Legal Concepts of Marketing

Graduate/Postgraduate

Diploma in Marketing

Foundation Level

Recommended Study Text

Eco

no

mic

& L

ega

l C

on

cep

ts f

or

Ma

rket

ing

Nishan C. Perera MBA(Sri.J), Chartered Marketer(UK),

Certified Professional Marketer(Asia Pacific)

Mallik De Silva ACA,ACMA,LTCL

Upekha Gunatilake Attorney at Law, LLB (Col)

M & N Solutions (Private) Limited

2nd

Edition, December 2005 ISBN 955-1244-02-8

© Copy Rights Reserved. No part of this text should be reproduced without prior written permission of M&N Solutions

(Private) Limited.

iii

Module One

Micro Economics

Chapter 01 – Fundamental Concepts of Economics 03

Chapter 02 – Price Theory 13

Chapter 03 – Theory of Elasticity 37

Chapter 04 – Cost, Revenue and Profit Maximisation Rules 59

Chapter 05 – Market Structures 75

Chapter 06 – Utility Theory and Household Equilibrium 87

Module Two

Macro Economics

Chapter 07 – Inflation 101

Chapter 08 – International Trade 115

Chapter 09 – National Income Accounting 131

Chapter 10 – Consumption, Savings & Investment/National Income Equilibrium 143

Chapter 11 – Fiscal Policy and Monetary Policy 157

Module Three

Legal Aspects

Chapter 12 – Introduction to the Law of Contract 173

Chapter 13 – Sale of Goods 211

Chapter 14 – Law Related to Consumer Protection 225

Chapter 15 – Law Related to Intellectual Property 233

Chapter 16 – Introduction to Other Legal Aspects Relevant to Marketing 247

CONTENTS

v

Module One

Micro Economics

Chapter 01 – Fundamental Concepts of Economics

1. Understanding Micro and Macro Economics 03

2. What is Economics? A Few Definitions 03

3. Fundamental Concepts of Economics 04

4. Production Possibility Curve (PPC) 07

5. Factors of Production 09

Chapter 02 – Price Theory

1. Introduction to Price Theory 13

2. Theory of Demand 13

3. Theory of Supply 22

4. Establishment of Market Price 28

5. Price Controls 31

6. Importance of the Price Theory for Marketing Decision Making 34

Chapter 03 – Theory of Elasticity

1. Understanding Elasticity 37

2. Elasticity of Demand 38

3. Elasticity of Supply 46

4. Elasticity and Taxation 49

5. Elasticity and Marketing Decision Making 52

Chapter 04 – Cost, Revenue and Profit Maximisation Rules

1. Costs of Firms 59

2. Revenue of Firms 66

3. Profit Maximizing 69

DETAILED CONTENTS

vi

Chapter 05 – Market Structures

1. Market Structure Classification 75

2. Perfectly Competitive Market Structure 76

3. Monopoly Market Structure 78

4. Monopolistic Competitive Market Structure. 81

5. Oligopoly Market Structure 82

6. Marketing Implications of Market Structures 85

Chapter 06 – Utility Theory and Household Equilibrium

1. Understanding Utility 87

2. Concepts of Utility 87

3. Household Preferences 89

4. Household Budget Line 92

5. Household Equilibrium 94

6. Household Equilibrium and Marketing Decision Making 96

Module Two

Macro Economics

Chapter 07 – Inflation

1. Understanding Inflation 101

2. Causes of Inflation 104

3. Effects of Inflation 107

4. Inflation and Marketing Decision Making 112

DETAILED CONTENTS

vii

Chapter 08 – International Trade

1. Introduction to International Trade 115

2. The Concept of Absolute Advantage 115

3. The Concept of Comparative Advantage 116

4. International Trade and Protectionism 117

5. Balance of Payments 118

6. Devaluation 121

7. Exchange Rates 126

Chapter 09 – National Income Accounting

1. Understanding National Income 131

2. The Circular Flow of Income 131

3. Calculating National Income 132

4. The Circular Flow and Economic Sectors 137

5. Per Capita Income 140

Chapter 10 - Consumption, Savings and Investment

National Income Equilibrium

1. Consumption 143

2. Savings 145

3. Relationship between Consumption and Savings. 146

4. Investment 147

5. The Concept of the Multiplier 149

6. The Concept of the Accelerator 150

7. Equilibrium National Income 151

8. The Concept of Full Employment 155

Chapter 11 – Fiscal Policy and Monetary Policy

1. Fiscal Policy 157

2. Monetary Policy 163

DETAILED CONTENTS

viii

Module Three

Legal Concepts

Chapter 12 – Introduction to the Law of Contract

1. Definition 173

2. Formation 174

3. Invalidation 190

4. Discharge 201

5. Remedies 206

Chapter 13 – Sale of Goods

1. Understanding the elements, Formalities of Sale of Goods 211

2. The Terms of Contract of Sale of Goods 213

3. The General Rule on Transfer of Title 217

4. Duties of the Seller 219

5. Duties of the Buyer 219

Chapter 14 – Law Related to Consumer Protection

1. Introduction 225

2. Regulations on Internal Trade 225

3. Establishment of a Consumer Affairs Authority 230

Chapter 15 – Law Related to Intellectual Property

1. Introduction 233

2. Patent Rights 233

3. Marks and Trade Names 238

4. Copy Rights 242

Chapter 16 – Introduction to Other Legal Aspects Relevant to Marketing

1. Law of Agency 247

2. Introduction to Company Law 253

3. Industrial Dispute 258

DETAILED CONTENTS



Foundation Level

Economic & Legal Concepts

for Marketing


M

icro

Eco

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Module One


Chapter 01

Fundamental Concepts of Economics

1. Understanding Micro and Macro Economics.

Oxford dictionary defines the words micro and macro in the following manner. Micro –

“Very small” and Macro – “Large scale”. So with this perspective let us try to understand

what micro and macroeconomics is all about.

Microeconomics is the study of individual economic units or particular parts of the economy.

This part of economics will give the learner specific insight into individual components of

economics. For example micro economic components would be the concept of scarcity,

demand of a firm, supply of a firm, cost of production, utility theory and market structures.

The study of this will help the marketer to understand specifics of consumer behavior.

Macroeconomics is the study of global or collective decisions by individuals, households or

producers and trying to understand the total impact of those individual concepts. It looks at

the national and international economic systems.

Microeconomics takes a closer look at the economy by trying to study the behavior of

individuals or groups of individuals while macroeconomics examines the aggregate behavior

of the whole economy from a broader perspective considering its overall performance and

how various sectors of the economy relate to each other.

2. What is Economics ? A Few Definitions

The following are some well noted definitions of economics

Economics is the science which studies human behavior as a relationship between

ends and scarce means which have alternative users.(Lionel Robbins – 1932)

An economic system is a set of institutional arrangements whose function is to

employ most efficient scarce resource to meet the ends of society (United Nations

dictionary of social science.)

Economics are concerned with the ways in which people apply their knowledge, skills

and efforts to the gifts of nature in order to satisfy their material wants. Economics

limits itself to the study of the material aspects of life (Stanlake, 1956)

This chapter will cover

1. Understanding Micro and Macro Economics

2. What is Economics? A few Definitions

3. Fundamental Concepts of Economics

4. Production Possibility Curve (PPC)

5. Factors of Production


In simple terms, human beings needs and wants are unlimited. The resources available to

satisfy those needs and wants are limited. Also these resources have alternative uses. The

following definition could be derived from analyzing the above definitions.

Economics is a science which tries to study the use of limited resources which has alternative uses in satisfying the unlimited wants and needs of humans in society.

My Working Definition

3. Fundamental Concepts of Economics

Illustration 01 – Scarcity, Choice and Opportunity Cost

3.1 Scarcity

Human wants are unlimited. However the resources that are available to satisfy these

unlimited needs are limited. This would lead us to understand that there is an imbalance.

Scarcity is the imbalance between our desires (needs/wants) and the means (resources)

of satisfying those desires. Scarcity is the fundamental base of economics.

Human Needs Resources

Unlimited Limited

Scarcity

3.2 Choice

When there is scarcity, the repercussion is choice. That is to choose which need to be

satisfied with the limited resources that are available. Choice is selecting the optimum

return-giving alternative out of the prevailing alternative uses of a resource.

For example you have Rs.100 with you. Lets assume that you desire to buy a slab of

chocolate, which is Rs.95, and a tub of ice crèam, which is Rs90. If you desire to buy

both, you will require Rs185. But you have only Rs100. There is a scarcity. Therefore

Scarcity

Choice

Opportunity cost


you decide to buy an ice cream tub as you feel that it will give you the highest

satisfaction. Here you have made a choice in selecting the tub of ice cream.

Decision makers in an economy and their rationality

• Consumers – try to maximize utility ( satisfaction) with minimum expenses

• Producers/investors – try to maximize profits/return with the minimum cost

• Government – try to maximize public welfare with the minimum cost

3.3 Opportunity Cost

Opportunity cost arises as a consequence of having to make choices. It is defined as “the cost

of the next best alternative sacrificed in selecting the best alternative” Let us try to

understand this through an example.

Let us say that you have Rs 100,000 with you. The following options are available to you.

• Invest in a business and get a 20% return per annum. ( ignore the risk element)

• Invest in a fixed deposit and get a 12% return per annum.

• To invest in company shares and get a return of 8% dividend

• Give it to one of your relatives and receive it after one year without any interest

Which choice would you make?

As a rational investor you would select the highest return with the minimum cost. So your

best alternative (or choice) would be to invest in a business and get a 20% return.

What would be the next best alternative? Investing in a fixed deposit and get a 12% return per

annum.

So the cost of investing in the best alternative (i.e. investing in the business and getting a 20%

return) is the lost opportunity to invest in a fixed deposit and get a 12% return.

So we say the opportunity cost of investing in the business is the cost of loosing a 12% return

by investing in a fixed deposit.

a) Importance of Opportunity Cost Concept

The concept of opportunity cost is very important in decision making, as always when you

make a choice you need to look at the cost of the next best alternative. This would guide one

in selecting the best choices in making decisions.

• Consumer and opportunity cost – When a customer makes a choice he would try to

maximize his utility (satisfaction) and will try to minimize his opportunity cost.


• Producer and opportunity cost – When a producer users a scarce resource, he will try

to maximize profits by minimizing opportunity cost.

• Government and opportunity cost. – The government will try to allocate limited

resources by trying to optimize public welfare thus will try to minimize the

opportunity cost of incurring them.

b) Economic Profit vs. Accounting Profit (Opportunity Cost Concept in Application)

In economics, in calculating profits, the opportunity cost is taken into consideration as a cost.

In accounting terms, opportunity cost is not taken as a cost in calculating profit. Lets look at

an example.

Lets assume that you decided to leave your present job (which gives you an annual income

of Rs 500,000) and decided to start a business. The opportunity cost of starting your business

is the loss of Rs 500, 000 as salary income.Let us say from the first year of operations you

earned Rs 2,000,000 revenue and incurred a cost of Rs 1,200,000. Lets calculated the

accounting profit and economic profit.

Description Economic profit Accounting Profit

Revenues 2,000,000 2,000,000

Cost (1,200,000) (1,200,000)

Opportunity cost (500,000) -

Profit 300,000 800,000

So in calculating profits in economics, the opportunity cost is considered as a cost in judging

the effectiveness of the decision taken.

c) Practical uses of the Concept of Opportunity Cost

• Collecting capital for organizations

• Developing and launching new products

• Branding decisions

• Selecting distribution channels.

• Doing market research

• Choosing promotional tools and media

‡ Activity

Discuss how the opportunity cost concept could be applied to the above marketing

situations. A point to note would be that opportunity cost will have to be analyzed from the

next best alternative in selecting the stated alternative as above.

What are the other marketing situations where opportunity cost concept could be related.


4. Production Possibility Curve (PPC)

This is a curve, which denotes the maximum production capacity of an economy with the

utilization of all the resources using the best possible technological conditions and the

maximum efficiency of production. It shows how to allocate resources between two products

when trying to produce them.

Assumptions in drawing the PPC

• Only two products are being produced in the economy

• All the resources are being used for production

• The best possible technological conditions are used for production

• The maximum efficiency of production is used.

Illustration 02 – Production Possibility Curve

Consumer

Goods (Y)

Capital goods ( X)

The capacity of the economy

A - 1000 units of consumer goods or

B – 100 units of capital goods or

C – 600 units of consumer goods and 60 units of capital goods.

4.1 Concepts highlighted by the PPC

a) Opportunity Cost

PPC shows maximum production capacity in an economy. So in order to increase/decrease

the production of items, it could only be achieved at the expense of the other. Let us try to

understand the concept of opportunity cost through the PPC.

If the economy produces only consumer goods (1000 units) using all the technology and

resources then it will have to sacrifice manufacturing 100 units of capital goods. Therefore

the opportunity costs of producing all consumer goods are 100 units of capital goods.

Similarly the opportunity cost of manufacturing all capital goods would be 1000 units of

consumer goods. If the economy decides to manufacture 600 units of consumer goods then it

could manufacture 60 units of capital goods.

1000

100

600

60

A

B

C


The opportunity cost of manufacturing 600 units of consumer goods are 40 units of capital

goods.(100 units of capital as the total capacity – present quantity of 60 units = 40 units lost).

PPC helps to understand the opportunity cost of allocating resources

b) Scarcity and Inefficiency in the Economy.

If you look at point D of the diagram below, it means 800 units of consumer goods with 100

units of capital goods. However as per the existing resources, point D cannot be achieved due

to the scarcity of resources. PPC will highlight the concept of scarcity.

Illustration 03 – PPC Curve with Scarcity and Inefficiency in the Economy

Consumer

Goods (Y)

Capital goods ( X)

Point E of the diagram shows inefficiency in the economy. The combination what it achieves

is 500 consumer goods and 60 capital goods. However with the existing resources it has the

potential of reaching up to 80 units of capital units. Here the PPC shows an inefficient point.

c) Economic Growth or Recession

Illustration 04 – PPC Curve with Economic Growth and Recession

Consumer

Goods (Y)

Capital goods ( X)

1000

100

800

60

A

B

C D

E 500

a

a

b

b

c

80

c


The movement of curve “aa” to “bb” (upward movement) indicates either an increase in the

resource levels of the economy or an improvement in the technology of the economy or an

increase in the efficiency levels of an economy. This indicates that now the economy can

manufacture a higher combination of goods than before. This is a sign of economic growth.

Similarly curve “cc” which is a downward movement indicates that the economy has reduced

its capability of its production capacity indicating an economic recession.

The PPC curve is essentially a graph which helps us to understand the scarcity of resources

and the opportunity cost concept in allocating resources among alternative uses.

5. Factors of Production

Factors of production are the resources that contribute to the process of production. There are

four factors of production that needs our attention

a) Land – refers to all the natural resources. Factor payment is RENT.

Features

• The quality of the land varies

• The supply of the land cannot be increased

• The effectiveness of land could be developed by technological advancements

b) Labour - This refers to the mental labour and physical labour of humans. Factor payment

is WAGES

Features

• Can get organized and demand what they require

• A live factor of production

• Effectiveness of labour depends on training

• Can increase its productivity by motivating/training

• If not used at any moment the labour energy is wasted

c) Capital - This refers to the monitory assets or the physical assets that are used for

production. Factor payment is INTEREST

Features

• Depreciate during its effective lifetime

• Used to produce goods

• Is an income generator

d) Entrepreneurship - This refers to the managing and the risk-taking stance of the owner.

Factor payment is PROFITS.

Features

• Collects other factors of production

• Use them in an effective combination

• Takes a risk


† Key Concepts

Basic Economic Problems

Resources are limited and have alternate users. But the needs are unlimited. So in trying to

allocate scarce resources to unlimited wants a choice has to be made. When choosing, any

economy will have to face 3 problems.

1) What to produce ?

2) How to produce ?

3) For whom to produce ?

1) What to Produce ?

An economy must decide what products it should produce. Either to produce capital goods,

consumer goods or a mix of them. After deciding what to produce you have to decide in

what quantity you have to produce. To find an answer one can use the production

possibility curve.

Capital goods Mix Consumer goods

2) How to Produce ?

There are basically two broad techniques of production. Labour intensive (using more labour

than capital) and capital intensive (using more capital than labour). Labour and capital are

alternative resources. Answering this question is having to decide which production

technique an economy would use.

In selecting the option, the levels of resource levels an economy holds will have to be looked

at. If the supply of labour were higher than the demand for it then the wage levels of the

country would be lower. Therefore it would be cheaper for a country to use labour intensive

methods of production. In countries where technology is advance, using capital-intensive

methods of production would be cheaper.

3) For whom to Produce ?

The decision here is to which party of the economy would one produce goods. One could

consider the income distribution and decide whether to produce to the “haves” or the “have-

nots” or irrespective of the income group to produce it for the whole economy.


† Key Concepts

Different type of Goods in Economics

1) Free goods – Goods which are given by nature – e.g. sunlight, river water, air

2) Economic goods – These are man made goods using scarce resources. E.g. – houses,

bottled water, artificial oxygen, machinery

Features of economic goods

• Limited in supply when compared to the unlimited demand

• There is a ownership

• They are transacted in the market

• There is an opportunity cost of producing them

• Uses of economic resources for production.

Features of free goods

• Unlimited in supply

• There is no ownership

• They are not transacted in the market

• No opportunity cost in producing

• Given by nature

Scarcity is the concept, which decides whether it is a free good or an economic good. When

a free good becomes scarce it becomes an economic good or if you add value to a free good

it becomes an economic good.

Types of economic goods

Capital goods – goods that are used to reproduce other goods. Helps businesses to

generate income over its lifetime. Manufactured by humans using various technology.

Depreciates over a period of time.

Consumer goods – goods that are used for final consumption. Those could be further

divided as durable and non-durables.

♪ My Short Notes


♪ My Short Notes


Chapter 02

Price Theory

1. Introduction to Price Theory

A useful and an important concept for marketing. Basic elements of the price theory will lay

out the rational behind consumer behavior towards price changes and how the final prices are

determined in the market place.

The essence of the price theory is how the prices of products are determined through the

interaction of free market forces of demand and supply. Demand is initiated by customers

with the intension of maximizing utility, where supply is initiated by suppliers with the

intension of maximizing profits. Let us try to understand the concepts of demand and supply

in understanding this total mechanism.

2. Theory of Demand

2.1 Concepts on the Theory of Demand

In economics demand means both the desire to have a product as well as the ability to buy

that product. It is only desire to buy that can be backed by actual purchasing power that

counts in the market. Demand in economics refers to effective demand. A mere wish or a

desire is not demand, as it has no effect on economic activity.

Effective Demand = Desire to purchase + Purchasing power.

Individual Demand is defined as the quantity of a commodity that a consumer is willing and

able to buy at a particular price and at a particular time.

Market Demand is the horizontal summation or the sub total of all the quantities of a

commodity that all consumers are willing to buy at a particular price at a particular period.

Demand Schedule is a statistical table showing the relationship between price and quantity

demanded. A demand schedule could be either for an individual or for the market.


1. Introduction to Price Theory

2. Theory of Demand

3. Theory of Supply

4. Establishment of Market Price

5. Price Controls

6. Importance of the Price Theory for Marketing Decision Making


Individual Demand Schedule Market Demand Schedule

Price/unit in (Rs) Qty demanded (units) Price/unit in (Rs) Qty demanded (units)

1 50 1 5000

2 40 2 4000

3 30 3 3000

4 20 4 2000

5 10 5 1000

Demand Curve is a graphical illustration, which denotes the relationship between the price

and quantity demanded. A demand curve could be either for an individual or for the market.

Illustration 01 – Demand Curve

Price/Units Rs

5

4

3

2

1

Quantity Demanded (units)

0 10 20 30 40 50

2.2 The relationship between the price of the product and the quantity demanded.

You will see an inverse relationship between quantity demanded and the price of its product.

In other words when price increases the quantity demanded will be reduced and when price

reduces the quantity demanded will be increased. So we see that the demand curve is a

downward sloping curve. (from left to right)

What are the reasons for the demand curve to be downward slopping?

Income effect

Substitution effect

a) Income Effect

Let us look at the following example. (We assume when price change the income is constant)

Situation Price(Rs) Money income Rs( constant) Ability to buy(units)/qty demanded

A 10 1000 100

A to B 20 1000 50

A to C 5 1000 200

Demand Curve


If you look at the above situation you will see in A to B (where price increases from Rs10 to

Rs20), the purchasing ability is reduced from 100 to 50 units (this is because the income is

constant) Similarly in situation A to C where the price is reduced from Rs.10 to Rs.5 the

ability to purchase has increased from 100 to 200 units.

So the income effect explains why when price increases/decreases the quantity demanded

will be decreased /increased as the ability to purchase will be limited/expanded as the income

of the consumer is constant. This proves the inverse relationship between the price of the

product and its quantity demanded and therefore why the demand curve slopes downwards.

(from left to right)

b) Substitution Effect.

The following example will explain the substitution effect. The assumption here is when the

price of the concerned product changes the prices of the substitute will not change.

Situation

Concerned product Substitute product

Price

(Rs)

Quantity

Demand

Utility Utility

per 1 Re

Price

(Rs)

Quantity

Demand

Utility Utility

per 1 Re

A 5 1000 50 10 5 500 50 10

A to B 10 500 50 5 5 1000 50 10

A to C 2.50 1250 50 20 5 250 50 10

Situation A – it does not matter whether you buy the concerned product or the substitute

products as the utility per 1 rupee for both products are 10.

Situation A to B – When the price of the concerned product increases from Rs 5 to 10 the

utility per 1 rupee of the concerned product drops from 10 to 5. However if we assume that

the price of the substitute remains the same, its utility per 1 rupee remains as it is (10). So for

a consumer it is advantageous to switch to the substitute product. So the loss sales of 500

units (1000 – 500) is gained to the substitute product. The same could be explained when the

price of the concerned product reduces.

So we see as per the substitution effect when the price of the concerned product

increases/decreases the quantity demanded for the concern product will decrease/increase

because the utility of the substitute products will be higher/lower (assuming the prices of the

substitutes are constant). This proves the inverse relationship between the price of the product

and its quantity demanded and therefore why the demand curve slopes downwards. (from left

to right)


2.3 Determinants of Demand

The following are determinants of demand

a) Price of the product ( Px)

Other factors

b) Prices of other goods (Py)

� Prices of substitute products

� Prices of complementary products

c) Income levels of consumers (Yd)

d) Consumer tastes and fashions (Ct&f)

e) Weather conditions (W)

Demand Function

QD = f(Px, Py, Yd, Ct&f , W)

Determinants of Demand in Detail

a) Price of the Product (Px)

Let us try to understand the relationship between the price of the product and the quantity

demanded for the product. When all other factors determining demand except the price of the

product is held constant (Ceteris Paribus) the quantity demanded of a product is inversely

related to the price of its product. This is also called the law of demand.

Illustration 02 – Contraction and Extension of Demand

Price/Units Rs

5

4

3

2

1

Quantity Demanded (units)

10 20 30 40 50

There are two dimensions to this relationship

• Contraction of Demand – When all other factors determining demand except the

price of the product is held constant, an increase in price will lead to a reduction of

quantity demanded of that product. This is an upward movement ALONG the

DEMAND CURVE

Contraction of Demand

Extension of Demand


• Extension of Demand – When all other factors determining demand except the price

of the product is held constant, a decrease in price will lead to an increase of quantity

demanded of that product. This is a downward movement ALONG the DEMAND

CURVE.

So we see in both instances the price of the product and its level of quantity demanded are

inversely related.

b) Prices of Other Goods (Py)

Other goods are essentially prices of substitute goods and prices of complementary goods that

would have an impact on the quantity demanded of the product concern. Let’s look at this

separately.

� Prices of substitute products and the demand of the product concern.

Let us take tea and coffee. The product concern is tea and the substitute product is coffee.

Let us try to understand when the price of a substitute product (coffee) changes when all

other factors effecting demand (including the price of the concerned product-tea) is

constant how the demand of the product concern (tea) behaves.

