of good B)

Goods, which are considered substitutes, will have a positive CE of D, whereas goods which are complementary will have a negative CE of D. Coffee and tea can be considered substitutes for one another. As the price of coffee rises, consumers will switch t o drinking tea. The greater the degree of substitutability between the two, the higher will be the CE of D.

2(c): A cartel occurs when a group of companies in an industry agree to act jointly in a market rather than to compete. Cartel agreements may be open or secretive and invariably lead to an attempt to control the market in the producers' interests.

A cartel may attempt to control output by fixing production quotas for its members below those that would exist in a competitive market. Supply is perfectly inelastic at zero output. In a competitive market the supply curve would have been positive at S1 S1. The restricted output of the cartel causes price to be higher at P2 than the competitive market price of P1.

3(a)(i) The public sector borrowing requirement (PSBR) is the amount of funds which the government needs to borrow in any single year if government expenditure exceeds revenues from taxes and other sources. The sum of the accumulated PSBR over the years forms what is known as the national debt.

ii) The public sector debt repayment (PSDR) is the amount of funds available to the government to redeem part of the accumulated national debt. PSDR becomes possible when government revenues from all sources exceeds its expenditure in any single year.

b) When a government has a PSBR, it is effectively running a fiscal or budget deficit. It finances this deficit by borrowing money to cover the shortfall between its revenue and its expenditure. Borrowing can take the form of marketable or non-marketable debt. Marketable debt describes any debt which can be bought or sold in the financial markets, and in the UK includes Treasury Bills (short-term debt traded in the money market) and gilt-edged stocks (long-term debt traded on the stock exchange). The Ba nk of England sells these short-term and long-term government securities to the private sector (individuals and financial institutions), to overseas investors, to the commercial banks. Occasionally, when the issue of such securities is very large, some o f them may be bought by the Bank of England itself.

Alternatively, the government can issue funds by the sale of non-marketable debt and, in the UK, this will include items such as National Savings Certificates and premium bonds.

c)(i) Over the period 1987 to 1990, government finances were in surplus as reflected by the positive PSDR. The government was in a position to redeem part of the national debt. For the period 1991 to 1994, government finances were in deficit as reflecte d by the negative PSBR. As a consequence, over this latter period, the government was adding to the national debt.

ii) The state of government finances, in other words PSBR or PSDR, reflects the health of the economy. If the economy is growing, as indicated by growth in GDP, the government tax revenues will rise. Companies will be selling more products so that their profits will rise, as will their corporation tax liabilities. Individuals will be earning higher incomes so that their income-tax payments will rise. Similarly, with higher incomes, consumer expenditure will rise increasing receipts from VAT. The period 1987 to 1990 was one of positive GDP with economic growth especially high in the earlier part of the period.

Government expenditures during the period 1987 to 1990 would also have fallen. Unemployment fell consistently over this period and as a consequence the government would have had to pay less in unemployment and social security benefits. The combination of rising government revenue and failing expenditures would explain why government finances were in surplus over the period 1987 to 1990 enabling government to make a PSDR.

The period 1991 to 1994 saw a deterioration in government finances. Economic growth, as indicated by GDP, was lower and was actually negative in 1991 and 1992. As economic activity was lower, so too would be tax receipts. Unemployment, however, rose betw een 1991 and 1993 and remained over 9 per cent in 1994. As a consequence, government expenditure on unemployment benefit and other social security payments rose. The combination of failing government revenue and rising expenditures helped to put governme nt finances into deficit between 1991 to 1994 as evidenced by the high figures for PSBR.

(d)(i) There is an inverse relationship between the rate of growth of GDP and the level of unemployment. As GDP rises, unemployment begins to fall. The relationship is not always immediate with unemployment failing with a time lag of approximately one to two years after the rate of growth of GDP has risen. Similarly, when the rate of growth fails and eventually becomes negative for 1991 and 1992, unemployment begins to rise again with a time lag of one to two years.ii) The demand for labour is a derived demand. This means that labour is wanted for its contribution to output. A rise in the rate of growth of GDP indicates rising levels of aggregate monetary demand (AMD) and output in the economy. More labour is required by companies to meet the rising AM D and to expand output. As a consequence of this, unemployment will fall.

e) An automatic stabiliser in respect of fiscal policy occurs when the government sector of the economy acts independently of discretionary (deliberate) government economic policy to reduce fluctuations in the business or trade cycle. This happens throu gh the operation of the tax and benefits system. When the rate of growth of GDP was failing, as from 1987 to 1991, so too would be AMD. If left unchecked, GDP could continue to fall rapidly and the economy could be driven into recession.

However, failing taxes and rising unemployment benefit also accompany the fall in GDP. As a consequence, less spending power is taken away from people in taxes and additional income is given to them via unemployment benefits. PSBR rises as an automatic r esponse to the fall in economic activity rather than because of any deliberate change in government economic policy. AMD is, therefore, partially maintained and any drift towards recession reduced. Automatic stabilisers, therefore, even out fluctuations across the economic cycle keeping an economy from the extremes of deep recession and unchecked boom.

(Source: ``Question Papers and Suggested Answers'' of The Chartered Institute of Management Accountants (CIMA), London.)