Illustration 03 – Prices of Substitute Products and the Demand of the Product Concern

Situation Substitute product ( Coffee) Concerned product ( Tea)

Price

(Rs)

Quantity Demand Price

(Rs)

Quantity Demand

A 5 500 5 500

A to B 10 250 5 750

A to C 2.50 750 5 250

Substitute Product (coffee)

Price

10

5

2.5

250 500 750 QD

Concerned Product (Tea)

Price

A B

C

5

B

A

C

250 500 750 QD

Increase in

demand

Dec

reas

e in

dem

and

A

B

C


If you look at the above example, you will see that there is a positive relationship between the

prices of substitute products(coffee) and the quantity demanded of the product in concern(tea)

while all other factors determining demand (including the price of the concerned product-tea)

is held constant.

The reason for this behavior could be explained as; substitute products satisfy similar needs

of consumers. The moment the price increases of a substitute product the utility of that

substitute reduces. It becomes cheaper for the consumer to consume the product concerned,

here your price has not changed thus the utility of your product is higher than the substitute

product.

In this situation you would experience that the demand curve of the product concern has

shifted outwards and downwards from the original demand curve. We see two dimensions

once again here

• Increase in Demand (AA – BB) - When all other factors determining demand except the

price of substitute products are held constant( including the price of the concerned

product), an increase in price of a substitute will lead to an increase in the quantity

demanded of the product concern. This is an outward shift of the demand curve.

• Decrease in Demand.(AA – CC) When all other factors determining demand except the

price of substitute products are held constant (including the price of the concerned

product), a decrease in price of a substitute will lead to an decrease in the quantity

demanded of the product concern. This is a down ward shift of the demand curve.

In conclusion, except for the price of the product concern, when all other determinants

effecting demand changes, there would be a shift in the demand curve. This is called an

increase or decrease in demand.

Please note the difference between extension/contraction of demand (which is a movement

along the demand curve which only happens when the price of the product concern changes

while other factors effecting demand is constant) with the concept of increase/decrease in

demand)

� Prices of complementary products and the demand of the product concern.

Let us take tubes and tyres. The product concern is tubes and the complementary product

is tyres. Let us try to understand when the price of a complementary product (tyres)

changes when all other factors effecting demand (including the price of the concerned

product - tube) is constant how the demand of the product concern (tubes) behaves.


Illustration 04 – Prices of Complementary Products and the Demand of the Product

Concern

Situation Complementary Product( Tyres) Concerned product ( Tubes)

Price

(Rs)

Quantity Demand Price

(Rs)

Quantity Demand

A 500 1000 50 1000

A to B 1000 750 50 750

A to C 250 1250 50 1250

If you look at the above example you will see that there is an negative/inverse relationship

between the prices of complementary products(tyres) and the quantity demanded of the

product in concern (tubes) while all other factors determining demand ( including the price of

the product concern - tubes) is held constant.

The reason for this behavior could be explained as, complementary products are used

together with the product in concern and a price increase/decrease of a complementary

product will lead to a decrease/increase of the complementary product itself.

Since the product concern cannot be used without that complementary product, the demand

for the product concern will also decrease/increase accordingly even without a change in the

price of the product in concern.

This will explain the inverse relationship between the complementary product prices and the

demand of the product concern. You will once again notice that the movement of the demand

curve of the product concern is a shift leading to an increase or decrease in the demand.

Complementary Product (Tyres)

Price

1000

500

250

0 750 1000 1250 QD

Concerned Product (Tubes)

Price

A C

B

50

C

A

B

0 750 1000 1250 QD

Increase in

demand

Decr

ease

in

dem

an

d

A

B

C


c) Income Levels of Consumers (Yd)

Let us try to see how when consumer income levels change (which is a determinant of

demand), how the demand for the product concern behaves while other factors which

determining demand (including the price of its product) is held constant.

Illustration 05 – Consumer Income and Demand of the Product Concern

Situation Price of the product (Rs) Consumer income (Rs) Quantity Demand

A 100 10,000 100

A to B 100 8,000 80

A to C 100 12,000 120

The above will explain a positive relationship between the consumer income and the demand

of the product concern. You will once again notice that the movement of the demand curve of

the product concern is a shift leading to an increase or decrease in the demand.

d) Consumer Tastes and Fashions (Ct&f)

You will see that consumer tastes and fashions would have a major impact on the demand

patterns of a product. The prices of the products will some times not have any impact to this.

So you will see that when consumers have a high level of tastes or if a product is in fashion

then the demand for that product will either increase or decrease based on the taste level. You

may find a positive relation ship between the two. This would also lead to a shift in the

demand curve leading to either an increase or decrease in demand.

Price

A C

B

100

C

B A

80 100 120 QD

Increase in

Demand

Dec

reas

e i

n

dem

and

Relationship between consumer

income and quantity demand

Income Quantity demand

Increase Increase

Decrease Decrease

With out a change to the price of the

product concern

So we see a positive relationship

between the changes in consumer

income to quantity demand of a

product while other factors affecting

demand (including the price of its

product) is held constant


e) Weather Conditions (W)

The weather conditions also have an impact on the demand pattern of a product. Think of ice

cream during the heavy rainy season. The price of the ice-cream does not have anything to do

to the decreasing levels of demand for the product during rainy times. The relationship

between the weather condition and the demand patterns will defer according to products. An

example would be umbrellas and rainy season and ice-cream and rainy season.

This would also lead to a shift in the demand curve leading to either an increase or decrease

in demand.

Illustration 06 – Determinants of Demand and their Relationship with Levels of Demand

(Summary)

Determinant of

demand

Relationship

to level of

demand

Constant

variables Term used

Movement of the

demand curve

Price of the

product(Px) Negative

Py, Yd,

Ct&f , W

Extension of

demand/contraction

of demand

Movement along

(upwards or

downwards)

Prices of

substitutes(Py) Positive

Px, Yd,

Ct&f , W

Increase in

demand/decrease in

demand

Shift in the demand

curve(outwards or

inwards)

Prices of

complementary

products (Py)

Negative Px, Py,

Ct&f , W

Increase in

demand/decrease in

demand

Shift in the demand

curve( outwards or

inwards)

Consumer

income (Yd) Positive

Px, Py,

Ct&f , W

Increase in

demand/decrease in

demand

Shift in the demand

curve(outwards or

inwards)

Consumer tastes

& fashions

(Ct&f)

Depends on

taste

towards

the product

Px, Py, Yd,

W

Increase in

demand/decrease in

demand

Shift in the demand

curve (outwards or

inwards)

Weather

conditions (W)

Depends on

the product

Px, Py, Yd,

Ct&f

Increase in

demand/decrease in

demand

Shift in the demand

curve (outwards or

inwards)


3. Theory of Supply

3.1 Concepts on the Theory of Supply

Supply in economics means the quantity of a commodity that producers are willing and able

to supply at a specific price and at a specific time.

Effective Supply = Willingness to supply + Ability to supply

Individual Supply This is what a single supplier would supply to the market at a particular

price and at a particular time.

Market Supply The quantities of a commodity that all the sellers in the market are willing

and able to supply at a specific price and at a specific time.

Supply Schedule is a statistical table showing the relationship between price and quantity

supply. A supply schedule could be either for an individual or for the market.

Individual Supply Schedule Market Supply Schedule

Price/unit in Rs Qty Supplied (units) Price/unit in Rs Qty Supplied (units)

1 10 1 1000

2 20 2 2000

3 30 3 3000

4 40 4 4000

5 50 5 5000

Supply is a graphical illustration, which denotes the relationship between the price and

quantity supply. A supply curve could be either for an individual or for the market.

Illustration 07 – The Supply Curve

Price/Units Rs

5

4

3

2

1

Quantity supplied (units)

10 20 30 40 50

S


The relationship between the price of the product and the quantity supplied.

You will see a positive relationship between quantity supplied and the price of its product. In

other words when the price increases the quantity supplied will be increased and when price

reduces the quantity supplied will be reduced. So we see that the supply curve is an upward

sloping curve. (from left to right)

What are the reasons for the supply curve to be an upward slopping curve?

Let’s see the reasons. We assume here that the cost of the production is constant at each level.

Cost per unit Price of the

product

Profitability

per unit

Quantity willing to

supply

Total profit

100 100 0 0 0

100 200 100 1000 100,000

100 300 200 2000 400,000

100 400 300 3000 900,000

100 500 400 4000 1,600,000

In the above situation if we assume that the cost of production is constant at any production

level, as the price increases, the profits that the producer gets will increase. Therefore when

the price increases he would like to supply more as he is motivated to make more profits.

This will explain the upward moving supply curve and the positive relationship between price

and quantity supply.

3.2 Determinants of Supply

The following are determinants of supply

a) Price of the product ( Px)

Other factors

b) Prices of other goods (Py)

c) Cost of production ( Fc)

d) Technological conditions (T)

e) Weather conditions ( W)

Supply Function

QS = f (Px, Py, Fc, T, W)

Determinants of Supply in Detail

a) Price of the Product (Px)

Let us try to understand the relationship between the price of the product and the quantity

supplied of the product. Except for the price of the product, when all other factors

determining supply stays constant (Ceteris Paribus) the quantity supplied of a product is

positively related to the price of its product. This is also called the law of supply.


Illustration 08 – Contraction and Extension of Supply

Price/Units Rs

5

4

3

2

1


0 10 20 30 40 50

There are two dimensions to this relationship

• Extension of Supply – When all other factors determining supply except the price of the

product is held constant, an increase in price will lead to an increase in quantity supplied

of that product. This is an upward movement ALONG the SUPPLY CURVE

• Contraction of Supply – When all other factors determining supply except the price of

the product is held constant, a decrease in price will lead to a decrease of quantity

supplied of that product. This is a downward movement ALONG the SUPPLY CURVE.

So we see in both instances the price of the product and its level of quantity supplied is

positively related.

b) Price of Other Goods

Let us see the impact of how a change in the prices of other goods will lead to a change in the

behavior of supply of the product concern while the other factors effecting supply (including

the price of the product concern) is held constant.

If you carefully look at the three situations as indicated in illustration 09, you would be able

to understand this concept easily.

Situation A – The production of the concerned product or the other product would not be a

decision to the supplier as the profit margins (Rs 20 per each product) would be the same.

Situation B – Here the price of the other product has increased where all other factors

affecting supply (cost of production, price of the product itself and others) are constant.

S

Extension of supply

Contraction of supply


In this situation the supplier will get Rs 45 per product if he manufactures the other product

while he will only get Rs 20 if he continues to manufacture the concerned product. This

increase in profitability in manufacturing the other product will induce the supplier to divert

his factors of production from the concerned product to the other product.

That is why you would see that even without a change in the price of the concerned product

the supply of the product has decreased (shift in the supply curve from AA to BB.)

Situation C – this would be the other side of the equation.

Illustration 09 – Prices of Other Products and the Supply of the Product Concern

Situation Other product Concerned product

Price

(Rs)

Cost

(Rs)

Profit

(Rs)

QS

units

Price

(Rs)

Cost

(Rs)

Profit

(Rs)

QS

units

A 50 20 30 50 50 20 30 50

A to B 75 20 55 75 50 20 30 25

A to C 25 20 5 25 50 20 30 75

You would see a negative relationship between the prices of other products and the quantity

supplied of the product concern.

The above will give rise to two dimensions once again

• Increase in Supply (AA – CC) - When all other factors determining supply except the

price of other products are held constant( including the price of the concerned product), a

decrease in price of the other product will lead to an increase in the quantity supplied of

the product concern. This is a down ward shift of the supply curve.

Decrease in

supply

Increase in

supply

Other Product

Price

75

50

25

0 25 50 75 QS

Concerned Product

Price B A

C

50

B

A C

25 50 75 QS

A

B

C


• Decrease in Supply (AA – BB). - When all other factors determining supply except the

price of the other product are held constant( including the price of the concerned product),

an increase in price of the other product will lead to a decrease in the quantity supplied of

the product concern. This is an upward shift of the supply curve.

Please note the difference between extension/contraction of supply (which is a movement

along the supply curve which only happens when the price of the product concern changes

while other factors effecting supply is constant) with the concept of increase/decrease in

supply.

c) Cost of Production

Let us try to see how when the cost of production change (which is a determinant of supply,

how the supply of the product concern behaves while other factors which determining supply

(including the price of its product) is held constant.

Illustration 10 – Cost of Production and the Supply of the Product Concern

Situation Price of the

product (Rs)

Cost of the

product (Rs)

Profit per

product(Rs)

Quantity Supply

A 100 80 20 100

A to B 100 70 30 120

A to C 100 90 10 80

The above will explain a negative relationship between the cost of production and the supply

of the product concern. You will once again notice that the movement of the supply curve of

the product concern is a shift leading to an increase or decrease in supply

Price

C A

B

100

C

C

A B

80 100 120 QS

Increase in

supply

Decrease in

supply

Relationship between cost of

production and quantity supply

Cost Quantity supply

Increase Decrease

Decrease Increase

Without a change to the price of the

product concern

So we see a negative relationship

between the changes in cost of

production to quantity supply of a

product while other factors affecting

supply (including the price of its

product) is held constant


d) Change in Technology

Change in technology will lead either to an increase or decrease in supply. If the technology

improves the production process and reduces the cost then, there would be an increase in

supply while if the existing technology were not sufficient to meet the levels of production

then, it would increase cost and would lead to a decrease in supply.

This would also lead to a shift in the supply curve leading to either an increase or decrease in

supply.

e) Weather Conditions

The weather conditions also have an impact on the supply of a product. This is very true for

agricultural products where the crop (supply) is totally depended on the weather condition.

The relationship between the weather condition and the supply patterns will defer according

to products.

This would also lead to a shift in the supply curve leading to either an increase or decrease in

supply.

Illustration 11 – Determinants of Supply and their Relationship with Levels of Supply

(Summary)

Determinant of

supply

Relationship

to level of

supply

Constant

variables

Term used Movement of the

supply curve

Price of the

product(Px)

Positive Py, Fc

T , W

Extension of

supply/contraction

of supply

Movement along

(upwards or

downwards)

Prices of other

goods(Py)

Negative Px, Fc, T ,

W

Increase in

supply/decrease in

supply

Shift in the supply

curve (outwards or

inwards)

Cost of

production

income (Fc

Negative Px, Py, T ,

W

Increase in

supply/decrease in

supply

Shift in the supply

curve (outwards or

inwards)

Change in

technology (T)

Depends on

the

technology

change

Px, Py, Fc,

W

Increase in

supply/decrease in

supply

Shift in the supply

curve (outwards or

inwards)

Weather

conditions (W)

Depends on

the product

Px, Py, Fc,

T

Increase in

supply/decrease in

supply

Shift in the supply

curve (outwards or

inwards)


4. Establishment of Market Price

4.1 Concept of Market Equilibrium.

Illustration 12 – Market Equilibrium

Price/Units Rs excess supply

5

4

3

2

excess demand

1


0 10 20 30 40 50

Point Price ( Rs) Demand (units) Supply (units) Excess Remarks

A 1 50 10 40 Excess demand

B 2 40 20 20 Excess demand

C 3 30 30 0 Mkt equilibrium

D 4 20 40 20 Excess Supply

E 5 10 50 40 Excess Supply

You will see at point C where the price is Rs 3, the demand and supply is 30 units. This point

is called the market equilibrium. It is the point where the total market demand equals the total

market supply. There is no excess demand or excess supply at this point. This is the point

where the objective of the suppliers to maximize profits and where customers objective of

maximizing utility agrees.The price which prevails at this point is called the market

equilibrium price. The quantity, which prevails at this point, is known as market equilibrium

quantity.

4.2 Changes in the Equilibrium Market Prices

You will understand that the interaction of demand and supply will determine the price.

Every time when the demand and the supply curves shift a new market equilibrium will be

formed and the price and the quantity demanded/supplied will be determined. Look at the

following diagrams.

As per the diagrams listed below, you may note that the interaction of demand and supply in

different directions will have different levels of impact in determining price levels.

D

S


Illustration 13 – Changes in Demand & Supply Levels and impact on Market Quantities

and Prices

Demand – Constant Demand – Constant

Supply – Increase Supply – Decrease

Pr Pr S1

D0 S0 D0 S0

S1 P1

P0 P0

S1

P1

S0 S1 D0 S0 D0

Q0 Q1 Qty Q1 Q0 Qty

Price - Decrease Price - Increase

Quantity - Increase Quantity - Decrease

Demand – Increase Demand – Decrease

Supply – Constant Supply – Constant

Pr D1 Pr

D0 S0 D0 S0

P1

D1

P0 P0

P1

D1

S0 D0 S0 D1 D0

Q0 Q1 Qty Q1 Q0 Qty

Price - Increase Price - Decrease

Quantity - Increase Quantity - Decrease

Demand – Decrease Demand – Increase

Supply – Increase Supply – Increase

Pr Pr D1

D0 S0 D0 S0

D1 S1

S1

P0 P0

D1

P1 S1

S0 S1 D1 D0 S0 D0

Q0 Qty Q0 Q1 Qty

Price - Decrease Price – No Change

Quantity – No change Quantity - Increase


Θ Practice Question 01

The above diagram shows the demand and the supply of televisions of a country. Letter

“A” indicated in the diagram shows the equilibrium prices and quantity of TV‘s in the

market. Based on the above diagram indicate the letter of the new equilibrium point

based on the following situations. Give brief reasons for your choice.

A1 – An increase in consumer incomes

A2 – A very sharp increase in cost of the TV license.

A3 – An improved technique in manufacturing TV’s

A4 – An increase in the wages of the workers who manufacture TV‘s due to trade

union action

A5 – A government advertising campaign to show the advantages of TV’s

A6 – A very sharp increase in cost of the TV license followed by an increase in

the wages of the workers who manufacture TV’s

A7– An increase in consumer income followed by an improved technique in

manufacturing TV’s

A8– An increase in consumer income and the cost of the TV license increasing in

the same proportion.

A9 – Introduction of Internet TV concept which would replace the above type of

TV’s

A10 – An extra ordinary increase in temperature in the weather.

D

D

S

S D1

D1

B D2

D2

C

A

S1

S2

E

F

D

S2

S2

G

H

I

Price

Quantity


4.3 The Concept of Price Mechanism

The price mechanism is a system of resource allocation based on the free interaction of

demand and supply. The following laws form the cornerstone of economic theory.

An increase in demand raises price

A decrease in demand lowers price

An increase in supply lowers prices

A decrease in supply raises prices.

5. Price Control

The government initiates price controls to protect the consumer or the producer. It is

essentially a regulation of the free market forces of demand and supply. Government does

this when they identify that the decided market price through the interaction between demand

and supply is not beneficial to either the consumer or the producer.

5.1 Maximum Price Control (Price Ceiling)

Initiated by the government to protect the interests of the consumer when the decided market

price is too high. Basically implemented for products like infant milk foods.

Illustration 14 – Price Ceiling

Supply

Demand

Price

Quantity

P

Q

Maximum price

QS QD

P1

QS< QD = Excess demand

P2


P & Q – Equilibrium price and Equilibrium quantity

P1 – Maximum price that the item could be sold – imposed by the government

QS – Quantity, which the suppliers are willing to supply at the maximum price

QD - Quantity, which the buyers are willing to demand at the maximum price

QS< QD = Excess demand

P2 – Black market price

As a consequence of imposing a maximum price, there would be an excess demand situation

in the economy. This would lead to the establishment of a black market price where suppliers

behind the counter will quote illegal higher prices in taking advantage of the excess demand

situation.

Solutions the Government can take to arrest the situation

a) Rationalize Scheme (Quotas)

Illustration 15 – Price Ceiling and Rationalization Scheme

The objective of rationalization is to reduce demand by way of quotas. Due to the decrease in

demand the equilibrium has moved from E to E1 where the maximum price is initiated.

S0

D0

Quantity

P

Q

Maximum price

QS QD

P1

D1

E

E1

Price


b) Subsidization Scheme

Illustration 16 – Price Ceiling and Subsidization Scheme

The objective here is to increase supply by giving a subsidy (grant) to suppliers. Government

reimburses the loss incurred by the producer with the price revision. By this there is a new

equilibrium created at E1 where maximum price is initiated.

5.2 Minimum Price Control (Price Floor)

Illustration 17 – Price Floor

S0

D0

Quantity

P

Q

Maximum price

QS QD

P1

S1

E

E1

Price

Supply

Demand

Price

Quantity

P

Q

Minimum price

QD QS

QS> QD = Excess supply

P1

Tendency for the

price to fall


Minimum price control is initiated to protect the producer when the decided market price

seems to be too low. Minimum price would be a higher price above the equilibrium price.

P & Q – Equilibrium price and Equilibrium quantity

P1 – Minimum price that the item could be sold – imposed by the government

QS – Quantity, which the suppliers are willing to supply at the maximum price

QD - Quantity, which the buyers are willing to demand at the maximum price

QS> QD = Excess supply

As a consequence of the government imposing a minimum price, the market price may even

come below the previous equilibrium price. Therefore the efforts of the minimum price will

be lost.

The Government could do the following to arrest the excess supply situation .The

government can buy the excess supply and either store it for future use, destroy it or export it.

‡ Activity

Discuss the general disadvantages associated in establishing price controls. Argue why price

controls are not effective in managing price levels of an economy.


You have been appointed a marketing consultant to the paddy board in Sri Lanka. The

chairman of the board has sent a memo to all the board members and yourself requesting to

put down their thoughts on the proposal made by the Minister of Agriculture to imposing a

minimum price on paddy to protect the interest of farmers.

a) List down the consequences of the government imposing a minimum price on paddy

both to farmers and to the government. You are expected to use diagrams in answering

this question.

b) Suggest an alternative marketing strategy for the board to suggest to the minister if

imposing the minimum price is not effective.

6. Importance of the Pricing Theory for Marketing Decision Making

Pricing has a greater impact in all marketing decision making.

The determinants of demand will give a marketer a lot of insight into aspects, which affects

the demand for a product and would help marketers to come up with strategies to handle

them.


� Understanding the impact from substitute prices will give an insight into the impact from

competitor products and its probable consequences.

� The impact of complementary products will help to plan an effective promotional

campaign taking advantage of the price variations that may take place.

� Understanding consumer income and its impact to demand will help them to come up

with strategies during bonus months in order to increase demand through various sources.

� Understanding and doing research into changing customer tastes and fashions will help

them to upgrade their products and trigger new product development efforts.

� Understanding that the weather could have an impact on demand will help them to be

conscious and predict patterns as much as possible.

Equally determinants of supply will give a marketer a greater understanding on

� Managing the product/market reach in order to get the maximum prices from the potential

markets.

� To understand when to move out from products. Handling product rationalizations as per

the product movement through its life cycle. Looking at products as per their price

movements and moving resources accordingly.

� The importance of managing costs in all marketing and business operations to maintain

profitability.

� The use of appropriate technology for all business activities to improve its productivity.

� Understanding how the weather could have an impact on supply, distribution and plan for

it.

♪ My Short Notes


♪ My Short Notes


Chapter 03

Theory of Elasticity

1. Understanding Elasticity

Elasticity is responsiveness. It is the responsiveness of one item to a change in another. In

other words when a variable change, to which degree does the other variable change to.

Elasticity variations could be classified as follows.

Illustration 01 – Categorizing Elasticity Typologies

Elasticity

Responsiveness of quantity demanded Responsiveness of quantity supplied

to changes in to changes in

Elasticity of

demand

Elasticity of

supply

Price of the

product

Income of

consumers

Prices of

other goods

Price of the

product

Price Elasticity of

demand

Income Elasticity of

demand

Cross Elasticity of

demand

Price Elasticity of

supply


1. Understanding Elasticity

2. Elasticity of Demand

3. Elasticity of Supply

4. Elasticity and Taxation

5. Elasticity and Marketing Decision Making

Advertising

Expenditure

Advertising to sales

elasticity of

Demand


2. Elasticity of Demand

Elasticity of demand is the responsiveness of quantity demand of an item to the changes in

the determinants of demand for that product. Variants of elasticity of demand are looked at in

detail as follows.

2.1 Price Elasticity of Demand

a) Understanding Price Elasticity of Demand

The responsiveness of quantity demanded of a product to a change of its price while all other

factors determining demand being constant.

b) Calculating Price Elasticity of Demand

The % change in quantity demand of a product

Price elasticity of demand (PED) =

The % change in price of that product

As a formula

∆ QD P

PED co-efficient = X

∆ P QD

P = Initial price

QD = Initial quantity demanded

∆ P = Change in price

∆ QD = Change in quantity demanded.

Example one

Price Quantity Demanded

10 100

20 50

∆ QD P


∆ P QD

= 50 (50 – 100) x 10

10 (20-10) x 100

= 5 x 0.10 = 0.5

When the price of the product has increased by 100% the quantity demanded has decreased

by 50% .In other words the quantity demanded has changed less than proportionately to a

change in price.


Example two


10 100

15 25

∆ QD P


∆ P QD

= 75 (25 – 100) x 10

5 (15-10) x 100

= 15 x 0.10 = 1.5

When the price of the product has increased by 50% the quantity demanded has decreased by

75%. In other words the quantity demanded has changed more than proportionately to a

change in price.

c) Variants of Price Elasticity of Demand based on the Co-efficient of Elasticity

Price Elasticity of Demand Co-efficient Value Elasticity Type

PED = 0 Perfectly Inelastic demand

PED = 0 to 1 Inelastic Demand

PED = 1 Unitary elastic

1 < PED < Infinity (∞) Elastic demand

PED = Infinity (∞) Perfectly elastic demand

i) Perfectly Inelastic Demand (PED = 0)

Demand Schedule


10 100

20 100

Calculation of PED Demand Graph

∆ QD P

= X

∆ P QD

= 0 x 10

10 100

= 0 x 0.1

= 0

Price

Quantity

10

20

100


The quantity demand does not respond to a change in the price of the product. Not a practical

concept but the behavior of salt is a little close to this.

ii) Inelastic Demand (PED = 0 to 1)

Demand Schedule


100 1000

120 900


∆ QD P

= X

∆ P QD

= 100 x 100

20 1000

= 5 x 0.1

= 0.5

There will be a less than proportionate change in quantity demand to a change in price when

all other determinants of demand are constant. QD has changed by 10% when price has

changed by 20%. This type of a behavior is seen for essential items. See that the slope of the

demand curve is steeper for inelastic demand situation.

iii) Unitary Elastic Demand (PED = 1)

Demand Schedule


100 1000

120 800


∆ QD P

= X

∆ P QD

= 200 x 100

20 1000

= 10 x 0.1

= 1

Price

Quantity

100

120

1000 900

Price

Quantity

100

120

1000 800


There will be a similar proportionate change in quantity demand to a change in price when all

other determinants of demand are constant. QD has changed by 20% when price has changed

by 20%. This type of a behavior is seen as a theoretical model. See that the curvature slope of

the demand curve for a unitary elastic demand situation.

iv) Elastic Demand (1 < PED < Infinity (∞))

Demand Schedule


100 1000

110 800


∆ QD P

= X

∆ P QD

= 200 x 100

10 1000

= 20 x 0.1

= 2

There will be a more than proportionate change in quantity demand to a change in price when

all other determinants of demand are constant. QD has changed by 20% when price has

changed by 10%. This type of behavior is seen for luxury items. The slope of the demand

curve is less steep in an elastic demand situation.

v) Perfectly Elastic Demand (PED = Infinity (∞))

Demand Schedule


10 100

10 200


∆ QD P

= X

∆ P QD

= 100 x 10

0 100

= Infinity x 0.1

= Infinity

Price

Quantity

100

110

1000 800

Price

Quantity

10

100 200


The quantity demand changes to any extent without any change in the price of the product.

Not a practical situation but the behavior of petrol, cigarettes seem to be close to this.

d) Determinants of Price Elasticity of Demand

i) The Availability of Substitutes

The higher the number of substitutes a product has the higher the elasticity of demand for that

product. The reason being for the slightest increase in price, the demand will decrease more

than proportionate as the customers will have a lot of substitutes to switch on to.

• Higher substitutes – elastic demand

• Lesser substitutes – inelastic demand.

The following is also applicable to substitutes

• Broad definition of a product – example “vegetables” – inelastic demand as the

amount of substitutes would be less.

• Narrow definitions of a product – example “carrots” – elastic demand as the amount

of substitutes are higher.

ii) The Proportion of Income that is spent on the Product

The higher the proportion of income one would spend on an item per time, the higher the

elasticity of demand would be. For example if we take cars, houses, durable goods, it is a

very large proportion of our income (annual).

An increase in price of such an item would erode purchasing ability to a great extent and

consumers would react to such price increases by reducing their demand more than

proportionately.

• High proportion of income spent on an item – elastic demand

• Low proportion of income spent on an item – inelastic demand

iii) Degree of Necessity

If the product consumed were a necessary item, then the elasticity would be fairly inelastic,

as it has to be consumed for survival.

High degree of necessity – inelastic demand

Low degree of necessity – elastic demand

iv) The Force of Habit

Demands for habit-forming goods are inelastic, as the products have to be consumed due to

habit. Less habit forming goods are elastic in demand.

v) Time

Demand tends to be more elastic over time as consumers would find alternative products.

During the short term demand for a product tends to be inelastic.


e) Price Elasticity of Demand and Pricing Decisions

Situation Price Change %

of Price

Quantity

Demand

Change %

of QD

Revenue/consumer

expenditure

A 10 1000 10,000

A - B 11 10% 800 20% 8,800

A - C 9 10% 1200 20% 10,800

Elasticity Co-efficient – Elastic

i) For goods which has an elastic demand

When price of the product increases (A– B) – Total revenue/consumer expenditure decreases

When price of the product decreases (A–C) – Total revenue/consumer expenditure increases.

Situation Price Change %

of price

Quantity

Demand

Change %

of QD

Revenue/consumer

expenditure

A 10 1000 10,000

A - B 15 50% 900 10% 13,500

A - C 5 50% 1100 10% 5,500

Elasticity co-efficient – Inelastic

ii) For goods which has an inelastic demand

When price of the product increases (A–B) – Total revenue/consumer expenditure increases

When price of the product decreases (A–C) – Total revenue/consumer expenditure decreases.

An increase or decrease in revenue to changes in price will be determined by the elasticity

that product holds.

2.2 Income Elasticity of Demand

a) Understanding Income Elasticity of Demand

The responsiveness of quantity demanded of a product to a change in the level of consumer

income, while all other factors determining demand being constant.

b) Calculating Income Elasticity of Demand

The % change in quantity demand of a product

Income elasticity of demand (YED) =

The % change in the consumer income

As a formula

∆ QD Y

YED co-efficient = X

∆ Y QD

See the following table for different YED values.


Consumer

Income (Rs)

Demand (units) YED co-

efficient

Income Elastic

type

Nature of

Goods

1000 100

0.5

Income Inelastic

Normal

goods 2000 150

1000 100

2

Income elastic Normal

goods 1500 200

1000 100

-0.4

Negative income

elasticity

Giffon Goods

1500 80

If the income elasticity co-efficient is more than one, we call it income elastic. That is to a

change in consumer income, the quantity demanded of the product concern responses more

than proportionately while other factors effecting demand is held constant.

Similarly if the income elasticity co-efficient is less than one, we call it income inelastic. That

is to a change in consumer income, the quantity demanded of the product concern responses

less than proportionately while other factors effecting demand is held constant.

Both the above situations are true for normal goods.

For giffon goods the income elasticity is negative. That is when the income increases, the

quantity demanded of that item decreases. Examples of Giffon goods could be margarine,

coconut oil for cooking etc.

‡ Activity

The income elasticity of demand coefficient is – 1.2 for product Y. If the target consumers

incomes are increasing what would be the likely impact on the demand for product Y.

Suggest a few product strategies a marketer could adopt in achieving high sales targets for

this product

2.3 Cross Elasticity of Demand

a) Understanding Cross Elasticity of Demand

The responsiveness of quantity demanded of a product to a change in the price of other goods

while all other factors determining demand being constant.

b) Calculating Cross Elasticity of Demand

The % change in quantity demand of the

concerned product

Cross elasticity of demand (XED) =

The % change prices of other goods

Cross elasticity of demand will be important for us to understand, when the prices of the

other goods change, to what extent the quantity demanded of the product concern would

behave. Cross elasticity could be calculated either for substitute products or for

complementary products.


i) Cross Elasticity of Demand for Substitute Products


Concerned product

XED Substitutes =

The % change prices of substitute product prices

XED value is positive for substitute products. The reason being, under the determinants

which effect demand, between prices of substitute products and the concerned product it

shows a positive relationship. However what is important is to assess the degree of their

relationship.

Example – Product A has two competitive products. They are product X and Y. Here product

A is the concerned product. Products X and Y are substitute products. Based on the XED

values given for product A and product X and product A and product Y, one could assess the

nature of their influence on each other.

Prices of X Demand of A XED co-efficient

10 100

4 8 20

Prices of Y Demand of A XED co-efficient

10 100

0.5 8 90

Based on the XED values we may see that product X is a higher threat to product A, as if the

prices of product X is reduced by the competitors, there is a more than proportionate change

in the prices of A.

But the price of Y does not seem to have the same effect on product A.

So if the cross elastic demand for a substitute is positive and the co-efficient is elastic then,

which substitute product needs to be closely monitored.

ii) Cross Elasticity of Demand for Complimentary Products


concerned product

XED complimentary =

The % change in prices of the complimentary product prices

XED value is negative for complimentary products. The reason been, under the determinants

which effect demand, between prices of complimentary products and the concerned product it

shows a negative relationship. Once again what is important is to assess the degree of their

relationship.

Similar to substitute products if the co-efficient of elasticity for the complimentary product is

high, what this means is that your product is highly depended on the prices of another

complimentary product. Without any change in your product, if the prices increase of such a

complimentary product your demand will get affected more than proportionally. You should

identify this relationship and work closely with those suppliers to minimize this negative

effect.


‡ Activity

You are a product manager in charge of Product A. You are planning to launch this product

into the market. The cross elasticity of demand for two competing substitute products with

Product A are as follows.

The cross elasticity of demand between Product A & Product B is + 6.5

The cross elasticity of demand between Product A & Product C is + 0.5.

If either product B or C adopts a penetrative pricing strategy to disrupt the launching of your

product, which competing product would effect badly on the sales of your product. What

can you do as a product manager to counter attack this

2.4 Advertising to Sales Elasticity of Demand

a) Understanding Advertising to Sales Elasticity of Demand

Advertising elasticity of demand measures the sensitivity of sales (quantity demanded) to

changes in expenditure for advertising and promotion. It is measured as;

b) Calculating Advertising to Sales Elasticity of Demand

Advertising to sales elasticity of demand =

% change in sales (quantity demanded) for the product concern

% change in the unit of advertising and promotions expenditure

The depended variable is the quantity sold of the product concern and the independent

variable is the expenditure incurred on advertising and promotions.

‡ Activity

The advertising to sales co-efficent of demand for a recent campaign that you carried out is

calculated to be +0.3. Your intension of running this campaign was purely to achieve the

high sales target budgeted for that month. One of your colleagues in the production

department was praising you saying that in his opinion that the above said campaign was a

success. Do you agree?

3. Elasticity of Supply

Supply elasticity is the responsiveness of quantity supply of an item to the changes in the

determinants of supply for that product.

3.1 Price Elasticity of Supply

a) Understating Price Elasticity of Supply

The responsiveness of quantity supply of a product to a change of its price while all other

factors determining supply being constant.


b) Calculate Price Elasticity of Supply

The % change in quantity supply of a product

Price elasticity of supply (PES) =

The % change in price of that product

As a formula

∆ QS P

PES co-efficient = X

∆ P QS

P = Initial price

QS = Initial quantity supplied

∆ P = Change in price

∆ QS = Change in quantity supplied.

Example one

Price Quantity supply

10 100

20 150

∆ QS P


∆ P QS

= 50 (150 – 100) x 10

10 (20-10) x 100

= 5 x 0.10 = 0.5

When the price of the product has increased by 100% the quantity supply has increased by

50% .In other words the quantity supply has changed less than proportionately to a change in

price.

Example two


10 100

12 125

∆ QS P


∆ P QS

= 25 (125 – 100) x 10

2 (12-10) x 100

= 12.5 x 0.10 = 1.25


When the price of the product has increased by 20% the quantity supply has increased by

25%. In other words the quantity supply has changed more than proportionately to a change

in price

c) Variants of Price Elasticity based on the Co-efficient of Elasticity

Price Elasticity of Demand Co-efficient Value Elasticity type

PES = 0 Perfectly Inelastic Supply

PES = 0 to 1 Inelastic Supply

PES = 1 Unitary Elastic Supply

1 < PES < infinity (∞) Elastic Supply

PES = Infinity (∞) Perfectly Elastic Supply

d) Determinants of Price Elasticity of Supply

i) Behavior of Costs of Production

If the average cost of production falls, as the production output increases, at this stage the

supply will be elastic. That is to an increase in price of a product, the quantity supplied will

be increased more than proportionately. Similarly if the average cost of production rises as

the production increases, then the firm will be reluctant to increase the output and the supply

will be inelastic.

ii) Excess Capacity

If a producer has excess capacity, he would like to use the unused capacity to a slight increase

in price. At this situation the supply will be elastic. Similarly if the producer does not have

excess capacity and running CLOSE to the peak, then they will not be willing to increase

supply by large means to an increase in price as the producer will have to expand the scale of

its operation. At this situation supply will be inelastic.

iii) Factor Mobility

If a manufacturer specializes in making a product, then his ability to move his factors of

production from one product to another will be limited. In this situation his supply is

inelastic. However if a producer is able to transfer his factors of production from one

operation to another, then his supply will be elastic

iv) Production Cycle

A product which has a longer production cycle (shipbuilding) tends to have a more inelastic

supply situation.

v) Time

Supply cannot be expanded in the short run as some factors are fixed. Thus supply becomes

inelastic. In the long run, all factors can be varied and supply will be elastic.


‡ Activity

Gamunu has been appointed as the head of marketing at MASST group of companies who

exports apparel products from Sri Lanka. With the removal of the multi-fiber agreement in

2005, which provided the quota based system; their products are expected to face severe

competition in post 2005. Gamunu who has a very strong marketing and an economics

background and has identified that most of the products sold by MASST group are elastic in

nature. He submitted a report to his immediate manager informing the background and the

circumstances surrounding the apparel industry and specifics of MASST group. Gamunu’s

manager having read the report has the following queries

i. He wants Gamunu to explain what he means by this term “elastic demand” and

why he says that garments are elastic in nature.

ii. Gamunu had recommended in his report that MASST group should make their

products more inelastic if they are to face global competition. Gamunu’s boss

wants to know what this means.

iii. Suggest at least two marketing strategies for MASST to follow in making their

garments more inelastic from a state of elastic demand at present.

4. Elasticity and Taxation

4.1 The Initial Impact of Taxation to Supply Situation

Illustration 02 – Elasticity and Taxation

Price Quantity Supply

( curve S)

Taxation Price which the

supplier gets

New quantity supply

( curve S1)

1 100 1 0 0

2 200 1 1 100

3 300 1 2 200

4 400 1 3 300

5 500 1 4 400

5

4

3

2

1

100 200 300 400 500 Quantity

Price S

S1


As you may see the initial impact of imposing a tax is, the supply curve moving upwards

causing a decrease in supply. The reason being that from the price the producer gets, he will

have to pay a tax which would increase his cost & bring down his profitability.

However depending on the elasticity of demand, the producer would be able to pass some

amount of that tax to the consumer. The amount, which the consumer has to bear, is called

the consumer borne taxation & the amount, which the producer has to bear, is called the

producer borne taxation.

4.2 Elasticity of Demand and How the Tax is Distributed.

a) Inelastic Demand Situation and Taxation

As per the below diagram at equilibrium point “a” , the market price is Rs 3 , and the quantity

demanded and supplied will be 100 units. Let us assume the government decides to impose a

50% tax on the selling price. The tax would be Rs1.5.

Total tax imposed – Rs 1.5 (50% tax on price)

Illustration 03 – Inelastic Demand and the Distribution of Tax

80 100

Since the demand for that product is inelastic, the producer can pass a larger portion of the

tax to the consumer, as the demand will decrease less than proportionately. In this instance

the producer has passed on Re 1 from the tax to the customer. However the producer will

have to bear another 50 cents from the price that he gets to cover up for the tax.

Based on the new equilibrium “b”, out of the unit price he charges from the customer (Rs 4),

Rs 1 is directly borne by the customer and the balance 50 cents is borne by the producer as

taxes. The quantity demanded and supplied will be units 80 at the new equilibrium. Quantity

demanded has come down to 80 as the price to the customer has increased and the quantity

supply has come down as the producer gets 50 cents less from the price that he earns due to

the tax.

D

a

Price

Quantity

S

3

2.5

4

CBT

PBT

b


So when the demand is inelastic, when the government imposes a tax, the consumer will have

to bear the bigger portion of the tax and the producer has to bear a lesser portion of the tax.

b) Elastic Demand and Taxation

As per the below diagram at equilibrium point “a” , the market price is Rs 3 , and the quantity

demanded and supplied will be 100 units. Let us assume the government decides to impose a

50% tax on the selling price. The tax would be Rs1.5.

Since the demand for that product is elastic, the producer cannot pass a larger portion of the

tax to the consumer because if he does the demand for the product will decrease more than

proportionately. In this instance the producer has passed 50 cents of the tax to the customer.

However the producer will have to bear another Re 1 from the price that he gets to cover up

for the tax.

Total tax imposed – Rs 1.5 (50% tax on price)

Illustration 04 – Elastic Demand and the Distribution of Tax

60 100

Based on the new equilibrium “b”, out of the unit price, he charges from the customer (Rs

3.5), 50 cents is directly born by the customer and the balance Rs 1 is borne by the producer.

The quantity demanded and supplied will be units 60 at the new equilibrium. Quantity

demanded has come down to 60 as the price to the customer has increased and quantity

supply has come down as the producer gets Rs 1 less from the price that he earns due to the

tax imposed.

So when the demand is elastic, when the government imposes a tax, the consumer will have

to bear a lesser portion of the tax and the producer has to bear a higher portion of the tax

Price

Quantity

S

D

S1

3

2

3.5 CBT

PBT

a

b


‡ Activity

See how a tax is distributed under perfectly elastic and perfectly inelastic demand situations.

Draw the diagrams and see its impact.

5. Elasticity and Marketing Decision Making

5.1 Practical Applications of Price Elasticity of Demand

a) Price Elasticity of Demand for Pricing Policy.

Price elasticity of demand has a direct impact on the pricing policy of a product. A producer

who has an elastic demand should reduce price if he requires his revenue to increase. On the

other extreme a producer of an inelastic item will have to increase his price to increase his

revenue.

Example

ELASTIC DEMAND INELASTIC DEMAND

Price Quantity Total revenue Price Quantity Total revenue

10 100 1000 10 100 1000

8 150 1200 12 90 1080

Therefore a manufacturer/marketer should be very cautious in his pricing decisions, which

will have a total impact on the revenue that will be earned

b) Change the Slope of the Manufacturers Demand Curve

From the previous point we understood how elasticity of demand affects total revenue.

Ideally any manufacturer would like to have the demand for their product as inelastic because

a price increase would lead to an increase in revenue. So they would aspire to change the

slope of their demand curve from elastic status to inelastic status. Manufacturers can change

the slope of the demand curve with the use of “Branding”

Illustration 05 – Change in the Slope of the Demand Curve

Price/Rs

Quantity

A

A

B

B


c) Taking Advantage of the Market Structure where a Manufacturer is Placed.

A manufacturer understanding the market structure they are placed in, can use the elasticity

of demand concept for their advantage. Think of a manufacturer like cigarettes that is in a

monopoly market structure.

The absence of close substitutes has made the demand for their product inelastic, thus could

increase their revenue and profitability by increasing prices. On the contrary a manufacturer

whose products are sold in a supermarket, will need to offer volume based discounts to

increase his volumes, revenue and profitability as the demand for the distribution channel

would be elastic due to the availability of many other supermarkets and similar products.

d) Price Elasticity of Demand as an Insight for New Product Development.

Understanding elasticity of demand in the new product development process will bring

dividends to the manufacturers in the long run if they follow such principles.

• Trying to develop new products, which does not have many substitutes in the market

place. These products could demand higher prices in the market.

• Development of necessity or habit-forming goods.

• Developing products, which are insignificant, spend from consumer’s income thus trying

to sell in volumes. Eg : pens, erasers, etc.

e) Effects of Taxation on Elasticity of Demand

The price elasticity of demand will have an impact on the distribution of taxes imposed by the

government. The immediate response from the supplier would be the left ward movement of

the supply curve when a tax is imposed.

This means that a less number of items are now supplied at the earlier price or the price of an

item has increased from that of before. The elasticity of demand prevailing for that product

will determine how much of this tax could be passed on to the end consumer.

In a perfectly elastic demand situation, the tax imposed will have to be borne by the supplier

fully as an increase in price would lead to a total loss of demand.

In a situation where a supplier has an elastic demand for his product, the imposition of a tax

will lead to the supplier bearing the bigger part of the tax because if he tries to pass the whole

of the tax amount, he will experience a more than proportionate decrease in his quantity

demanded that will lead to a significant loss of revenue.

However the loss of profitability will discourage him to continue his present levels of supply

thus he will reduce his supply.


If a supplier has an inelastic demand for his product then, he can pass a significant amount of

the tax to the consumer as a price increase will not lead to a significant reduction in quantity

demand, thus his revenue will also increase. Since he will have to pay that tax to the

government his supply will anyway reduce, as there will not be any additional revenue as a

consequence of this.

A supplier with a perfectly inelastic demand could pass the total tax to the consumer, as his

demand will not get affected.

5.2 Practical Applications of Income Elasticity of Demand

a) Long Range Planning of a Firm’s Growth.

All economies basically go through a cycle of economic boom and recession. Firms who sell

products which generates a higher income, elasticities like luxury goods will have good

growth prospects in time of economic boom and will be highly vulnerable during times of

economic recession. Similarly firms who concentrates on low income elastic goods will

survive the recession very well while they cannot be expected to grow fully in times of

economic boom.

Both types of firms indicated above needs to diversify into products, which have, high and

low income elasticities if they are to thrive during economic boom and survive during times

of recession.

b) Developing Marketing Strategies

The income elasticity of demand influences decisions on the location and the nature of sales

outlets as well as the extent and focus of advertising and promotional activities. For example,

vendors of luxury goods typically direct their advertising to rising young professionals whose

income can be expected to grow substantially.

c) Retention of the Agricultural Communities in a Country.

In recent years, it has become painfully apparent that the income of farmers growing our

foodstuff which has low income elasticities have not kept up with urban workers wages.

Since farmers cannot usually diversify into products with high income elasticities, the

country can expect to have a shortage of agricultural output in the future. Government may

therefore find it necessary to continue or increase certain farm subsidies.

d) Strategy for Giffon goods suppliers.

Giffon goods demand decreases as income levels increase in an economy. If the income

levels are on the increase an inferior goods supplier has two options.

1) Stop supplying inferior goods and start supplying non-essentials,

2) Increase quality levels and the image of the product and re-position them as normal

goods.


5.3 Practical Applications of Cross Elasticity of Demand.

The concept of cross elasticity of demand is particularly useful in two different levels of

business. At the level of the firm, cross elasticises help in the formulation of marketing

strategy. The firm needs to know how the demand for its products will react to price changes

in either substitutes or complementary goods offered by a competitor. The following are

some examples of the use of cross elasticities in the firm level.

a) Effect of Substitute (direct or non direct competition) Product Prices

A supplier should watch out for competitors who have a very high cross elasticity co-efficient

of demand with their products. If an alternative pricing or promotional strategy is not

introduced to counter attack a price reduction by the substitute product, the product concern

will loose a significant amount of market share.

Some of the measures that could be introduced are offering value for money by way of

banded offers, quantity discounts etc. Also branding one’s products will avoid competition

grabbing market share by mere price reductions, as loyalty of the consumers will remain high

due to strong branding.

Similarly when a competitor decides to increase his prices, by maintaining the same prices by

the company concern, the competitor will loose significant market share. This could only be

done if the cross elasticities of the products are known.

b) Effect of Complementary Product Prices.

Complementary product suppliers could have significant impact on a company’s demand

pattern. For example if a gas supplier decides to increase its prices significantly, the demand

for gas cookers will be reduced drastically without any change in its price. Similarly if a beer

manufacturer decides to reduce its prices the demand for beer bottles will also increase

without any change in its price.

The strategy here would be to work closely with complementary product manufactures and

offer value to the end customers.

At the industry level, the cross elasticity of demand indicates whether or not a substitute

exists for the industry’s product.

Taking all three types of elasticities into consideration, suppliers could use the concept of

elasticity to forecast their demand. Firstly the organization should calculate the cross

elasticities of demand of the competitors and complementary product manufactures. Also by

understanding the income elasticities of the target audience, and then it could determine what

kind of a price increase it requires for its product. The price elasticity of demand will then

determine the demand estimation of those products.


5.4. Practical Applications of Advertising to Sales Elasticity of Demand

In treating sales as a function of advertising expenditure, one must recognize that the

advertising budget is clouded by a number of factors such as ;

a) The stage of the product’s market development.

b) The extent to which competitors react to the company’s advertising, either with their own

advertising campaigns or by increased merchandising.

c) The quality and quantity of the company’s past and present advertising compare to that of

competitors.

d) The importance of non-advertising demand determinants, such as growth trends, prices

and income and the extent to which these can be filtered out of the analysis.

e) The time that elapses between advertising out lays and a sales response to those out lays,

which is difficult to ascertain because such intervals depend in part on the type of

product, type of advertisement etc.

f) The influence “investment effect” of the company’s past advertising and the extent to

which this may affect current and future sales through delayed and cumulative buying.

All of these factors must be considered when reckoning the sales as a function of advertising.

In order to do this, measurement methods must be devised that will allow and compensate for

the complexities just mentioned. As one might imagine this is no easy task. Indeed, it may

prove to be exceptionally difficult, but the usefulness of advertising elasticity depends on the

successful accomplishment of this task.

5. 5. Practical Applications of Elasticity of Supply

a) Excess Capacity available with a Supplier

If a manufacturer has excess capacity available with them, his supply will have an elastic

response over his existing levels of supply to a change in price as by an increase in his

variable costs he could extend its supply.

Similarly for a supplier who does not have excess capacity, his supply will be inelastic to an

increase in price close to his capacity level, as any capacity increase would lead to an

increase it their fixed costs. The lesson here is that suppliers will have to constantly plan for

capacity utilization and expansion keeping a close watch on the market trends.

b) Cost Behavior Pattern of the Supplier.

We learnt that if the average cost of the supplier falls as his output rises, his supply will be

elastic to a change in price of that product. If the average cost increases as output rises then

the supply will be inelastic to any change in price.

Under cost theory it will be discussed that until a manufacturer reaches his capacity his

average cost will decrease with an output increase and subsequently increase after the

maximum capacity point. This type of a cost behavior is an indication to the supplier about

his capacity levels and would prompt him towards capacity expansion.


c) Production Cycle.

Suppliers who have longer production cycles tend to have an inelastic supply. If a supplier

has a long cycle they could compare themselves with the industry and check their status. This

would prompt for the utilization of improved technologies thus leading to new methodologies

of production shorting the cycle further.

d) The Status of Factor Mobility of the Supplier. A supplier should always attempt to utilize his factors of production in such a way to transfer

them as required from one product to another. If this is the case, his supply will be more

elastic.

Knowing this he may be able to avoid various threats of competitor attacks on certain

products, business takeovers, and the state trying to take over business, various policy

changes in an economy, which is hostile for business (applies to multinationals) by

mobilizing his factors of production and counter attacking those threats.


a) The following are the prices and the demand for product A & B of XYZ Company

limited. Calculate the PED value for each of the products.

Product A Product B

Price (Rs) Quantity (units) Price (Rs) Quantity (units)

10 100 10 100

15 80 12 50

2 marks

b) Explain what type of a pricing strategy the company should adopt for both A and B if

the revenues are to be increased for both product lines. Explain your answer using a

numerical example. 5 marks

c) Explain what are the determinants of price elasticity of demand and its impact on the

elasticity of that product. 8 marks

d) The elasticity of a product in XYZ limited is depicted graph A. The company wants to

change its elasticity to what is shown in graph B. Advice how company XYZ could

achieve this. 5 marks

Price/Rs

Quantity

A A

B

B



Lisa has left her job and has decided to open a chain of outlets in selling garments of various

types. Having worked in the garment industry for over 10 years she is quite confident of her

ability to make this a profitable venture.

Having analyzed the market, she decided to sell designer cloths in her outlets. In order to

be confident of what type of demand levels she may had to calculate her break even

points, she carried out a pilot survey for a few sample designer items she had and the results

are as follows.

Suggested Price per Garment Likely Demand in Units (Monthly)

Rs 1000 200 units

Rs 1500 100 units

Rs 2000 50 units

Based on the above scenario, answer section i to iii

a) Assess and comment on the nature of the responsiveness of demand that Lisa may have

for her intended line of garments. Is this the ideal type of responsiveness that Lisa would

like to experience for her products?

4 marks

b) If the identified responsiveness of the demand pattern is to be influenced during a period

of time what factors should Lisa be concerned of.

4 marks

c) Suggest at least two strategies that Lisa could use to change the nature of the

responsiveness for the demand of her designer clothing line.

6 marks

d) Explain the concept of the budget line under the indifference curve analysis. What is the

purpose of this in explaining the consumer equilibrium in an organization?

6 marks

Total of 20 marks

Chapter 04 – Costs, Revenue and Profit Maximizing Rules 59

Chapter 04

Cost, Revenue and Profit Maximization Rules

1. Costs of Firms

The objective of the firm is to maximize the profits from its operations. In order to

understand how to maximize its profits, we need to understand what constitutes profits. In

order to do so we need to understand how costs and revenue behave and as a consequence

how it would affect profitability. Also in analyzing the profits, a firm will have to consider

what would be the cost and revenue behavior in the short run and in the long run.

1.1 Short Run Cost Behavior

Short run costs could be categorized into three types. They are total costs, average costs and

marginal costs.

a) Total Costs

In economics total costs would be made up of three components.

Total costs = Variable costs + fixed costs + opportunity cost.

i) Total Variable Costs

Variable costs are those costs, which fluctuate directly with the level of out put. For

example, if the variable cost per unit is Rs, 10 then let us see how the total variable costs will

behave

Units of production Total Variable Cost (Rs)

1000 10,000

2500 25,000

5000 50,000

This chapter will cover 1. Costs of Firms

1.1 Short Run Cost Behavior

1.2 Long Run Costs Behavior

1.3 Economies of Scale

2. Revenue of Firms 2.1 Total Revenue

2.2 Average Revenue

2.3 Marginal Revenue 3. Profit Maximizing

3.1 Profit Maximizing Output

3.2 Normal and Super Normal Profits


The total variable cost will increase as the level of output increases. The variable cost curve

will be as follows.

Illustration 1 –Total Variable Cost Curve

ii) Fixed Costs

Costs are costs, which would not change with the level of activity. These are one time costs.

Let us assume that in order to manufacture an item one needs a machine, which costs Rs

100,000. This is a one-time cost and let us also assume that the maximum designed capacity

of this machine is 5000 units.

Units of production Total Fixed Cost

1000 100,000

2500 100,000

5000 100,000

You may see that until 5000 units the fixed cost will not change as per the level of output.

The fixed cost curve will be as follows.

Illustration 2 – Total Fixed Cost Curve

Cost (Rs)

Output 1000 2500 5000

10,000

50,000

25,000

TVC

Output 1000 2500 5000

100,000

Cost ( Rs)

FC


Assumption – For the convenience of calculation, it is assumed that the opportunity cost of

the machine (Rs 10,000) is built into the fixed cost mentioned above. (actual fixed cost is Rs

90,000 + opportunity cost of 10,000 )

iii) Total Cost

Total cost is the addition of the total variable costs at each output level and the fixed costs.

Units of production Total Vriable Cost (Rs) Total Fixed Cost (Rs) Total Costs (Rs)

1000 10,000 100,000 110,000

2500 25,000 100,000 125,000

5000 50,000 100,000 150,000

Illustration 3 – Total Cost Curve

b) Average Cost

Average cost is the cost of producing one unit of an item. Therefore average cost is calculated

as follows.

Total cost (Rs)

Average cost =

Total Output (units)

So you may note that in the short run, the average cost will reduce until the output reaches its

capacity and after that it will start to increase. The reason why the average cost will start to

Cost ( Rs)

Output 1000 2500 5000

10,000

50,000

25,000

TVC

100,000

110,000

125,000

150,000

TFC

TC


increase above the capacity (50 units) is that as the output increases there will be break downs

in the machinery and additional costs will have to be incurred thus the average cost will tend

to increase.

‡ Activity

Draw the average cost curve in the given graph area based on the information provided in

the table

Graph Table

130 A B C

120 Output

(units)

Total

Cost

(Rs)

Average Cost

(Rs) 110

100 B / A

90 10 1100 110

80 20 1600 80

70 30 1750 58

60 40 2000 50

50 50 2500 50

40 60 3120 52

30 70 3990 57

20 80 5120 64

10

0 10 20 30 40 50 60 70 80 90 100

c) Marginal Cost

Marginal cost is the additional cost incurred in producing an additional unit of out put.

Therefore marginal cost is calculated as follows.

∆ Total Cost (Rs)

Marginal cost =

∆ Total Output (units)

You will also see that marginal cost curve would reduce gradually and will increase as the

output increase

Average

Cost

(Rs)

Output


‡ Activity

Draw the marginal cost curve in the given graph area based on the information provided in

the table

Graph Table

130 A B C

120 Output

(units)

Total

Cost

(Rs)

Marginal Cost

(Rs) 110

100 ∆ B / ∆ A

90 10 1100

80 20 1600 50

70 30 1750 15

60 40 2000 25

50 50 2500 50

40 60 3120 62

30 70 3990 87

20 80 5120 113

10

0 10 20 30 40 50 60 70 80 90 100

d) Relationship between Marginal Cost Curve and the Average Cost Curve

‡ Activity

Draw both the marginal cost and the average cost curves in the given graph area based on

the information provided in the table.

Graph Table

130 A B C D

120 Output

(units)

Total Cost

(Rs)

Average

Cost

Marginal

Cost 110

100

90 10 1100 110

80 20 1600 80 50

70 30 1750 58 15

60 40 2000 50 25

50 50 2500 50 50

40 60 3120 52 62

30 70 3990 57 87

20 80 5120 64 113

10

0 10 20 30 40 50 60 70 80 90 100

Marginal

Cost

(Rs)

Output

Marginal

/Average

Cost

(Rs)

Output


As per the drawing you will see that the marginal cost curve will cut the average cost curve at

its lowest point. The lowest point of the average cost curve is when the output is 50 units. We

said earlier that the capacity of the machine was 50 units. So the following observations could

be made

• Below capacity (that is below 50 units of output) AC>MC. What this means is that below

the capacity level, the cost of manufacturing an additional unit is less that the average cost

of its product.

• At the capacity (that is 50 units of output) AC=MC What this means is that the cost of

manufacturing an additional unit is equal to the average cost of its product.

• Above capacity (above 50 units of output) AC<MC. What this means is that the cost of

manufacturing an additional unit is higher than the average cost of the product.

RULE 01 - Related to Cost Relationships

Marginal cost curve will cut through the lowest point of the average cost curve.

Point to remember – When drawing both AC and the MC curves remember the above rule 01

1.2 Long Run Cost Behavior

The long run cost curve is drawn by connecting the lowest points of the short run average

cost curves. In the long run there are no fixed costs. All costs are variable.

Illustration 4 – Long Run Cost Behavior

LAC – long run cost curve

SAC – short run cost curves

Cost (Rs)

Out Put

Each

represents

one plant/

machine

LAC is falling

Economies of scale LAC is constant LAC is increasing

Diseconomies of scale

SAC1

SAC2

SAC3

SAC4

SAC5

SAC6

SAC7

LAC


1.3 Economies of Scale

The concept of economies of scale is a result of the behavior of the long run cost curve. What

economies of scales concept basically says is that as a company continues to manufacture

products in mass scale the unit cost of the products will decrease. Let us see the different

types of economies of scales available for a firm

a) Financial Economies of Scales

Example One

Large scale production Bulk purchases Bulk discounts

Reduction in total purchase cost Per unit purchase cost reduction

Example Two

Large firms who produces in large volumes Loans at lower interest rates

Reduce capital costs Reduction in per unit cost.

b) Managerial Economies of Scales

Large-scale firms can afford employees with better skills leading to better productivity in

their performance and decision-making allowing reduction in overall costs. This would lead

to managerial economies of scales.

c) Technical Economies of Scales

A machine, which can manufacture 10,000 units, would not cost double as a machine, which

can manufacture 5,000 units. Buying larger machines the firm can produce higher volumes at

lesser capital costs achieving economies of scales.

d) Research and Development Economies of Scales

When a firm manufactures in larger volumes, the % of sales that it can invest in R&D is

higher leading to innovative methods of production, lowering the overall reduction in costs.

This will contribute towards achieving economies of scales.

Diseconomies of Scale

You will also notice that after a while the LAC will be constant and will begin to rise. This

will indicate an over trading situation in the firm. That is selling units which it cannot handle.

The reason why the LAC tends to increase would be due to the following reasons.


a) The number of times the plant breaks down will be higher due to over capacity and

down time will add to increase in costs

b) The machine repair and maintenance costs will increase

c) The management will try to exploit its employees to increase production and

relationships will break down. Low levels of motivation will bring the output down.

2. Revenue of Firms

2.1 Total Revenue

Total revenue is the value of total goods sold.

Total revenue = quantity sold x unit selling price

2.2 Average Revenue

Total Revenue (Rs)

Average revenue =

Total quantity sold ( units)

For example if the total revenue is Rs 100,000 and the total quantity sold is 10,000 units then

average revenue is Rs 10.

Average Revenue = Unit Price

Total revenue = Quantity sold x unit price

Total Revenue (Rs)

Unit price =

Total quantity sold ( units)

For example if the total revenue is Rs 100,000 and the total quantity sold is 10,000 units then

the unit price is Rs 10.

† Key Concepts

In calculating revenue the firm will have to look at it based on the market condition that it

faces. In economics there are two basic market conditions. 1) Perfectly Competitive Market Conditions

A situation where there are large number of buyers and sellers in the market place. The

market price is determined based on the total demand and supply situation. Each buyer or

seller will have only a negligible amount of influence towards the price on its own. So in a

perfectly competitive market, price cannot be altered and at the given price quantity

demanded would vary to any extent. This will be similar to the perfectly elastic demand


situation. So the demand curve would be horizontal to the x-axis. 2) Imperfect Markets

All practical markets are imperfect. That is market prices are determined based o demand

and supply levels and at different prices different quantities would be demanded. The

demand curve in an imperfect market would be downward sloping as in normal terms.

Average Revenue Curves

Let us try to draw the average revenue curve in a both perfectly competitive market and in an

imperfect market. ‡ Activity

Based on the data presented in the below tables draw the demand curve and the average

revenue curves for both market situations and attempt to understand their relationships

Perfectly Competitive Market Imperfect Market

Unit

price

Quantity Total

revenue

Average

revenue

Unit

price

Quantity Total

revenue

Average

revenue

TR/Qty TR/Qty

10 60 600 10 10 60 600 10

10 40 400 10 20 40 800 20

10 20 200 10 30 20 600 30

Pri

ce /

Av

erag

e re

ven

ue

Pri

ce /

Av

erag

e re

ven

ue

15 30

10 20

5 10

0 0

10 20 30 40 50 60 70 80 90 10 20 30 40 50 60 70 80 90

Conclusion - AR=Demand curve AR=Demand curve

You will see that the average revenue curve is the same as the demand curve.

2.3 Marginal Revenue


Marginal revenue is the additional revenue obtained by selling an additional unit of a product.

It is calculated as follows

∆ Total Revenue (Rs)

Marginal Revenue =

∆ Quantity sold ( units)

Marginal Revenue Curves

‡ Activity

Based on the data presented in the below tables draw the demand curve, average revenue

curves and marginal revenue curves for both market situations and attempt to understand

their relationships


Unit

price/

AR

Quantity Total

revenue

Marginal

revenue

Unit

price/

AR

Quantity Total

revenue

Marginal

revenue

∆TR/∆Qty ∆TR/∆Qty

10 60 600 10 10 60 600

10 40 400 10 12 40 480 6

10 20 200 10 14 20 280 10

Pri

ce /

Av

erag

e /M

arg

inal

Rev

en

ue

Pri

ce /

Av

erag

e /M

arg

inal

Rev

en

ue

15 30

10 20

5 10

0 0

10 20 30 40 50 60 70 80 90 10 20 30 40 50 60 70 80 90

Conclusion - AR=Demand Curve=MR AR=Demand Curve AR=Demand Curve > MR

RULE 02 - Related to Revenue Relationships

Rule 2A – In the Perfectly Competitive Market, AR=Demand Curve=MR

Rule 2B – In the Imperfect Markets, AR=Demand Curve and the Marginal Revenue Curve is

½ of the slope of the AR curve.


3. Profit Maximizing

3.1 Profit Maximizing Output

‡ Activity

In order to understand the profit maximizing rules fill in columns 3,4,5,7,8 and 9 as per the

instructions given in the decimal places.

1 2 3 4 5 6 7 8 9

Out put Price TR AR MR

TC AC MC Profits

1 x 2 3/1 ∆ 3/∆ 1 6/1 ∆ 6/∆ 1 3-6

1 510 720.00

2 470 800.50

3 430 860.20

4 400 885.70

5 370 1010.20

6 340 1200.00

7 310 1400.00

8 290 1585.00

9 260 1678.50

10 230 1981.50

Answer in no of

decimal points 1 1 1 1 1 2

Conclusions that you can arrive from the above table.

Profit is maximized at when the firm manufactures 6 units. So profit maximizing out put is 6

units.

At the profit maximizing output MR = MC. In other words Marginal Revenue = Marginal

Cost.

So one could conclude saying that Profit maximizing output is where MR=MC.In a firm the

profit is maximized when marginal revenue is equal to the marginal cost.

RULE 03 - Profit Maximizing Rules

Profit maximizing output would be where MR = MC


.

‡ Activity - Profit Maximizing Output Graphically

Apply Rules 1,2A,3 and draw the below

Apply Rules 1,2B,3 and draw the below


3.2 Normal Profits and Supernormal Profits at the Profit Maximizing Output

a) Normal Profits

Normal profits are when all factor costs (rent, wages, interest and profits ) are covered by the

revenue earned by the firm. Let us see an example.

Total Revenue (1,000 @ Rs100) Rs.100,000 Average Revenue (AR) = 100

Minus - Factor Costs

Land – rent Rs 20,000

Labour – wages Rs 50,000

Capital – interest Rs 10,000

Entrepreneurship - Profits Rs 20,000

Total Factor Cost Rs 100,000 Average cost (AC) = 100

Excess/(Deficit) 0 AR = AC

Normal Profits = AR=AC

Price/

AR/AC/

MC/MR

Price/

AR/AC/

MC/MR

Output Output

AR=MR=D

MR

AR=D

AC MC AC MC

MR=MC

MR=MC

Q

Profit

Maximum

Output

Profit

Maximum

Output

Q


So we see a firm achieves normal profits when AR=AC. In other words its average revenue

will be equal to average cost. The reason why it is called normal profits is that it only

contains the normal profit paid to the entrepreneur.

b) Supernormal Profits

Supernormal profits are when the revenue earned by a firm exceeds all factor costs ( rent ,

wages, interest and profits ) incurred by the organization. Let us see an example.

Total Revenue ( 1,000 @ Rs150) Rs.150,000 Average Revenue (AR) = 150

Minus - Factor Costs

Land – rent Rs 20,000

Labour – wages Rs 50,000

Capital – interest Rs 10,000

Entrepreneurship - Profits Rs 20,000

Total Factor Cost Rs 100,000 Average cost (AC) = 100

Excess/(Deficit) Rs 50,000 AR > AC

Supernormal Profits = AR >AC

So we see a firm achieves supernormal profits when AR>AC. In other words its average

revenue is more than average cost.

RULE 04 - Nature of Profits at the Profit Maximizing Output

Rule 4A - Normal Profits would be where an organizations AR=AC

Rule 4 B - Supernormal profits would be earned by an organization when it AR>AC.

‡ Activity – Normal Profits Graphically

Apply Rules 1,2A,3 and 4A to draw the

diagram

Apply Rules 1,2B,3 and 4A to draw the

diagram


Price/

AR/AC/

MC/MR

Price/

AR/AC/

MC/MR

Output


‡ Activity – Supernormal Profits Graphically

Apply Rules 1,2A,3 and 4B to draw the

diagram

Apply Rules 1,2B,3 and 4B to draw the

diagram


Answer to Activity 3.1

1 2 3 4 5 6 7 8 9

Out put Price TR AR MR

TC AC MC Profits

1 x 2 3/1 ∆ 3/∆ 1 6/1 ∆ 6/∆ 1 3-6

1 510 510 510 510 720.00 720 720 -210.00

2 470 940 470 430 800.50 400 81 139.50

3 430 1290 430 350 860.20 287 60 429.80

4 400 1600 400 310 885.70 221 26 714.30

5 370 1850 370 250 1010.20 202 125 839.80

6 340 2040 340 190 1200.00 200 190 840.00

7 310 2170 310 130 1400.00 200 200 770.00

8 290 2320 290 150 1585.00 198 185 735.00

Output

Price/

AR/AC/

MC/MR

Price/

AR/AC/

MC/MR

Output Output


9 260 2340 260 20 1678.50 187 94 661.50

10 230 2300 230 -40 1981.50 198 303 318.50


For each of the following statements state clearly whether it is TRUE or FALSE. Explain

with numericals whenever it is relevant.

I. Opportunity cost is not considered in economics when calculating total costs.

II. In the short run fixed costs does not change with the level of activity. But average

fixed cost is said to decrease as production increases in the short run

III. Average cost will increase as production increases up to the designated capacity of a

machine and will decrease after that point.

IV. The marginal cost curve cuts through the lowest point of the average cost curve. Any

point before this point is a situation where the cost of manufacturing an additional unit

is less than the average cost of its product.

V. Economies of scales is a result of the short run cost behavior of a firm

VI. Average revenue is the same as the unit price of the product

VII. In a perfectly competitive market Average revenue > demand curve

VIII. In a perfectly competitive market Average revenue = marginal revenue = demand

curve

IX. Normal profit is a situation where AR>AC

X. Supernormal profit is a situation where AR>MC

( 2 marks x 10 = Total of 20 marks )

♪ My Short Notes


♪ My Short Notes


Chapter 05

Market Structures

1. Market Structure Classification

An industry is defined as a collection of firms producing the same or similar products. It is a

group of competitors producing products that compete directly with each other.

In economic theory, the motive of a firm is said to be profit maximization. Profit is the

difference between revenue and cost. Pricing which can affect the revenue and profits of the

firm depends partly on the market structure in which the firm operates.

Typically market structures could be classified based on the following criteria.

a) Number of firms in the industry

b) Nature of the product

c) Freedom to entry

The following table will give you a summary of how the above variables could lead to the

classification of different market structures.

Illustration 01 – Market Structure Classifications

Criteria Perfect

Competition

Monopolistic

competition

Oligopoly Monopoly

Number of

firms

Extremely Large

Amount

Many Few One

Nature of the

product

Homogeneous Differentiated

(Branded)

Homogeneous

or differentiated

Standardized

Freedom of

entry

No entry

barriers

No entry

barriers

Entry Barriers Entry barriers


1. Market Structure Classification

2. Perfectly Competitive Market Structure

3. Monopoly Market Structure

4. Monopolistic Competitive Market Structure.

5. Oligopoly Market Structure

6. Marketing Implications of Market Structures


Based on the above, the following are typical market structures as identified in economic

theory.

a) Perfectly competitive market structure

b) Monopoly market structure

c) Monopolistic competitive market structure

d) Oligopoly market structure

Perfect competition is said to be a perfect market situation where the rest is said to be under

imperfect market conditions.

2. Perfectly Competitive Market Structure

2.1 Features of the Perfectly Competitive Market Structure

a) There are large number of buyers and sellers

• Total market demand and total market supply will determine the market price.

• Single supplier or a buyer has a negligible proportion of the total supply or

demand.

• Therefore a single buyer or a seller cannot influence market price (demand curve

is perfectly elastic)

• The suppliers are price takers because they cannot influence price thus they accept

it.

b) Homogeneity of products

• The products are perfect substitutes in quality, utility and dimensions.

• So if one producer increases his price, consumers will totally ignore him (loss of

total demand) as the exact product could be bought at a lower price from another

supplier.

c) Free entrance and exit to the market.

• No barriers to enter the market

• If a producer has access to factors of production they can enter a market.

d) Availability of perfect information in the market.

e) Free transferability of factors of production – a supplier can change his production

from one to another without a problem.

f) No government intervention to the free market activities.

2.2 Profitability of the Market

In understanding the profitability of this market, short run and long run profitability has to be

considered separately.


a) Short Run Profitability

Illustration 02 – Short run Profitability of the Perfectly Competitive Market Structure

Market Firm

The firm will obtain supernormal profits in the short run.

b) Long Run Profitability

Illustration 03 – Long run Profitability of the Perfectly Competitive Market Structure

Market Firm

Price/

AR/AC/

MC/MR

Output

Price

Output

Market supply

curve

Market

demand

curve

P1

AC MC

AR=MR=D

Q

AC

AR

Supernormal

Profits

Price/

AR/AC/

MC/MR

Output

Price

Output

Market supply

curve

Market

demand

curve

P1

AC MC

AR=MR=D

Q

AR= AC

Normal Profits

P2


Other firms seeing supernormal profits in the short run would start to enter the industry in the

long run as there are no barriers to enter the market. This means an increase in supply in the

market. As a consequence of this, the market price would go down (Increase in supply and no

change in demand). This would erode the super normal profits earned by the firm in the short

run and in the long run the firm will only earn normal profits.

2.3 Practically of the Perfectly Competitive Market

Perfectly Competitive market is not a practical market. The reasons are as follows

a) It is said that there are a large number of buyers and sellers in this market not

allowing one single buyer or seller to influence the market. In reality this is not true.

There would always be single suppliers and buyers who could influence the market

b) The assumption of homogeneity of products is also not practical as there would be

some form of a variation in any product not making them perfect substitutes

c) The above two will challenge the concept of a price taker.

d) The assumption of no barriers to entry and exit is also not practical as in the real

world there will be some form of barriers to entry and exit

e) Availability of perfect information is not true in any practical market. This

assumption itself will undermine the entire theoretical base of this market structure.

f) Free transferability of factors of production is not possible in any practical market as

there will be some form of an opportunity cost.

3. Monopoly Market Structure

3.1 Features of the Monopoly Market Structure

a) There is only one supplier in the market. The supplier and the industry is one. Under

this situation

• The supplier is a price maker.

• It should be stated that a monopoly could only control either the price or the

market quantity at one time.

• By controlling the price it will determine the market quantity or by controlling

market quantity it will determine market price.

b) No homogeneous products – There are no other suppliers supplying products, which

are near substitutes to the product of the monopoly supplier.

c) Barriers to entry are created. They are created either by large capital investments,

technology, through price reductions or by other unethical barriers such as destroying

competition etc.


3.2 Profitability of the Market Structure a) Short and Long Run Profitability.

Illustration 04 – Short run and Long run Profitability of the Monopoly Market Structure

In the short run, the monopoly market will earn supernormal profits. In the long run also it

will continue to earn supernormal profits, as there are barriers to entry. Due to lack of

competition, ability to increase prices and the relatively inelastic nature of its demand, it will

continue to earn this supernormal profit.

3.3 Advantages of the Monopoly Market Structure

a) It irradiates the waste incurred in resources due to intense competition

b) Gives the supplier the ability to produce in mass scale allowing enjoying economies

of scales.

c) It allows the organization to stand competition from a foreign competitor as it controls

the entire local market

d) The organization would be able to enhance quality of life in society through its

facilities and its operations due to the vast resource base that it tends to collect over a

period of time.

3.4 Disadvantages of the Monopoly Market Structure

a) Due to lack of competition there would be less consumer choice. This may bring

down the standard of living

b) It could increase prices arbitrarily and could exploit the customers

c) It could practice discriminating pricing policies and discriminate customers.

Price/

AR/AC/

MC/MR

Out put

AR=D MR

AC

MC

Q

AC

AR

Supernormal

Profits


3.5 Causes of Monopolies

a) Through trademarks, patents a firm can become a monopoly.

b) Provision of essential goods, which may be disrupted if supplied under competitive

conditions, the government, could create a monopoly. Ex Ceylon Petroleum,

Railways, electricity etc.

c) Monopolies could emerge due to horizontal and vertical mergers and acquisitions.

d) Industries, which require large sums of capital, will be restricted to monopolies.

‡ Activity

List down firms which operate in a Monopoly Market Structures in Sri Lanka

• ________________________________________________

• ________________________________________________

• ________________________________________________

• ________________________________________________

• ________________________________________________

• ________________________________________________

• ________________________________________________

• ________________________________________________

3.6 Practice of Price Discriminating under Monopoly Markets

The monopoly markets will have greater opportunities in practicing price discrimination. This

is a situation where the firm charges different prices in different markets. In order to practice

price discrimination the following criteria should be available

a) The two markets will have to be different from each other in terms of

� Distance – The two markets will have to be geographically distant otherwise products

will be bought from the low priced market and will be sold in the high price markets.

Distance will also deprive knowledge of the existence of price discrimination. Also

transport costs will have to be higher to avoid transferring of products between the

markets.

� Age – This is also a good criterion for discriminating pricing. Cinema tickets could be

a good example.

� Time – Off peak hours and peak hour rates is a good price discrimination example of

time.

� Consumer ignorance – Non-availability of perfect information in practical markets

will lead to practice price discrimination.

b) Different price elasticities in different markets

If two markets have two types of price elasticities, price discrimination could be effectively

practiced. This will allow firms to achieve an overall higher level of profits.


4. Monopolistic Competitive Market Structure

This market portrait features of a monopoly and a perfectly competitive market.

4.1 Features of this Market

a) Large number of buyers and sellers. – There is competition in the market. Price cuts as

well as other forms of promotion are seen. Market share could be increased only at the

expense of competitor share. Demand curve tends to be elastic in this market.

b) Free entrance and exit (no barriers to entry)

c) Products are differentiated - products are differentiated in terms of quality, brand or

packaging. One firm will lead the market. He will become a price maker. ‡ Activity

List down firms which operate in a Monopolistic Market Structures in Sri Lanka

• ________________________________________________

• ________________________________________________

• ________________________________________________

• ________________________________________________

• ________________________________________________

• ________________________________________________

• ________________________________________________

• ________________________________________________

4.2 Profitability of the Market a) Short Run Profitability

Illustration 05 – Short run Profitability of the Monopolistic Competitive Market Structure

Perfect competition Monopolistic

competition Monopoly

Price/

AR/AC/

MC/MR

Out put

AR=D MR

AC

MC

Q

AC

AR

Supernormal

Profits


Super normal profits will be earned in the short run. The reason being that due to product

differentiation, a firm could charge different prices based on the extent they have branded

their products. b) Long Run Profitability Illustration 06 – Long run Profitability of the Perfectly Competitive Market Structure

In the long run the monopolistic firm will achieve only normal profits. The reasons being that

due to free entrance, new firms will enter the market seeing supernormal profits in the short

run. This will cause a reduction in market share, which will trigger intense competition. The

overall costs in the firm will increase due to higher advertising and promotional battles

leading to normal profits.

The monopolistic market is said to be “Productively Inefficient” in the long run. You may

see that the profit maximizing output (Q is where MC=MR) is very much lower than the

available capacity in the market. Which means that the firm is operating at a lesser capacity

than it actually could in maximizing its profits (MC=MR)

5. Oligopoly Market Structure This is a market structure where a few number of large scale firms operate in the industry.

5.1 Features of this Market

a) Only a few number of firms in the industry

b) They produce in large scale

c) Most of them use modern technology

d) One firm is aware of what the other is trying to do

Price/

AR/AC/

MC/MR

Output

AR=D MR

AC MC

Q

AR= AC

Normal

Profits


e) Firms are interdependent on each other

f) Firms may either produce homogeneous or differentiated products

g) There are entry barriers to the market.

h) Firms try to avoid price competition as much as possible. Price competition would

lead to lowering of profits in the entire industry due to the kinked demanded curve in

this market

i) Rely on non price competitive methods such as advertising, sales promotions, product

features, better after sales service, better guarantees, free demonstrations and easy

payment terms etc.

5.2 The Kinked Demand Curve in the Oligopoly Market Structure

Illustration 07 –Kinked Demand Curve in the Oligopoly Market Structure

The kinked demand curve combines two types of elasticies of demand. Let us try to

understand how this would happen in the oligopoly market.

At point A, the market price is Rs 9 and quantity demanded is at 100. The revenue the firm

would get at this point is Rs 900.

If the firm decides to increase its price to Rs 12 the rest of the firms will NOT follow. Due to

this reaction from the competitors when the firm increases its prices it will loose its quantity

demanded more than proportionally indicating an elastic demand situation. You will see this

at Point B when the price is increased to Rs 12, quantity demanded will come down to 60

reducing the firm’s income to Rs.750

If the firm reduces its price to Rs 8, then all other firms will follow as otherwise they will

loose market share. Due to the price reduction, the quantity increases will be less than

proportionate indicating an inelastic demand situation. The revenue the firm would earn

would once again be down to Rs 880.

Price

Demand

9.00

10060

12.00

110

8.00

A = Rs 900

B = Rs 750

C = Rs 880


Based on the above discussion, at point A, where the demand curve meets the elastic and an

inelastic points, firms would attempt to maintain its prices as in any other point (above or

below this point), the firm will be loosing revenue. We call this situation price collusion

agreement or existence of price rigidity. Any point above the kinked point of the demand

curve, demand will be elastic and below the point it would be inelastic

Due to the above reason, oligopoly markets will try to avoid competing on price and will

resort to non-price competition.

‡ Activity

List down firms which operate in a Oligopoly Market Structures in Sri Lanka

• _______________________________________________

• _______________________________________________

• _______________________________________________

• _______________________________________________

• _______________________________________________

• _______________________________________________

• _______________________________________________

• _______________________________________________

5.3 Profitability of this Market Structure

Illustration 08 – Short run and Long run Profitability of the Oligopoly Market Structure

As you may see that in the oligopoly market, profit maximizing out put is at the market price

where the demand curve is at its kinked point. This would be true for the short and long term

as well.

Price/

MR/MC/

AR/AC

Demand Q

MR

AR=D

AC

MC

AC

AR

Supernormal

Profits


6. Marketing Implications of Market Structures

Market structures would have a significant impact on the way in which a marketer can

operate in gaining competitive advantage. The marketing mix variables will have to be

handled differently to handle different market conditions. The success of the marketing

operations will depend on how successful a marketer will be able to identify these different

market situations and adopt the marketing mix variables to effectively compete.

‡ Activity

Identify how the marketing mix variables could be utilized to support different market

structures as indicated below

Marketing

aspects

Perfectly

Competitive

Market Structure

Monopoly

Market Structure

Monopolistic

Competitive

Market Structure

Oligopoly

Market Structure

Product Mix

Decisions

Pricing Related

Decisions

Promotional

Mix Design

Distribution

Strategy

People related

issues

Process related

issues

Physical

Evidence

related issues


♪ My Short Notes


Chapter 06

Utility Theory and Household Equilibrium

1. Understanding Utility 1.1 Definition

Utility in economic terms means the satisfaction a consumer derives when consuming a

product (good or a service). This is an important concept as these deals with consumer

behavior. There are some unique characteristics about how a consumer gains satisfaction and

from an economic sense one will have to understand these phenomena.

1.2 Types of Utilities a Consumer can Experience.

• Form utility – Utility experienced by changing the form of a resource. In order to do

this one will have to be engaged in production. Example would be, buying cloth and

getting a suit or a dress done

• Place utility – Utility derived by having products at the place where the customer

wants it. Through distribution this is achieved.

• Time utility - Utility derived by having the products at the right time when it is

required. Achieved through storage.

• Possession utility – Utility gained by possessing something. Achieved through

trading.

A unit called UTILES measures utility.

2. Concepts of Utility

2.1 Total Utility

This is the total satisfaction derived by consuming the total units of a product.

2.2 Marginal Utility

The additional utility gained by consuming an additional unit of a product. In other words the

change in total utility when consumption changes by one unit. Marginal utility is calculated

as

This chapter will cover 1. Understanding Utility

2. Concepts of Utility

3. Household Preferences

4. Household Budget Line

5. Household Equilibrium

6. Household Equilibrium and Marketing Decision Making


∆ Total utility

Marginal utility =

∆ Quantity

2.3 Diminishing Marginal Utility

The utility that any consumer derives from SUCCESSIVE units of a particular product

diminishes as total consumption of the product increases while the consumption of all other

products remains constant. Illustration 01 will indicate an example of how the utility of

consuming 10 glasses of milk changes.

Illustration 01 – Diminishing Marginal Utility

Glasses of milk

consumed per

day

Total utility

( in Utiles)

Marginal utility

(in Utiles)

0 0

1 15 15 (15-0)/(1-0)

2 27 12 (27-15)/(2-1)

3 37 10 (37-27)/(3-2)

4 45 8 (45-37)/(4-3)

5 51 6 (51-45)/(5-4)

6 55 4 (55-51)/(6-5)

7 57 2 (57-55)/(7-6)

8 57 0 (57-57)/(8-7)

9 55 -2 (55-57)/(9-8)

10 51 -4 (51-55)/(10-9)

Assumptions made for the diminishing marginal utility concept

1) There is no time gap between consumption

2) The mental condition of the consumer is constant

3) Nothing is done to make the product more tastier or any other additions done during

consumption

Diminishing

Marginal

utility

Total Utility Curve

Quantity

To

tal

Uti

lity

Marginal Utility Curve

Mar

gin

al U

tili

ty

Quantity


3. Household Preferences 3.1 Indifference Curve Analysis a) Indifference curves are based on two Axioms

1) Non Satiation – In case of desirable goods, more is preferred to less

2) Ordering

A > B

A < B

A = B (indifferent)

Based on the above two axioms, the indifference curves could be constructed.

b) Constructing the Indifference Curve

Illustration 02 – Basis of drawing the Indifference Curve

Explanation of the points of the curve based on the different points of the graph;

Quadrant Point X Y Explanation

Original A 200 200

I D 100 100 A is preferred to D (Axiom 01)

III G 300 300 G is preferred to A (Axiom 01)

II K 100 300 - ∆ x = + ∆ y (Axiom 02)

Utility dropped in X of 100 = Utility gained in Y

of 100. The consumer is indifferent between A &

K

IV J 300 100 + ∆ x = - ∆ y (Axiom 02)

Utility dropped in Y of 100 = Utility gained in X

of 100. The consumer is indifferent between A & J

Utility of

consuming

Y

Utility of

consuming

X

200

100

300

200 300 100

K G

D J

Quadrant II Quadrant III

Quadrant I Quadrant IV

A

- ∆ Y 100

+ ∆ X 100

- ∆ X 100

+ ∆ Y 100


Indifference curves are built on two axioms (rules) which states that;

i) Non Satiation

This axiom states that in terms of goods which are desired by individuals, more will be

preferred to less. Based on this condition, the bundle of goods consumed at point A (200 of X

and 200 of Y) will be superior to bundle of goods consumed at point D (100 of X and 100 of

Y – see quadrant 01). On the same axiom, the bundle of goods consumed at point G (300 of

X and 300 of Y – see quadrant 03) will be superior than point A. Based on this, a consumer

who is at Point A will not be motivated to move to point D. However the consumer would

prefer point G to point A.

ii) Ordering

This axiom essentially states that when the utility from one item increase while the utility of

the other reduces (assuming that both provide the same utility), the consumer will be

indifferent between whatever the combination of those products consumed.

When the consumer moves from point A to point J (Quadrant IV), the consumer looses 100

utiles from Y but gains 100 utiles from X. By this the consumer would be indifferent between

point A and J.

Similarly when the consumer moves to point K from point A, (Quadrant II), the consumer

will loose 100 utiles from X and will gain 100 utiles from Y. Once again the consumer will

be indifferent between point A and point K.

Therefore the indifference curve is drawn by connecting points K, A and J as illustrated in

Illustration 03. The customer is indifferent at any point of the curve.

Illustration 03 –Drawing the Indifference Curve

Utility of

consuming

Y

Utility of

consuming

X

200

100

300

200 300 100

K G

D J

Quadrant II Quadrant III

Quadrant I Quadrant IV

A

Indifference

Curve


Indifference Curve – A curve showing all combinations of goods that yield equal satisfaction

to the customer. In general an indifference curve shows combinations of commodities that

yield the same satisfaction to the households. The household is indifferent between the

combinations indicated by any two points on one indifference curve. c) Indifference Map

• A collection of indifference curves.

• Indifference curves further away from the origin indicates a higher level of satisfaction

than curves closer to the origin.

Illustration 04 –Indifference Map

Properties of the Indifference Map;

• There can be any number of indifference curves referring to different levels of utility.

• All indifference curves are downward sloping and convex to the origin.

• Density property – at any point in the map there has to be a indifference curve.

• In the indifference map, two indifference curves cannot intercept.

• If two curves intercept, then there is a contradiction.

d) Marginal Rate of Substitution (MRS)

i) Definition

The rate at which one product is substituted for another with utility held constant. In other

words graphically, it is the slope of the indifference curve.

Utility of

consuming

Y

Utility of

consuming X

U1

U2

U3

U4


ii) Calculating the Marginal Rate of Substitution

∆ Y

Marginal Rate of Substitution

∆ X

Change in Y Change in X MRS

-12 5 2.4

- 5 5 1

- 3 5 0.6

-2 5 0.4

Illustration 05 – Marginal Rate of Substitution Graphically

iii) Diminishing Marginal Rate of Substitution The hypothesis that less of one commodity being consumed, the less willing would be the

consumer to obtain an additional unit of a second commodity. In other words the diminishing

slope of the indifference curve.

This concept would support marketers in influencing consumers in the buyer behavior

process in order to increase purchase frequency of a bundle of goods.

4. Household Budget Line

The budget line shows all those combinations of the goods that are just obtainable, given the

household’s income and the prices of the commodities that it buys. The household budget

line is a subject of constrain maximization. Consumers maximize their satisfaction subject to

certain constraints.

∆ Y

∆ Y

∆ X ∆ X


Points of constrains are;

• Consumer Income.

• Prices of two goods.

Assumption: Consumers spend their entire income in buying a bundle or a combination of

two commodities

The budget line shows all those combinations that are just obtainable given a household

income and the prices of all commodities. The household budget line could be shown as a

formula as well as graphically.

a) Formula to indicate the Budget Line

M = Py * Y + Px * X

M = Consumer income

Py = Price of commodity y

Y = Quantity of Y that could be purchased

Px = Price of commodity x

X = Quantity of X that could be purchased

b) Graphical Illustration of the Household Budget Line

Illustration 06 – Household Budget Line

One may note that at point A, the bundle of goods cannot be purchased by the households

given the household income and the prices of the goods. Thus a point outside the budget line

is a combination that the households cannot obtain.

Y

M/Py

X

M/Px

Household Budget Line - those

combinations that are just

obtainable

A

Unable to purchase given the

household income and prices

B

Households not spending the

entire income


c) Slope of the Budget Line

The slope of the budget line indicates the opportunity cost of purchasing one item against the

other in the commodity bundle. An increase in one price may deprive the household to

purchase less of that item or if to maintain the same quantity, then less of the other product

could be purchased.

The slope of the budget line will depend on the prices of the two commodities that are

purchased. It is calculated as;

Px

Slope of the budget line

Py

5. Household Equilibrium

The household seeks to maximize its satisfaction by reaching the highest possible

indifference curve in a given indifference map. However the budget line indicates the

constrain the household faces in selecting a bundle of consumption of the two products.

Therefore the household would seek to maximize satisfaction given the budget constrain.

Household equilibrium is where the consumer maximizes his utility subject to the budget

constrain. Satisfaction is maximized at the point where an indifference curve is tangent to a

budget line. At that point, the slope of the indifference curve (MRS) is equal to the budget

line. The household equilibrium could be shown both graphically and also as a formula.

5.1 Household Equilibrium Graphically. Illustration 07 – Household Equilibrium

Utility of

consuming

Y

Utility of

consuming

X

U1

U2

U3

A

B

C

D

E


5.2 Household Equilibrium as a Formula.

Point Marginal Rate of

Substitution (MRS)

Relationship Slope of the Budget

Line

Comment

A MRS > Px/Py

B MRS > Px/Py

C MRS = Px/Py Household Equilibrium

D MRS < Px/Py

E MRS < Px/Py

As per the above table, household equilibrium sets when MRS = Px/Py. In other words this is

the point where the households reach the highest level of satisfaction within the indifference

maps, given the constrains of consumer income and prices of the two commodities.

5.3 Change in the Household Equilibrium with the changes in the Budget Line.

Household equilibrium will change given any change in the budget line of a household. This

change can happen in two forms.

a) Change in Consumer Income

A change in the household income will lead to the entire budget line to shift. An increase in

the income will lead the budget line to shift outwards. At this point the bundle of goods that

could be purchased by the household will increase allowing the household to reach a higher

level of utility. A decrease in income will lead the budget line to shift inside. At this point the

bundle of goods that could be purchased by the household will decrease leading to a decrease

in utility. Graphically it could be shown as follows.

Illustration 08 – Shift in the Budget Line and Change in Household Equilibrium

Utility of

consuming

Y

Utility of

consuming

X

U1

U2


b) Change in Prices of One Commodity

A reduction in the prices of one commodity will put the consumer to a higher indifference

curve for that product and will also increase the amount of items that could be purchased. The

opposite will happen in the case of a price increase.

The above could be shown graphically as follows.

Illustration 09 – Change in Price of One Commodity and Change in Household

Equilibrium

`

A reduction in price of commodity X has put the household to the U2 indifference curve from

the original state of U1. Similarly the opposite could occur in the case of a price increase of

X. The same scenario could be applied to any of the two products of the commodity mix.

6. Household Equilibrium and Marketing Decision Making

The above concepts would allow a marketer to work on valuable clues in influencing the

behavior of consumers. The following activity would help in synthesizing and relating the

concepts related to household equilibrium in understanding its impact on marketing decision

making.

‡ Activity

Identify how marketing activities could be aligned based on the learning’s of the below

mentioned concepts;

Utility of

consuming

Y

Utility of

consuming

X

U1

U2


Concept Implications to Marketing Activities

Diminishing Marginal

Utility Concept.

Diminishing Marginal Utility

occurs due to habituation

taking place in reacting to a

relevant marketing mix. How

could a marketer reduce

habituation among

consumers and reduce

diminishing marginal utility

in purchasing and consuming

a product?

Consumer Indifference

(Deriving from the

Indifference Curves)

This concept indicates that

consumers are indifferent

between certain bundles of

commodities. How does this

concept help marketers in

devising their marketing mix

with particular reference to

product mix and

promotional mix decisions?

Budget Line

How does the budget line

help marketers in their

pricing decisions? How

could they balance the

dilemma between earning

maximum profits verses

consumer’s purchasing

power?

Household Equilibrium

How could the marketer help

the household to reach its

highest equilibrium given the

budget constraints?



You are a merchandising display manager in charge of a chain of supermarkets looking after

their visual displays. Taking the diminishing marginal utility concept into consideration,

explain how you would attempt to avoid diminishing marginal utility among shoppers who

visit your outlets on a frequent basis.

10 marks

♪ My Short Notes



Foundation Level


for Marketing


M

acro

Eco

no

mic

s

Module Two

Chapter 07 - Inflation 101

Chapter 07

Inflation

1. Understanding Inflation

1.1 Definitions of Inflation

Sustained rise in the price level over a period of time (Slavin, Stephan)

Persistent tendency for the general price level to rise.(Hardwick et, el)

Inflation is a dynamic process with the general price levels of goods and services moving

upward over a period of time. It can also be defined as a continuous fall in the value of

money.

Inflation can be categorized by the speed with which the price levels change – the rate of

inflation. This rate is expressed as the percentage of increase from one year to the next. For

example, the government may announce that the inflation rate over the past year is 6%. This

means that the level of prices is 6% higher than it was at the same point in time last year. This

6% inflation rate does not mean that the price of each and every good and service rose by 6%.

The prices of some goods and services may not have gone up at all and some prices may have

even fallen. Others may have risen by a greater amount. However the overall rise, on average

was 6%.

1.2 Measures of Inflation

A common way of measuring the rate of inflation is to use a price index. A price index

measures the relative changes in prices of selected items from one year to the next. The index

specifies the price levels for one year as a base, which is denoted as 100. All the other years

in the index are stated in terms of the base year.

This chapter will cover the following areas

1. Understanding Inflation

2. Causes of Inflation

3. Effects of Inflation

4. Inflation and Marketing Decision Making


The two most commonly used price indices are the Consumer Price Index (CPI) and the

Wholesale Price Index (WPI).

The Consumer Price Index consists of an average of prices on a selected basket of goods and

services that are presumed to be bought by a typical consumer. The Wholesale Price Index

measures selected prices on key industrial and agricultural products, such as steel, sugar,

coffee etc. Since the WPI deals in raw, unfinished products, the WPI tends to measure price

level changes before the CPI does. However, the CPI more accurately reflects the prices paid

by consumers.

‡ Activity

Refer to the most recent publication of the central bank annual report. Refer various indices

used by the central bank to measure Inflation in Sri Lanka. Refer to the same report and find

out the present rate of inflation in the country.

† Key Concepts

Building an index to measure price changes of a number of products over a period.

Steps in building an index

1. Select a base year

2. Select a basket of goods which represents the lifestyles of the consumer groups that you

wish to measure the general movements of the price levels

3. Assign a weight for each of the products based on their importance. This weight could be

in the form of a percentage or the number of units purchased for an average period.

4. Gather the prices paid to purchase each unit in the base year

5. Multiply the unit prices by the average quantities identified earlier (or weights assigned)

6. Arrive at the total expenditure for the base period.

7. Assign the value of the base period expenditure to 100.

8. Gather the prices paid to purchase each unit in the current year

9. Multiply the unit prices by the average quantities identified earlier (or weights assigned)

10. Arrive at the total expenditure for the current period

11. Use the following formula and arrive at the change in the prices from the base 100

Current year expenditure

Index year Y = x 100

Base year expenditure

12. See the difference of the current year and the base year rates and arrive at the inflation

rate.


Example of Building an

Index

Step 01

Base Year Current Year

2003 2004

Step 02 Step 03 Step 04 Step 05 Step 08 Step 09

Basket of Goods Weight Base

Prices

Base

Expenditure

Current

Prices

Current year

Expenditure

Bread ( Loaves) 300 15.00 4500.00 18.00 5,400.00

Milk ( Packets) 50 80.00 4000.00 100.00 8,000.00

Rent ( Payments) 12 5000.00 60,000.00 5,500.00 66,000.00

Fuel (Liters) 900 60.00 54,000.00 70.00 63,000.00

Step 06 122,500.00 Step 10 142,400.00

Step 07 100 Step 11 142,400

x 100

122,500

= 116

Inflation Rate = 116 (Current Year ) – 100 ( Base Year) = 16% (Step 12)

The change in general price levels between 2003 and 2004 is 16%. Therefore the

inflation rate is 16%

1.3 Degree of Inflation

Degree of inflation refers to the extent of the inflation percentage. Depending on the

percentage of inflation in a country, different terminology is used to explain its nature. The

following are some of the frequently used terms.

a) Mild Inflation

Mild inflation is a situation where the inflation rate is below 6%. Some Economists are of the

view that this is a creeping form of inflation. Most Economists would agree that this type of

inflation is not harmful to an economy. In fact mild inflation is favored by many producers

since a slight increase in price will not have a drastic impact on consumer demand but this

increase in price would allow producers to increase their profitability given the other costs are

constant.

See the following example

Factor Payments 2000 2001 (Mild inflation) Remarks

Rent 10.00 10.00 Ceteris Paribus other

factor costs Wages 10.00 10.00

Interest 10.00 10.00

Profit 10.00 12.00 Increased profits

Price 40.00 42.00 5% increase in prices


b) Double -Digit inflation

On the other hand, inflation rate of 10% or above is generally considered to be harmful to an

economy and would also have social and political complications. This double-digit inflation

is a clear signal that the value of a nation’s unit of money is eroding rapidly and if relevant

remedies are not taken it could become a serious economic crisis to a nation.

c) Hyperinflation

Double-digit inflation is not the worst that can happen. Economies can also suffer

hyperinflation, with inflation rates reaching 100% or even higher. There is no strict dividing

line between double-digit inflation and hyperinflation. High double-digit inflation can be

considered as hyperinflation.

2. Causes of Inflation

There are two major causes of inflation that have been described by Economists. That is

Demand-pull inflation and Cost-push inflation.

2.1 Demand-Pull Inflation

Demand-pull inflation is a situation where the aggregate demand from the government,

producers and the households exceeding the aggregate supply of the economy. The natural

consequence of this is the rise in price levels. That is, too much money chasing too little

goods. This is further elaborated as follows.

Aggregate Demand is the sum of consumer and government spending on goods and services

and the net investments made by the entrepreneurs. The ordinary functioning of an economy

should result in distributing and spending income, in such a manner that aggregate demand

for output is equivalent to the cost of producing total output, including profits and taxes.

However at times households, the government or entrepreneurs will try to grab a bigger part

of the output than what they usually do. Since another sector will not compromise on its share

of the output, the net result would be that all sectors will try to get more of the national

output. This is the basic cause for inflation to start and aggregate demand for consumption,

investment and government expenditure exceeds the supply of goods at current prices.

Therefore the excess aggregate demand will lead to an increase in price. The following graph

explains how demand-pull inflation takes place with the interaction of aggregate demand and

aggregate supply.


Illustration 01 – Demand Pull Inflation

D

P3 C

P2 B

P1 A

Y1 Y2 YF

AD1 – AD4 will represent aggregate demand at different output levels. AS represents the

Aggregate Supply. The AS curve rises upwards and at the full employment level (Yf) and

takes a vertical shape as the level of full employment supply of out put cannot be increased.

There are four equilibrium points A, B, C and D depicted in the above graph. At points A, B

and C, the aggregate demand increases price levels,(P1, P2&P3) and out put (Y1, Y2 &YF)

will continue to increase.

However, beyond point C, even through aggregate demand increases, aggregate supply will

not increase further as the economy is at full employment level. At point D you will see that

at the same output level of YF the price has increased to P4. It is quite evident at this point

that an increase in the aggregate demand has pulled the prices up, causing inflationary effects.

The above is termed as demand pull inflation as the aggregate demand pulls the general price

levels up in the economy.

2.2 Cost-Push Inflation

Cost push refers to a situation where the increase in costs of the producers would tend to put

pressure in increasing the general prices up in order to retain their profitability since the latter

is a prime objective of the entrepreneurs. Cost-push inflation could be viewed from three

dimensions. They are Profit-Push Inflation, Supply-Side Cost Shocks and Wage-Push

Inflation.

AS

AD1

AD2

AD3

AD4

P4

Price

Level

Aggregate Demand and Supply


a) Profit-Push Inflation

Firms working under monopolistic and oligopolistic conditions have the capacity to charge

higher prices from the consumers, causing them to enjoy a higher profit margin. Since in

economics the profit is also a cost paid to the factors of production, an increase in profits will

push the cost of the firm thus leading to an increase in price, causing cost-push inflation.

b) Supply Side Cost Shocks

A cost increase is a major factor of production (example – price increase in oil) will lead to

an increase in costs in manufacturing many other products which use this input and in turn

will further increase costs of many other factors of production. For example, an increase in

oil prices will lead to an increase in the prices of electricity, transport etc which are also

factors of production. The ultimate result would be the increased costs of production pushing

the prices up.

c) Wage Push Inflation

Wage push inflation is a primary cause for the existence of imperfect competition in the

labour market, particularly the existence of strong trade unions who make use of their

monopoly power in controlling the supply of labour and to push for wage increases.

The higher wage claims are more likely to be successful when the economy is at (or close to)

full employment because then employers will be competing with each other for existing

workforce. As a consequence of higher wages, the costs of the firm are pushed upwards

leading to a decrease in aggregate supply. Assuming a constant aggregate demand level the

net result would be an increase in the price levels of an economy.

The following table will indicate how cost push inflation based on the three dimensions

discussed above would lead to an increase in price thus causing inflationary pressures.

Factor Payments 2000 2001 Cost Push

Inflation)

Remarks

Wages 10.00 13.00 Wage Push

Rent 10.00 12.00 Supply Side Cost

Shocks. Interest 10.00 11.00

Profit 10.00 14.00 Profit Push

Price 40.00 50.00 Cost push Inflation

The above is one form of cost push inflation where the increase in costs would lead the

selling price to increase. Another form would be supposing when the costs of the factor


payments increase and if the producer is unable to maintain his present level of profit, then

the latter will be demotivated and will decrease supply. The reduction in aggregate supply

levels in the economy would create an excess demand situation thus the general price levels

would increase.

The above phenomenon is described in the below table, followed up by the graph as seen in

illustration 02.

Factor Payments 2000 2001 Cost Push

Inflation)

Remarks

Wages 10.00 13.00

Rent 10.00 12.00

Interest 10.00 13.00

Profit 10.00 7.00 Reduction in profits

would lead the supplier to

reduce supply Price 40.00 45.00

The following diagram explains this phenomenon.

Illustration 02– Cost Push Inflation

P2

P1

Y2 Y1

3. Effects of Inflation

The effects of inflation could be viewed as anticipated and unanticipated Inflation.

Anticipated inflation refers to groups and individuals in the economy expecting, and will take

steps to make suitable adjustments to avoid the negative effects of inflation.

Price

Level

Aggregate output

AD

AS1

AS2


On the other side unanticipated inflation refers to where the actual inflation rate exceeds the

expected rate of inflation. If you take the economy as a whole or as a group or as an

individual, within it there will be a redistribution effect. That is to say, some people will be

made better off while others will be made worse off. Following are some of the possible

redistribution effects of anticipated Inflation.

Inflation will have a negative impact on individuals, business and the economy at large. The

following is an analysis of above.

3.1 Negative Impact of Inflation on Individuals

a) Effects to Fixed Income Groups.

Anyone earning a fixed income or anyone relying on fixed interest income will find the real

value of his income being eroded by inflation. For example, let’s assume an individual who

earns a monthly wage of Rs 1000. Suppose he spends his entire income on bread, he could

purchase 100 loaves when the price is Rs 10 per loaf. If the price increases up to Rs 20 while

his income stays constant, his purchasing power would reduce to 50 loaves of bread.

Inflation will reduce purchasing power of fixed income earners.

b) Taxpayer to Government

As money income rises, earners with the same money income move to higher tax bands

(unless these are adjusted) and so pay a bigger proportion of their income for tax. This is

known as a fiscal drag. This applies to countries with a progressive income tax system. There

will not be any increase in their real income thus would not gain from their increased income

since they will be paying higher taxes to the government. The following example will

highlight this further.

Description Pre Inflation

Situation

Post Inflation

Situation

Remarks

Money Income LKR 10,000 LKR 15,000 Wages are increased to

increase money income

Tax (Over 12,000,

20%)

0 LKR 3,000 Paying taxes due to increased

money income

Net Income LKR 10,000 LKR 12,000

Loaf of Bread LKR 10 LKR 12 Inflation

Purchasing

Power

1000 loaves of

bread

1000 loaves of bread No change in purchasing

power although money

income has increased.


c) From Lenders to Borrowers

During times of inflation, if the interest rates are not higher than the inflation rate then,

lenders will lose and borrowers will gain. As debts are repaid, their real value will be less

than that prevailing when the loans were made. See example below.

Lender Borrower

2000 Lending

amount

Rs

Price

of

Bread

Purchasing

Power

in 2000

Borrowing

amount

Rs

Price of

Bread

Purchasing

Power

in 2000

Amount 10,000 10 1000

pounds

10,000 10 1000

pounds

2001 Receiving

amount

Rs

Price

of

Bread

Purchasing

Power

in 2001

Re-payment

amount

Rs

Amount +

Interest 20%

12,000 15 800

pounds

12,000

Remarks You may note that in year 2000 the lender could have consumed 1000 units

of bread based on the prevailing prices. The borrower by utilizing this

amount in 2000, consumed 1000 loaves of bread.

However in 2001, even though with an interest payment of 20%, the

lender’s purchasing power of bread has decreased to 800 loaves.

Point to note is that the inflation rate (50%) is higher than the Interest rate

(20%)

d) Wealth Holders of Cash, Bonds and Debentures

Inflation also adversely affects wealth holders who hold their wealth in the form of cash

money, demand deposits, savings and fixed deposits, interest bearing bonds and debentures.

Inflation reduces the real value of their wealth.

3.2 Effects on Business

a) Effects on Production

Demand-pull inflation is associated with buoyant trading conditions, where the risk of trading

is greatly reduced. These easy market conditions might give rise to complacencies and

inefficiency since the competitive pressures to improve both product and performance will be

greatly weakened.


b) Impact on Investments

Due to inflationary pressures, the money available for savings tends to reduce. (As to

consume the same basket of goods a consumer will have to pay more) Due to low savings

levels, money available for banks and financial institutions will be less. This will impede the

investments of the firm affecting the long-term growth in the productivity of the firm. Also

due to increases in the cost of production due to higher wages and supply shocks (if firms opt

to absorb fully) the profits available to invest on business operations will further come down

reducing investment opportunities.

c) Effect on Output

In cost-push inflationary situations, due to the increase in costs paid for factors of production,

the firm’s immediate response would be to reduce the supply. This means there could be

situations of firms not utilizing its full capacity and even cutting down its staff. These may

lead to labour unrest, de-motivation of staff and finally to an overall inefficiency.

3.3 Impact on the National Economy

a) Impact on Economic Efficiency

It is generally believed that inflation causes misallocation of resources and therefore results in

loss of economic efficiency. Inflation causes distortions in prices, which misallocate

resources, and results in inefficiency. (This distortion in prices occur, as a result of inflation.

All prices do not rise to the same extent so that there are changes in relative prices).

b) Impact on Value of Money

Inflation also distorts the use of money. Currency is money that bears a zero nominal interest

rate. If the inflation rate rises from 0-10% annually, the real interest rate on currency falls

from 0 to –10% per year. As a result of the negative real interest rate on money, people

devote real resources to reducing their money holdings during inflationary times.

c) Impact on Reduced Savings

Investments are important to a country as it expands the capital. The most important source of

investment is bank savings, especially the personal savings of the consumers. Inflation can

lead people to reduce savings in banks, as the purchasing power gets lower daily.

For example let’s say that a savings account yields 6% interest. That 6% is money earned.

But if inflation is 5%, the true earnings are only 1%.


If inflation on the other hand goes up to 8% then the saver is actually losing 2% per year of

purchasing power. Therefore, when inflation is present the saver will most likely decide to

spend money immediately and enjoy its present purchasing power.

Some people turn to speculation rather than investment during times of inflation. They may

purchase gold, art works, diamonds and other items that they hope they can easily sell later at

prices that have at least kept pace with inflation.

d) Impact on Balance of Payments

In economies which are dependent upon high levels of imports and exports, inflation often

leads to balance of payment difficulties. If other countries are not inflating to the same extent,

home produced goods will become less competitive in foreign markets and foreign goods will

be more competitive in home markets. Exports will fall and imports will rise.

If this process continues it will lead to a balance of payment deficit in the current account.

The problem will be particularly difficult where inflation is of the demand-pull type, because

in addition to the price effects the excess demand at home tends to draw in more imports.

This will further worsen the balance of payments.

An example will be as follows

Description Home Country Other

Country

Prices

Remarks

Pre Inflation

Situation

Post Inflation

Situation

Export

Situation Rs 1000 or

USD 20

Rs 1500 or

USD 30

Export price

other countries

is USD 20.

Due to inflation, the

home country prices

are higher than other

countries

Imports

Situation

Local

Manufacture

price

Rs 1000

Local

Manufacture

price

Rs 2000

Imported Price

USD 20 or

Rs 1000

Due to inflation,

importing this product

would be cheaper than

producing in own

country

Impact to

Balance of

Payment

Export revenue will tend to reduce and imports expenditure will tend to

increase affecting the balance of payment adversely.

Note : Exchange Rate – I USD = Rs 50

The above facts will indicate that inflation will have a negative impact on individuals,

business and even the economy.


4. Inflation and Marketing Decision Making

4.1 Implications of Inflation to Marketing Activities

Inflation will also have a negative impact on many marketing activities. The following

activity would allow to focus on these aspects better.

‡ Activity

Assess how inflation will effect the following marketing activities

Marketing Activity Implications of Inflation

New Product Development

Efforts

Product Packaging Efforts

Branding Decisions

Pricing and Costing

Aspects

Promotional Mix Decisions

Physical Distribution

Aspects and Working with

Intermediaries

People, Processes and

Physical Evidence

Activities.


4.2 Marketing Strategies to Fight Negative Impacts of Inflation

Inflation causes reduction in purchasing power of consumers. The following are some

strategies that could be followed to reduce the negative effects of inflation.

Proposed Strategies/Activities

Product Related Decisions

• Develop smaller pack sizes

• Offer non branded generic products

• Remove the package layers and offer economically

packed items

• Offer second quality products (lower quality)

Pricing Decisions • Offer discounts

• Offer easy payment schemes, leasing, hire purchase

Promotional Decisions • Carry out more consumer and trade promotions

• Offer banded, value offers

Distribution Decisions • Promote more direct sales and offer saved distributor

margins to consumers

Production & Purchasing • Work with production and purchasing in increasing buying

efficiencies to reduce raw material costs

• Large scale production to achieve economies of scale


While you were having tea in the university campus, you happen to hear the following

conversation between two of your colleagues.

Chandana : Why did our Economics master say that inflation is not always harmful to the

economy?

Upul : Well! he did not explain why he said that, but I liked his argument which he

said that the contractionary monetary policy is the best recourse to cure

inflation since the use of the contractionary fiscal policy may have political

repercussions with the masses.

a) Explain to Chandana why inflation is not always harmful.

5 marks



Mr. Muragasu an ordinary factory worker has been working very hard for the last 20 years.

Every year he has been getting salary increments for his hard work. However Mrs.

Muragasu has always been complaining that however hard her husband works and gets

salary increments every year, there is no change in the net effect of their family’s ability to

meet their day to day needs. She blames the cause for this to ever increasing prices of

products.

a) Explain how inflation effects fixed family income earners.

3 marks

♪ My Short Notes


Chapter 08

International Trade

1. Introduction to International Trade

International trade refers to the exchange of goods and services between nations.

International trade arises simply because countries differ in their demand for goods and their

ability to produce them. The following are some advantages of engaging in international

trade.

• Ability to produce in larger volumes – Since markets are quite large internationally,

the domestic producer would be able to produce goods on a larger scale leading them

to decrease its unit costs due to economies of scale.

• The quality of its products will be higher – Due to high levels of international

competition and high standards, the quality of the products are higher than the ones

supplied into the local market.

• Wider variety of goods – A country will be able to import a wider variety of goods

leading to higher assortment of goods being consumed by its citizens. This will

increase the choice they have, leading to higher standards of living.

• Survival purposes – Certain countries do not manufacture essential items. They have

to be involved in international trade for them to survive.

• Leads to economic growth – Free Trade would promote investment into the country

leading to an increase in its output, and thereby employment. This increase in output

will lead to the economic growth of that country.

2. The Concept of Absolute Advantage

The concept of absolute advantage is a situation where a country could produce an output

more than another country using the same amount of input. See the example below.


1. Introduction to International Trade 2. The Concept of Absolute Advantage 3. The Concept of Comparative Advantage 4. International Trade and Protectionism 5. Balance of Payments 6. Devaluation 7. Exchange Rates


Input - Using one resource unit Output – as follows

Country Cars (units) or Wheat (bushels)

A 30 or 300 B 10 or 250

As per the above example we see that country A has an absolute advantage in producing cars

and producing wheat. The absolute advantage for a country depends on the amount of natural

resources it may have or the amount of man made resources (know how) a country possesses.

3. The Concept of Comparative Advantage

This concept says that countries should choose and specialize in goods, which it can produce

at a lower opportunity cost than others and should exchange the surplus of these goods for

other goods which cannot be produced at a lower opportunity cost domestically, as imports. See the following example.

Input - Using one resource unit

Output – As follows

Country Cars (units) or Wheat (bushels)

A 30 or 300 B 10 or 250

Opportunity cost of producing each unit

Country Opportunity cost of producing one unit of cars

Opportunity cost of producing one bushel of wheat

A 10 bushels of wheat 1/10 of a car

B 25 bushels of wheat 1/25 of a car

As you see, the opportunity cost of producing a car in Country A is lower than in country B

(10 bushels in country A and 25 bushels in country B). So we could say that country A has a

comparative advantage in producing cars over country B.

If you consider looking at the opportunity cost of producing a bushel of wheat, it is lower in

Country B than in country A. (1/10 of a car in country A and 1/25 of a car in Country B). So

we say that country B has a comparative advantage in producing wheat over country A.As

per the concept of comparative advantage country A should concentrate on producing cars.

Through its specialization, it should exchange its surplus cars with country B and buy wheat

from country B. Similarly country B should produce wheat and it should exchange its surplus

wheat for cars with country A. Comparative advantage is the underlying basis of international

trade.


If the opportunity costs are the same for both countries then there won’t be any comparative

advantage for either country.

4. International Trade and Protectionism

The concept of comparative advantage could only reap its benefits in international trade if

there is free trade between countries. Unfortunately, free trade between countries is restricted

due to the implementation of protectionism policies by countries. Protectionism is the complete or partial control of the operation of international trade.

There are two (major) types of protectionism policies.

4.1 Tariff Barriers

These are essentially taxes imposed on imports and exports of a country. The objectives of

imposing tariff barriers are, to earn income for the government and also, to a very large

extent, to encourage or discourage imports and exports. Higher tariffs are imposed to

discourage imports of certain items.

4.2 Non-Tariff Barriers

These are invisible barriers, other than tax, created to restrict imports and exports. They are as follows

a) Trade embargoes – This is the total or partial restriction of trade between countries. This

is used to reduce a particular item coming into the country. At present, many countries

use trade embargoes as a politically motivated sanction to isolate certain countries which

do not adhere to world policy on certain issues.

b) Quantity restrictions – This restricts the quantity imported into the country. In the recent

Indo-Lanka free trade agreement, there are quantity restrictions posed on garments and

tea, which could be imported to the Indian economy from Sri Lanka.

c) Exchange control – Restricting the issue of certain currencies which are required to

purchase foreign goods, is another mechanism to control imports.

d) Prior-to-import deposits - In order to discourage imports, the government could make it

compulsory to deposit a certain percentage of the import value with the government,

which will be frozen until the transaction is concluded.

Advantages of Protectionism

a) Protecting infant industries – Infant industries would require a certain amount of shielding

from international competition until they are established. Protectionism is mainly targeted

to protect those industries.


b) To carry out industrialization policy - The government will try to discourage imports of

certain products in order to setup its own local industry policy.

c) To prevent dumping – Dumping is selling goods in a foreign country below the cost

required to manufacture this item in the domestic market. Most developing countries try

to dump products into the developed world to capture its market share. The exporter

survives by the subsidies provided by the exporting country’s government. Foreign

countries would impose protectionism measures to avoid such dumping by imposing anti-

dumping duties.

d) To cut the Balance of Payment deficit - The objective is to restrict its imports and reduce

the balance of payment gap.

Disadvantages of Protectionism

a) Reduction of world output – When one country imposes protectionism measures the other

country will retaliate. Through this, countries will not be able to take advantage of the

comparative advantages they have and indulge in free trade.

b) There would be problems in the Balance of Payments – When imports are restricted,

similarly exports will also get affected due to countermeasures taken by those countries.

5. Balance of Payments

Balance of Payments (BOP) refers to a country’s statistical accounting records on

international trade transactions and capital transactions with other countries, during a period

of time. In other words, it is a systematic account/statement, which presents the inflows and

the outflows of a country due to international trade. Balance of Payment consists of two main

accounts. There can be presented as follows.

Illustration 01 – Balance of Payment Structure

Balance of payments

Current account Capital account

Visible Trade

(goods)

Invisible Trade

(services)

Visible balance/ Balance of trade

Invisible balance

Capital A/C balance


5.1 Balance of Payment Statement

1. Current Account 1.1 Visible Account Export of Goods xxxx Less – Import of goods (xxxx) Visible Balance/Balance of Trade xxx/(xxx) xxx/(xxx)

1.2 Invisible Account 1.2.1 Services Receipts xxxx Payments (xxxx) Net services xxx/(xxx) xxx/(xxx) 1.2.2 Property income(interest/profits/dividends) Receipts xxxx Payments (xxxx) Net property Income xxx/(xxx) xxx/(xxx) 1.2.3 Net Transfers Receipts xxxx Payments (xxxx) Net Transfers xxx/(xxx) xxx/(xxx)

Balance of the Invisible Account xxx/(xxx xxx/(xxx) Current Account Balance xxx/(xxx 2. Capital Account Capital inflows xxxx Capital outflows (xxxx) Capital Account Balance xxx/(xxx) xxx/(xxx)

Balance of Payments xxx/(xxx)

a) Current Account

The current account records payments and receipts arising from trading goods and services

and income and expenditures in the form of interest, profits and dividends earned on real and

financial capital by investing in other countries.

The current account consists of two parts. The first part is called the Trade (visible) Account.

This records visible transactions which refer to tangible goods being traded. The difference

between outward and inward fund flows pertaining to these visible transactions, is known as

the balance of trade.

The second part is called the invisible/service account. It records the payments arising out of

intangible trade in services such as insurance, shipping, tourism etc and interest, dividends

and profits accrued. Inward remittances from people employed abroad are also recorded in

the invisible account. Further transfers namely aid, loans and grants are also recorded in the

invisible account.


‡ Activity

Comment on Sri Lanka’s current account balance based on the latest Central Bank report

b) Capital Account

The Capital account records transactions relating to international movements of financial

capital assets such as bonds, equities, and project investments. The capital account often

distinguishes between short term and long-term capital.

Short-term money refers to funds, which are being invested for a short period (usually less

than a year). Further the flows to and from reserves, which consist of gold and foreign

currencies are also recorded in the Capital Account.

‡ Activity

Comment on Sri Lanka’s Capital Account balance based on the latest Central Bank report

c) Sri Lanka’s Balance of Payment Situation

‡ Activity

Comment on Sri Lanka’s Balance of Payment based on the latest Central Bank report. What are the major contributing accounts which affect the Balance of Payments in Sri Lanka? You are expected to prepare a mini statement of the balance of payment for the last two years and comment on its movements.

d) Deficit in the Balance of Payments

A deficit in the balance of payments means that a country’s outflow is higher than its inflow.

In such a situation, a government will have to borrow money from the international

community to cover for its payments. A prolonged deficit in the balance of payment would

mean that the country would get into constant debt and this will be a burden on the economy.

5.2 Correcting a Deficit in the Balance of Payments in the Long Run

i) Promoting Exports

• Provision of low interest loans to the exporters

• Subsidies and duty rebates to exporters

• Reduce export duty

• Provision of export credit guarantees


ii) Restrict Imports

• Place embargos on non essential goods

• Fix quotas for imports

• Impose tariffs on imports

• Complicated procedures in importing

ii) Exchange Controls

• Limit the amount of exchange allowed for locals going abroad

• Limit the amount of exchange that could be remitted abroad

• Place limits on profits, interests and dividends that foreign companies operating in the country could remit

• Limit the amount of foreign exchange released for imports

iv) Devaluing the currency against major trading currencies

6. Devaluation

The concept of devaluation is where the value of the local currency is de-valued against a

foreign currency. In most cases this foreign currency is the US dollar, which is the world’s

trading currency. The objective of devaluation is to make the export prices cheaper in the

overseas markets and the imports more expensive in the domestic market thus encouraging

exports and discouraging imports and improving the current account balance.

6.1 Devaluation Correcting the BOP Deficit.

An assumed exchange rate would be as follows.

Pre devaluation exchange rate 1USD = 50 RS

Post devaluation exchange rate 1 USD = 75 RS

a) Analyzing the Export Situation

A Sri Lankan exporter quotes Rs 750 as his price for his export product to the overseas

customer. The following will explain how the exporter is affected due to devaluation.

Situation Export Price in Rupees Exchange Rate Export price in USD

Pre Devaluation Rs 750 1USD = Rs 50 USD 15

Post devaluation Rs.750 1 USD = Rs 75 USD 10

Export price has come down from 15 USD to 10 USD due to devaluation.

You will see that as a consequence of devaluation the export prices have come down in terms

of USD and the product is cheaper to the overseas buyer. When the prices of the export

products tend to reduce (as a consequence of devaluation) the export demand will tend to

increase and the export revenue will increase.


b) Analyzing the Import Situation

Let us assume that an overseas supplier quotes USD 10 as his price to the Sri Lankan

importer. The following will explain how the importer is affected due to devaluation

Situation Import Price in USD Exchange Rate Import price in Rupees

Pre Devaluation USD 10 1USD = Rs 50 Rs 500

Post devaluation USD 10 1 USD = Rs 75 Rs 750

Import price has increased from Rs 500 to Rs 750 due to devaluation.

Since the import price has increased, the demand for imported products will reduce thus the

import expenditure will tend to reduce.

c) Impact on BOP from Devaluation

An increase in export revenue and a reduction in imports expenditure will lead to a favorable

trade balance influencing the current account balance thus influencing the overall balance of

payment to be positive.

6.2 Criterion for Devaluation to be Successful

Marshall’s Learner Condition

Devaluation of currencies will only improve the balance of payments if the sum of the

elasticities of domestic demand for imports and foreign demand for exports is in

excess of one (1.0).

An assumed exchange rate would be as follows.

Pre devaluation exchange rate 1USD = 50 RS

Post devaluation exchange rate 1 USD = 75 RS

a) Exports Scenario

The price of the export product quoted by a Sri Lankan exporter to an overseas buyer is Rs

750. Let us see how this will affect the export price before and after the devaluation.

Export Price in Rs Export Price in USD

Before 1USD = Rs. 50 Rs 750 USD 15

After 1USD = Rs 75 Rs 750 USD 10

If we assume that the exporter passed the full cost benefit to the export buyer an item that

cost 15USD to the export buyer will now cost him 10USD. Traditional demand theory states

that a reduction in price will lead to an increase in demand. However the price elasticity of

demand concept will tell us that the revenue increase will depend on the elasticity of demand.


Let us look at the following two scenarios.

OVERSEAS ELASTIC DEMAND OVERSEAS INELASTIC DEMAND

Export Price

Export Demand

Export Revenue

Export Price

Export Demand

Export Revenue

$15 1000 $15,000 $15 1000 $ 15,000

$10 2000 $20,000 $10 1200 $ 12,000

PED Coefficient = 3 PED Coefficient = 0.6

So we find that although the product is cheaper to the export buyer after the devaluation, the

export revenue will only increase if the elasticity of demand for the bulk of the export

products is elastic.

b) Imports Scenario

An imported product, which costs 10 USD, will cost the importer in the following manner

before and after the devaluation

Imported Price in USD Imported Price in Rs

Before 1USD = Rs. 50 USD 10 Rs 500

After 1USD = Rs 75 USD 10 Rs 750

Traditional demand theory states that an increase in price will lead to a decrease in demand.

However, the price elasticity of demand concept will also determine the import expenditure

behavior depending on the elasticity of demand for the imported product. Let us look at the

following two scenarios.

LOCAL ELASTIC DEMAND LOCAL INELASTIC DEMAND

Imports Price

Imports Demand

Imports Expenditure

Imports Price

Imports Demand

Imports Expenditure

500 10,000 Rs. 5,000,000 500 10,000 Rs. 5,000,000

750 4,000 Rs 3,000,000 750 9,000 Rs.6,750,000

PED Coefficient = 1.2 PED Coefficient = 0.2

The above example indicates that only an elastic demand for imported products will lead to a

more proportionate change in demand thus reducing the import expenditure drastically. When

demand is inelastic; the import expenditure will further increase.

For devaluation to correct the BOP deficit

• The elasticity of demand for exports goods in export markets – Elastic (Export revenue

will increase due to an increase in export demand more than proportionately when export

price to the overseas buyer reduces due to devaluation)


• The elasticity of demand for imported goods in the local market – Elastic (imports

expenditure will reduce due to a reduction in quantity demand for imported items when

price increases to the local importer as a consequence of devaluation)

So the above numerical example also proves the MARSHALL LEARNER CONDITION’s

line of argument, where the sum of the elasticity of domestic demand for imports and foreign

demand for exports should be elastic.

However it is also noted that for devaluation to be more effective there should not be similar

concurrent devaluations by other competing countries where the export buyer might see a

comparative advantage of cost reduction from one country to another.

6.3 Devaluation and the Sri Lankan Experience

The exports and import baskets of Sri Lanka is analyzed as follows.

Export Goods Composition of Sri Lanka – 2003

Category % of Exports Type of Elasticity

Industrial sector (Mainly textiles and

garments)

77.5% Elastic Demand

Agriculture (tea, rubber, coconuts) 20.5% Inelastic Demand

Mineral (gems 1.6% Elastic Demand

Others 0.4%

According to the export goods basket we could safely conclude that 79.1% of our exports

seem to have an elastic demand. The balance 20.9% seems to have inelastic types of a

demand due to the primary nature of its products. When we analyze the 77.5% of our

industrial goods exported, 50% consist of textiles and garments. The majority of the raw

materials that go into the production of garments are imported to Sri Lanka.

With the above scenario let us try to comment on the effect of devaluation on our exports

goods basket.

a) 20.5% of primary goods due to their inelastic nature of demand will not experience an increase in revenue by devaluation based on our theory presented.

b) Also if there is an increased demand for these primary goods like tea, rubber and

coconut, their output cannot be increased in a relatively short time period due to the

inelastic nature of supply, losing increased revenues from the volume increase,

leading to an reduction of export revenue.

c) It was mentioned that the majority of raw materials for garments are imported to Sri

Lanka. With the devaluation, the cost of raw materials will increase further losing the

net effect of the devaluation.

Therefore Sri Lanka would not get the benefit of increasing the export revenue through

devaluation due to the above factors.


Import Goods Composition of Sri Lanka – 2003

Category % of Imports Type of Elasticity

Consumer goods (mainly food and drink, rice,

sugar, wheat)

22% Inelastic Demand

Intermediate goods (Petroleum, fertilizer,

chemicals, textiles and clothing)

57% Inelastic Demand

Investment Goods(machinery and equipment,

transport equipment and building materials)

20% Elastic Demand

Unclassified imports 1%

In analyzing the imports goods basket, we find that 79% of our imports have an inelastic

demand. With the above scenario let us try to comment on the effect of devaluation on our

imports goods basket.

a) The main purpose of devaluation is to discourage imports, but with over 79% of imports

having an inelastic demand pattern, the devaluation of the rupee will only increase the

imports expenditure even more than what it was thus worsening the current account

balance of the country.

b) Only 20% of the goods imported to the country have an elastic demand, out of which the

majority of these aid the development of the country’s infrastructure, which has a direct

link to the economic development of the country. With the demand decreasing more than

proportionately for these items, it will have a negative impact on the country’s

infrastructural development thus affecting the growth of local industries, which will

supply goods to the local market, and even the export industries. This again will have an

impact on the export revenue and the import expenditure affecting the balance of payments.

On an overall basis we see that the effects of devaluation do not bring in results to Sri Lanka

as posed in theory due to the reasons stipulated above.

6.4 What should Sri Lanka do to take advantage of devaluation?

With the above situation in our minds what should Sri Lanka do if they need to achieve the

results of devaluation

a) Improving Exports

• The government should promote industries, which have an elastic demand for exports.

For example industrial products, mineral products etc.

• The authorities should try to change the elasticity of the primary goods, which are

exported. For example – Value added teas like green tea, gift tea packs; etc should be

exported with strong Sri Lankan brand names. The example of Dilmah and Mlesna needs

to be followed.


For rubber items more value added products like rubber mats, industrial types, gloves etc

should be exported as against raw rubber materials. This will convert the inelastic nature

of the raw materials to elastic demand patterns.

• Providing incentives for local raw material suppliers for exports. By encouraging the

textile manufacturing in Sri Lanka we would be able to get the maximum advantage from

the garment exports thus avoiding the negative effects of importing the raw materials.

• Helping the export promotion of our items – The government should aid the exporters in their marketing efforts to enter new markets and to improve supplies to existing markets.

b) Managing the Imports Situation.

• Industries which provide substitutes for imports to be promoted for essential items - The

government should encourage industries, which supply necessary items to be

manufactured in Sri Lanka. If the local entrepreneur is unable to do so it should

encourage foreign direct investment towards these industries. By this, over dependence

on imports for necessities, will be reduced, thus not letting the import expenditure

increase due to devaluation.

• Promote cottage industries - The government should also try to promote its cottage

industries which would aid import substitution further.

• Encourage BOO or BOT transfer type of projects to improve the infrastructure of the

country, which will develop the import substitution and export industries.

7. Exchange Rates

An exchange rate is the rate at which one country’s currency is traded in exchange for

another country’s currency. There are two ways of quoting the exchange rate.

a) Direct Quote – Rupee being the domestic currency in Sri Lanka, we offer so many rupees

to a dollar or any other foreign currency. For example we quote 103 Sri Lankan rupees to

a Dollar. (Dec 2004).

b) Indirect Quote – Where so many foreign currency units are offered to a Rupee. For

example 0.009 dollars for one rupee. 7.1 Determining the Exchange Rate

The exchange rate is determined based on the demand and the supply for the currency. Let us

see how this works.


Let us assume that Sri Lanka has quoted its export prices in USD. Also the import prices are

also quoted in USD. Let us see how the exchange rate between the Sri Lankan rupee and the

USD is determined based on the demand and the supply for USD.

Demand for USD would be when a Sri Lankan needs to import goods, which are quoted and

required to pay in USD. Supply of USD to the Sri Lankan foreign exchange market would be

when an exporter earns USD as a consequence of export revenues. Let see the determination

of the exchange rate on a graph.

Illustration 02 – Determining the Exchange Rate between two Currencies

The interaction of demand and supply for USD will determine the exchange rate at 1USD =

50 Rupees. Due to a subsequent increase in imports, the demand for USD will increase. In

this situation assuming that the supply of USD is constant (where there is no increase in

export revenues) one will have to pay more Sri Lankan dollars to buy one USD and a new

exchange rate will be determined. (1 USD = 75 Sri Lankan Rupees)

7.2 Exchange Rate Policies

There are two main exchange rate policies a government could follow. They are as follows.

a) Fixed Exchange Rate System

A situation where the exchange rate between two currencies is fixed between two currencies.

This is the highest order of government intervention in determining the exchange rate. The

government will use their official reserves to match the demand and supply of the currencies

in order to manage the fixed exchange rate.

Exchange Rate

USD=RS

USD Quantity

Supply of USD – From Exports

Demand for USD – For Imports

1US=50Rs

Increased demand for USD

– Increase in Imports

1US=75Rs


Advantages of the Fixed Exchange Rate System

• Reduces uncertainty. – This will reduce problems of economic planning.

• No speculative holdings – The storage currencies will not lead to speculate the

exchange rate.

Disadvantages of the Fixed Exchange Rate System

• Rigid and inflexible system – The exchange rate does not reflex the relative trading

strengths of the country

• Need to hold official reserves – Some currencies will have a higher demand in the

world market. Since the exchange rate does not reflect the trading strength of a

country, a government will need to have enough reserves to manage the rate.

b) Floating Exchange Rate System

A situation where the exchange rates between two currencies are determined based on the

demand and supply of the prevailing currencies through imports and exports. Floating

exchange rate could further be categorized as managed floating exchange rate and free float

exchange rate.

• Managed floating exchange rate is where the government intervenes in adjusting the

exchange rate based on the market situations for the currency.

• Free float exchange rate is where the exchange rate is determined by the free market

demand and supply forces for a currency. Sri Lanka adhered to the Free Floating

exchange rate system from January 2001.

Advantages of Floating Exchange Rate System

• It reflects the relative trading strength of a country

• Possibility of speculative gains.

• Example – The present exchange rate between USD and SL Rupee is 103. If a trader

speculates that this will be 120 SL rupees to a USD within the next three months

people will hold on to their USD and sell when it reaches the targeted amount and

enjoy gains

• No requirement to hold official reserves.

Disadvantages of Floating Exchange Rate System

• Exchange rate is not certain – Economic policy planning will become a problem

• Stronger currencies will be kept out of circulation for speculation gains.

7.3 The Relationship between Free Floating Exchange Rate and the BOP Deficit.

It is said that under the free floating exchange rate system the BOP deficit will be

automatically settled. Let us see how this is settled. A BOP deficit is greatly influenced by a

deficit in the trade balance and the current account balance.


A BOP deficit is a situation where the outflow of foreign exchange will be higher than the

inflow. In such a situation when a free floating system is operating in the economy, as the

demand for imports increase, the exchange rate between the SL rupee and the USD will be

adjusted where one will have to pay more rupees to buy USD. See diagram below.

In other words the rupee will depreciate. In such a situation the import prices will increase

reducing the import expenditure and since the export prices are low, the demand for export

products will increase, increasing the total export revenue. Providing the existence of the

Marshall’s Lerner condition, export revenue would increase and with a reduction of import

expenditure, BOP deficit will be adjusted.

However it should be kept in mind that based on the elasticity for export goods and import

goods, the demand will determine the effectiveness of devalued currencies.

Illustration 03 – Free Floating Exchange Rate and the BOP Deficit Summary of the Process Explained Above

Exchange Rate USD=RS

USD Quantity

Supply of USD – From Exports

Demand for USD

– For Imports

1US=50Rs

Increased demand for USD – Increase

in Imports

1US=75Rs

BOP Deficit Currency

Depreciates

Corrects the Balance of

Payment Deficit

Marshall’s Learner Condition

Free Floating Exchange Rate


♪ My Short Notes


Chapter 09

National Income Accounting

1. Understanding National Income

National Income refers to the total market value of all final goods and services produced in

the economy in a year. When understanding National Income two things must be noted.

a) It measures the market value of annual output. In other words, National Income is a

monetary measure. This is because there is no other way of adding up the different sorts

of goods and services except by their monetary prices. However in order to know

accurately the changes in physical output , the figure for national income is adjusted for

price changes.

b) To calculate National Income accurately all goods and services produced in any given

year must be counted only once. Most of the goods go through a series of production

stages before reaching the market. In order to avoid the counting of parts of goods that are

sold and resold several times, National Income only includes the market value of all final

goods and services and ignores the transactions involving intermediary goods.

2. The Circular Flow of Income

The circular flow of income will explain how the economic activities of a country flow from

one sector to another. The following diagram will indicate the circular flow of national

income in a simple economy. In drawing the circular flow of income diagram, the

assumptions that have been considered are as follows.

a) All the factor payments received by households are used for consumption. (No savings

and therefore no investments)

b) There is no government involvement and thus there are no taxes charged from households

and firms and similarly subsidies are not paid.

c) There are no exports or imports into the country.


1. Understanding National Income

2. The Circular Flow of Income

3. Calculating National Income

4. The Circular Flow and Economic Sectors

5. Per Capita Income


Illustration 01 – Circular Flow of Income

Looking at the circular flow you will see that when you calculate the national income based

on the output method, the income method and the expenditure method , one will get the same

national income figure.

As all factor payments paid by the firms will become factor income to the households.

(shown in arrow C) This is captured under the income method.

As all expenses paid by households in acquiring the goods and services will be received by

the firms. (shown in arrow B) . This is captured under the expenditure method.

As all products and services manufactured will be captured under the output method which

is reflected in the flow of goods and services from the firms to households (shown in arrow

A)

Based on the above circular flow of income and based on the given assumptions, the output

method (National Product) = Income method ( National Income) = Expenditure method

(National Expenditure).

3. Calculating National Income

As indicated above, National Income could be measured by three methods. They are as

follows.

a) Output method

b) Expenditure method

c) Income method

Firms

Households

Goods

and

Services (Real

Flow)

Expenditure

on goods and

services

(Money Flow)

Factor Inputs

Land, Labour, Capital

and Entrepreneurship

(Real Flow)

Factor Payments

Rent, Wages

Interest and profit

(Money Flow) D

C

A

B

B

B


a) Output Method

The final outcome using this method is called the national output. This is the money value of

final goods and services produced in an economy within one year. It is obtained by totaling

the money value of these goods and services. In calculating the national output one will have

to avoid the double counting error. Let us try to understand the double counting error.

i) Double Counting Error.

Let us simply take an example of baking bread.

A B C

Process (10, 000

units of bread)

Input Value Value Addition Final Value/Transfer

Price.

Growing wheat Rs 70,000 Rs 70,000

Processing wheat Rs 70,000 Rs 30,000 Rs 100,000

Bakery Rs 100,000 Rs 50,000 Rs 150,000

National out put Rs 170,000 ? Rs 150,000 ? Rs 320,000 ?

You would see that there are three stages in this production process. If the country adds the

final values of all these three stages then we say that it has got caught to the double counting

error.

You may note that Rs 70,000 (input) is included in Rs 100,000 (output of process two) and in

turn this becomes the input value for the final process which is included in the final value

(bakery). So by simply adding all final values you would add input values twice over, causing

the double counting error.

ii) Avoiding the Double Counting Error.

• Value Addition Method

This is where you add only the value that is being added at every stage of the process.

You may notice that according to the above table, under the value addition method the

final value would be Rs. 150,000 ( column B) reflecting the correct value of the goods

that were manufactured.

• Final Value Method

This is where you take the final value of the products that come out of the value chain

which includes all the costs and value added into the products. Under the output method

the national income is calculated as follows. Please see the diagram below.


iii) Sri Lanka’s National Out Put

Sri Lanka’s Situation ( In Rs Mn) ( 2001)

f* - Current

factor costs

g* - Constant

factor costs

(1996)

% contribution

Agricultural Sector 242,532 170,073 20.10%

Agriculture (Tea, Rubber, Coconut

, Paddy , Other )

193,891 131,121

Forestry 17,116 16,342

Fishing 31,525 22,610

Industry 332,616 231,594 27.40%

Manufacturing 198,073 143,153

Mining and quarrying 23,869 15,019

Construction 94,547 61,292

Electricity , gas and water 16,127 12,130

Services 677,654 442,944 52.50 %

Transport , Storage and

Communication

154,587 105,927

Wholesale and Retail 274,805 177,086

Banking , Insurance and Real

Estate

105,552 68,076

Ownership of dwelling 22,190 15,228

Public administration/defence 69,409 41,857

Other services ( N.E.S) 51,111 34,770

a* - Gross Domestic Product at

factor costs 1,252,801 844,611 100%

b*- Net property factor income -25,048 -15492 c* - Gross National Product at

factor costs 1,227,754 829,120

d* - ( Less) Depreciation e* - Net National product

iv) Few Terms Explained

• a* - Gross Domestic Product at factor costs – The money value of all final goods and

resources produced by normal residents as well as non residents in the DOMESTIC

territory of a country.

• b* - Net property factor income – The difference between factors payments made and

income from abroad.

• c* - Gross National Product at factor costs = Gross Domestic Product at factor costs + Net

property factor income

• d* - Depreciation – Reduction of value of capital assets used for production.

• e* - Net National Product = Gross National Product at factor costs – Depreciation

Based on the output method, National Income is calculated as above.


b) Expenditure Method

Under the Expenditure Method the Gross Domestic Expenditure and Gross National

Expenditure is calculated based on the major expenses that a country would incur.

Sri Lanka’s Situation

( In Rs Mn) 2001)

Consumption Expenditure 1,185,482

• Private 1,043,937

• Government 141,545

Gross Domestic Capital Formation (Investment) 308,473

• Private Sector and Public Corporations 266,449

• Government 42,024

Add Exports of Goods and Non Factor Services +517,528

(Less) Imports of Goods and Non Factor Services - 611,303

Gross Domestic Expenditure at Market Prices 1,400,180

(Less) Indirect Taxes less Subsidies 149,361

Gross Domestic Expenditure at Factor Costs 1,250,819

+/- Net Property Factor Income -25,048

+ Statistical Discrepancy 1,983

Gross National Expenditure at Factor Costs 1,227,754

(Less) Depreciation

Net National Expenditure

You may notice that as per the above two tables that both figures derived from Gross

National Expenditure and Gross National Product would yield the same answer.

Gross National Expenditure = Gross National Product

c) Income Method

Under the income method the Gross Domestic Income and the Gross National Income is

calculated as follows.


Sri Lanka does not

calculate NI based on

Income

� Wages (Income from employment and self employment) XXXX

� Rent Income XXXX

� Interest Income XXXX

� Profits (Gross Trading Profits of Companies and

Corporations)

XXXX

Gross Domestic Income at Factor Costs XXXXXXXXXXXX

+/- Net Property Factor Income XXXX

Gross National Income at Factor Costs XXXXXXXXXXXX

( Less) Depreciation XXXX

Net National Income XXXXXXXXXXXX

When tallying the final figures from all methods, one would see the following relationship.

Gross National Expenditure = Gross National Product = Gross National Income

‡ Activity

Calculate Sri Lanka’s Gross National Product and Gross National Expenditure at Factor

Costs based on the most recent publication of the Central Bank annul report.

d) Difficulties in Measuring National Income

The following are some possible difficulties in measuring the national income.

• Difficulty in achieving 100% coverage of households (to calculate income or firms to

calculate output)

• Difficulty in achieving 100% accuracy – In many countries the data or National Income is

based on tax returns. There is a reluctance on the part of people to disclose their true

income as this can increase their tax liability.

• Most government services are provided without profit (valued at true costs) whereas the

firm’s output is provided at market prices (including profits). A country with a very large

government sector may understate its national income


• Valuation of unpaid services (housewives) and Do–It–Yourself services. National Income

will only count goods and services which are sold for money. In most developed

countries Do-It -Yourself goods are used, which will understate the National Income.

• Danger of the double counting error

• Difficulty in calculating the depreciation accurately – different companies use different

depreciation policies, thus in consolidation, this would not be very accurate.

• Existence of a black economy - The black economy will not be captured into the national

income and if a country has a big black market then the National Income will be under

represented.

e) Importance of National Income Statistics

• It indicates the rate at which the economy has grown from year to year.

• It will indicate the sectorial representation of the country’s GDP and its relative

importance over the years

• It’s used to compare the economic growth rates of different countries.

• It shows how National Income is shared among the owners of factors of production and

equitability of income distribution

• It shows the pattern of expenditure between consumption and investment. The difference

can be seen when considering the National Income calculation under the expenditure

method for the consumption expenditure and investment expenditure (gross domestic

capital formation).

4. The Circular Flow and Economic Sectors

Two Sector Economy Three Sector Economy Four Sector Economy

Households + Firms Households + Firms +

Government

Households + Firms +

Government + rest of the

world.

A two sector economy is where there are only firms and households. The above circular flow

diagram is based on the two sector economy. A three sector, is the existence of the

government other than the firms and the households. A four sector is the presence of

transactions from the rest of the world, included with firms, households and the government.

4.1 Injections and Withdrawals of the Circular Flow

a) Withdrawals (Leakages)

Income or resources that moves away from the circular flow. The following table will show

the withdrawals from the two sector , three sector and the four sector economies.


Two Sector

Economy

Three Sector

Economy

Four Sector Economy

Households +

Firms


Government



world.

Withdrawals

(W)

Savings (S) Taxes (T) Imports ( M)

W= S W=S+T W=S+T+M

• Savings

This is the income that the households choose not to spend. Savings will be deposited in

financial institutions or banks. This means, that the money circulating in the circular flow

is withdrawn from the system. This is applicable for both savings from households and

firms.

• Taxes

This removes money from the household income and firms’ revenue and takes it to

government coffers. This becomes a withdrawal in the circular flow.

• Import Expenditure

Money spent on imports of goods and raw material is withdraw from the circular flow of

the country.

Total withdrawals from the circular income = W =S+T+M ( 4 sector economy)

b) Injections

Additions of resources or funds into the circular flow. The following table will show you the

withdrawals from the 2 sector , 3 sector and the 4 sector economies.

Two Sector

Economy

Three Sector Economy Four Sector Economy

Households +

Firms


Government



world.

Injections

J

Investments ( I) Government

expenditure(G)

Exports ( X)

J= I J= I+G J=I+G+X

• Investment

This is the money that firms or households spend which they draw from various financial

institutions either through past savings or loans. Investments act as injections to the

circular flow of income.

• Government Expenditure

This could be direct government expenditure on goods and services, grants to firms ,

wages to government employees , or transfer payments to households (pensions) . Money

spent by the government acts as an injection into the circular flow of income.


• Export Revenue

Money flows into the circular flow from abroad when foreigners buy export products.

Total injections to the circular income J = I+G+X ( 4 sector economy).

Injections and Withdrawals in a two sector, three sector and in a four sector economy is

shown in Illustration 02

4.2 Equilibrium in the Two sector, Three sector and Four sector economies.

A state of equilibrium would be where there are no injections or withdrawals in the circular

flow of income. Even through there maybe injections and withdrawals, if they are equal to

each other then the circular flow would be at an equilibrium. The following table will show

the equilibrium in the different types of economies.

Two sector

economy

Three sector economy Four sector economy

Households +

Firms


Government



world.

Injections I I+G I+G+X

Withdrawals S S+T S+T+M

Equilibrium I=S I+G=S+T I+G+X=S+T+M

Illustration 02 – Circular Flow of Income with Injections, Withdrawals & Equilibrium

Firms

Households

Expenditure

on goods and

services

(Money Flow)

Factor Payments

Rent, Wages

Interest and profit

(Money Flow)

C 1000

2 Sector 3 Sector 4 Sector

Injections

Leakages

Bank Government Overseas

I I+G I+G+X

S S+T S+T+M

S = T S+T=I+G S+T+M=I+G+X Equilibrium

B 500

200

200 100 200

100 200


5. Per Capita Income

Per Capita income is the national income per head. It is calculated as follows.

Per capita gives the average income a citizen of a country would earn for an year. That is

simply an average. This does not indicate how the income is distributed. Per capita income is

used as a measure of the standard of living, taking distribution also on to consideration

‡ Activity

Refer the Per capita Income in USD for Sri Lanka, SAARC Countries, Major Western

Countries including Japan. How much can one comment on the standard of living based

on these figures.

5.1 Per Capita Income as a Measure of Standard of Living

The following factors will highlight why the per Capita income alone will not be a good

measure in deciding the standard of living. The reasons are as follows

a) Per capita income is only an average. If income is unequally distributed the average

income might seem attractive while in reality the majority would be living below the

poverty line. This would only mislead when using per capita in judging the standard

of living.

b) Per capita is an outcome of the GDP. In developing countries National Income data

might lack accuracy. This will once again give a wrong picture of the standard of

living comparisons.

c) An attractive salary in one country might be a poor salary in another due to

differences in cost of living. For international comparisons per capita is calculated in

USD but based on prevailing exchange rates and it may ignore cost of living

d) Even though per capita income of a country may be low, citizens maybe enjoying free

medical health care, free education etc. These should also be added to a person’s

income if the standard of living is actually to be compared.

e) GDP would be higher in certain countries due to very high defense expenditure thus

the per capita would be shown as higher. This might not reflect a higher standard of

living.


5.2 Other Tools to Indicate Standard of Living

a) Lorenz Curve

Lorenz curve is a curve which shows how income is distributed among the population of a

country. This curve of income distribution shows how much of total income is accounted for

by given proportions of the nation’s families. Further the curve bends away from the line of

best fit, the more unequal is the distribution of income.

The line of perfect equality will indicate the perfect distribution of income and it will act as a

mark to compare the bend in the Lorenz Curve in assessing the income distribution of a

country.

Illustration 03 – Lorenz Curve

According to the Lorenz curve drawn for Sri Lanka, It suggest that 50% of the population is

earning 25% of the national income. The Lorenz curve drawn for Fuji states that 75% of the

population is only earning 25% of the national income indicating a higher disparity of

income.

b) GINI Index

This is an index which measures the degree of the distribution of income among individuals

or households within a country. The index measures the areas between the Lorenz curve and

hypothetical line of absolute equality expressed as a percentage of the maximum area under

the line.

% cumulative

income

% of Population

Line of perfect

equality

50%

25%

25% 50% 75%

75%

Lorenz

Curve for

Sri Lanka

Lorenz

Curve for

Fuji


Gini index of zero is perfect equality in distribution of income and 100 is perfect inequality of

distribution of income in a country. The following example will further reinforce this.

‡ Activity

Country Per Capita Income (USD) Gini Index

Sri Lanka 820 34.4

Fuji 800 50.9

Comment on the standard of living between Sri Lanka and Papua New Guinea considering

the Per capita Income and the Gini Index.

Comment

Although the Per Capita Income seem to be similar in both countries , the disparity of

income in Fuji seem to be very higher than in Sri Lanka. There is reasonable ground to

conclude that based on the above, the standard of living in Sri Lanka seems to be higher

than Fuji.

♪ My Short Notes

Chapter 10 – Consumption, Savings & Investment 143

Chapter 10

Consumption, Savings & Investment


1. Consumption

Consumption refers to the expenditure incurred on goods and services. That is the amount of

money that one decides to spend on consuming goods and services.

1.1 Determinants of Consumption

The following are the determinants of consumption.

a) Consumer Income

This is one of the major determinants. Higher the income that one gets, the higher the

ability for one to spend on consumption.

b) Level of Wealth

An increase in wealth tends to increase consumption.

c) Rate of Interest

Interest rate is a reward for saving. Higher interest rates would induce households to

save more and spend less.

d) Consumer Tastes and Preferences

Based on the changes in consumer taste and fashion, consumption may change for

that product.

e) Expectations of Future Price Changes

If prices of goods are expected to increase in future households might spend more on

consumption at present.


1. Consumption

2. Savings

3. Relationship between Consumption and Savings.

4. Investment

5. The Concept of the Multiplier

6. The Concept of the Accelerator

7. Equilibrium National Income.

8. The Concept of Full Employment


f) Terms of Credit and Access to Credit

Hire purchase and easy payment schemes can encourage spending.

g) Income Taxes

High income taxes will reduce the disposable income of households.

h) Government Transfers

Various benefits passed down by the government to the poor. For example, through

the pensions provided by the government, people’s purchasing power would increase.

1.2 Consumption Function

The consumption function describes the relationship between households planned

consumption and all of the above determinants.

Therefore C = f (a, b,c,d,e,f,g,h)

1.3 Propensity to Consume

Propensity refers to desire. So propensity to consume refers to the desire to consume an item.

If one has a higher desire to consume then one has a higher propensity to consume.

Propensity to consume could be looked at from two perspectives.

a) Average Propensity to Consume. (APC)

This refers to the consumption expenditure as a proportion of total income during a particular

time period. It is calculated as follows.

Total Consumer Expenditure (C)

APC =

Total Income (Y)

Example

Consumer Expenditure (Rs) 800

Consumer Income (Rs) 1000

Average Propensity to Consume 800

1000

0.8

An APC of 0.8 denotes that with every Re 1 the consumer earns, he would have a desire to

spend 80 cents.

b) Marginal Propensity to Consume (MPC)

This refers to the rate at which consumption expenditure changes as consumer income

changes.


∆ Total Consumer Expenditure (∆ C)

MPC =

∆ Total Income (∆ Y)

Example Year 01 Year 02 Change

Consumer Expenditure (Rs) 800 900 100 (900 - 800)

Consumer Income (Rs) 1000 1200 200 (1200 – 1000)

Marginal Propensity to Consume 100

200

0.5

An MPC of 0.5 denotes that with an increase in income of one rupee, the consumer would

be willing to spend 50 cents on consumption.

2. Savings

This refers to the amount of money not spent. It is the transfer of current purchasing power to

the future. Savings is a withdrawal from the circular flow of income.

2.1 Determinants of Savings

The following are some determinants of savings

a) Income Levels

Higher income groups have higher capacity to save.

b) Interest Rates

Higher interest rates on savings deposits would encourage higher levels of savings.

c) Savings Habits

Some communities by nature are thrifty. They tend to save more.

2.2 Savings Function

The savings function describes the relationship between households planned savings and all

of the above determinants.

Therefore S = f (a, b, c.)

2.3 Propensity to Save.

As indicated above propensity refers to desire. So propensity to save would mean the desire

to save. So we say if one has a higher desire to save then there is a higher propensity to save.

Propensity to save also could be looked at from two perspectives.


a) Average Propensity to Save (APS)

This refers to savings as a proportion of total income during a particular time period.

Total Savings (S)

APS =

Total Income (Y)

Example

Consumer Expenditure (Rs) 800

Consumer Savings (Rs) 200

Consumer Income (Rs) 1000

Average Propensity to Save 200

1000

0.2

An APS of 0.2 denotes that with every Re 1 the consumer earns, he would have a desire to

save 20 cents.

b) Marginal Propensity to Save (MPS)

This refers to the rate at which savings changes as consumer income changes.

∆ Total Savings (∆ S)

MPS =

∆ Total Income (∆ Y)

Example Year 01 Year 02 Change

Consumer Expenditure (Rs) 800 900

Consumer Savings (Rs) 200 300 100 (300 - 200)

Consumer Income (Rs) 1000 1200 200 (1200 – 1000)

Marginal Propensity to Consume 100

200

0.5

An MPS of 0.5 denotes that with an increase in income of one rupee, the consumer would

be willing to save 50 cents on consumption.

3. Relationship between Consumption and Savings

3.1 Observations

First Observation

Income = Consumption + Savings

Y = C + S

Second Observation.

APC + APS = 1

APC = 0.8, APS = 0.2, Therefore APC (0.8) + APS (0.2) = 1


Third Observation

MPC + MPS = 1

MPC = 0.5, MPS = 0.5, Therefore MPC (0.5) + MPS (0.5) = 1

Inferences from the above formulae

MPS = 1 – MPC

MPC = 1– MPS

4. Investment

Investment refers to the addition to the stock of capital goods in a country. For example

factory buildings, houses, machinery and inventories etc. Investment is a form of a spending.

It is the spending on capital goods.

Investment is also said to be the allocation of resources with an expectation of future return.

Investment is an addition to the productive capacity of a country and thus it is an injection

into the circular flow.

4.1 Determinants of Investment.

a) National Income (This is called Induced Investment)

National Income as a determinant of investment could be viewed from two perspectives.

Illustration 01 - First Perspective (From National Income Point of View)

When National Income increases (factor income increases) the amount of money available to

consumers to save will increase. An increase in savings would mean that there would be more

money available for investments. This would lead to an increase in investment levels of the

country

Illustration 02 - Second Perspective (From National Expenditure Point of View)

Increase in

National

Income

Factor

incomes to

households

increase

Increase in

income leads

to an increase

in savings

Increase in

savings

would

increase

investments

Increase in

National

Expenditure

Increase

expenditure on

Gross Domestic

Capital Formation

Increase spend on

investment expenditure

would mean increase in

investments in the

country


From the expenditure method an increase in national expenditure (national income) would

mean an increase in consumption expenditure or investment expenditure. So if the national

income increases due to an increase in investment expenditure then this means that an

increase in the national income has been caused by an increase in investments.

b) Other factors (These Factors are called Autonomous Investment)

i) Marginal Efficiency of Capital (MEC)

This refers to the expected return on capital. Expected future returns would influence

investment decisions up to a large extent. So an increase in the MEC would mean an increase

in investments.

Determinants of MEC

• Future sales trends in an industry (this would give some indication of future

profitability of that industry.)

• Expected cost conditions in the industry – prices of raw material etc.

• Political stability

• State of the economy ( boom or recession)

• Government tax policy ( If the Government taxes heavily on returns on investments

or capital gains, then MEC will be low)

• Technological innovations

• Stock exchange prices

ii) Cost of Capital

The interest rate that needs to be paid to borrow money will decide the cost of capital. If one

has to pay high interest rates then, people will not be encouraged to spend on investments.

The relationship between interest rates (cost of capital) and the volume of investment is

inverse indicating a downward sloping curve.

Illustration 03 - Relationship between Interest Rates and the Volume of Investment

Interest rate (R)

R1

R2

I (Volume of Investments)

I1 I 2


iii) Autonomous Investment Triggers

For autonomous investments to take place, MEC will have to be higher than the cost of

capital. In other words the expected return will have to be higher than the cost of that

investment.

4.2 Investment Function

The investment function describes the relationship between investments and all of the above

determinants.

There fore I = f (Interest rate, MEC)

5. The Concept of Multiplier

The concept of the multiplier shows how many times the national income will INCREASE

given an increase in autonomous investment.

Increase in autonomous investment Multiplied effect on Increase in National Income

Autonomous Investment x Multiplier = Increase in National Income.

5.1 Calculating the Multiplier.

Practice Example

Autonomous investment in a country is Rs 10,000 million. The Marginal Propensity to

Consume is 0.80.

a) Calculate the value of the multiplier.

b) What is the increase in National Income?

Solution

a)

b) Increase in National Income = 5 x 10,000 = Rs Million 50,000


5.2 The relationship between the Multiplier and the Marginal Propensity to Consume.

Marginal Propensity

to Consume ( MPC)

Marginal Propensity

to Save ( MPS)

Multiplier Formula

( based on MPC)

Value of Multiplier

0.2 0.8

1

1- MPC

1.25

0.4 0.6 1.66

0.6 0.4 2.50

0.8 0.2 5.00

You will identify that there is a positive relationship between marginal propensity to consume

(MPC) and the value of the multiplier. In order to understand this further the reader is

requested to refer to appendix one at the end of this chapter.

6. The Concept of Accelerator

The concept of the accelerator states that an increase in the national income will lead to an

increase in the investment in capital goods of a country. In other words, an increase in

National Income accelerates the investments of a country.

The following example would iterate this further.

Capacity of a machine – 100 pairs for the year

Year National

Income

Consumer

Demand

Required

Machines

Available

Machines

Additional

Machines

Investment

01 Constant 1000 pairs 10 10 None None

02 10% increase 1100 pairs 11 10 1 Yes

03 20% from Y2 1320 pairs 13.2 11 2 Yes

The following diagram will show you how the accelerator will affect the expansion of

investment due to an increase in National Income.

Illustration 04 – Accelerator at Work

Purchasing power of people increases

Increase

in

national

income

Increase in

purchasing

power of

people

Increase

demand for

consumer

products

Increase demand for

capital goods to

manufacturer

consumer goods

Increase in

Investment


Based on the above analogy, you may note that an increase in National Income will lead to an

increase in the investments of a country. This increase in investment is called induced

investments.

Both the accelerator and the multiplier will have a spiral effect on the economy. The

following illustration will demonstrate this further.

Illustration 05 - Accelerator and the Multiplier both at work in the Economy.

7. Equilibrium National Income

7.1 Understanding the National Income Equilibrium

National Income is said to be in equilibrium when there is no tendency for it (national

income) to either increase or decrease. The National Income is said to be in equilibrium

when it is in either one of the following is in force.

• National Income(Y) = National Expenditure (E)

(based on income expenditure method)

• Leakages(S) = Injections (I) in a two sector economy.

(based on leakages/injections method)

The following table will validate this claim further. Also illustration 06 will further highlight

this graphically.

Increase in

investments

National income

Multiplier

Induced investments

in capital goods

Accelerator

National income

Multiplier

Induced investments

in capital goods

Accelerator


Point National

Income

Consumption

(household)

Savings Investments Planned Expenditure

( National

Expenditure)

Y=C+S C S I E= C+I

A 0 300 -300 300 600

B 400 600 -200 300 900

C 800 900 -100 300 1200

D 1200 1200 0 300 1500

E 1600 1500 100 300 1800

F 2000 1800 200 300 2100

G 2400 2100 300 300 2400

H 2800 2400 400 300 2700

I 3200 2700 500 300 3000

Equilibrium National Income is at point G where

• National Income (Y = 2400) = Planned Expenditure (E = 2400)

• Leakages (Savings = 300) = Injections (Investments = 300)

Illustration 06 – National Income Equilibrium Graphically

Planned expenditure

E=C+I

National Income (Y)

E=Y

At the point where E=Y National Income is at equilibrium. Also you will find that at this

point S=I (explanation Y=C+I = E=C+S. Consumption is common so at Y=E, S=I)

E > Y

Any point below Y=E will be this and in this area the national economy will be in

disequilibrium. This area will indicate a situation where the expenditure would be higher than

the national output. (Income) In other words; there would be more demand in the economy

than what it could supply. This excess demand situation will drive the national income up as

suppliers will start to increase their output reaching E=Y.

E=C+I Y=E

E>Y

E<Y

Y = C+S


E< Y

Any point above Y=E will be this. The national income will be at a disequilibrium. This area

will indicate a situation where the national output (income) is higher than the planned

expenditure. In other words, there will be excess products in the economy being unused. This

excess supply situation will build up unnecessary stocks and there will be pressure to reduce

national output (income) till reaching E=Y.

As a conclusion, a state of equilibrium is where the national income will not have any

tendency to either increase or decrease when it is in equilibrium.

7.2 National Income Equilibrium in a Two, Three and Four Sector Economies.

Illustration 07 – National Income Equilibrium in 2, 3 & 4 Sector Economies

Planned Expenditure

E=C+I+G+(X-M)

National Income (Y)

You may note as a higher sector economy is introduced to the above diagram, the equilibrium

level of that economy tends to increase.

7.3 National Income Equilibrium formulae for Two, Three and Four sector economies

Economy Income Planned

expenditure Equilibrium

condition

Y=E , S=I


Formulae

2 sector Y=C+S E=C+I Y = C + I

3 sector Y=C+S E=C+I+G Y = C + I + G

4 sector Y=C+S E=C+I+G+(X-M) Y = C + I + G + ( X-M)

The above table will indicate how the National Income Equilibrium Formulae are derived for

the different sector economies

E=C+I

2 sector economy

Y = C+S

E=C+I +G

3 sector economy

E=Y (2)

E=Y (3)

E=C+I +G + (X-M)

4 sector economy

E=Y (4)


Practice Example

The following details are given for a hypothetical economy.

Investments LKR. 3,500 million

Government Expenditure LKR 1,250 million

MPS 0.2

Exports LKR 1,600 million

Imports LKR 1,900 million

a) Calculate the equilibrium National income

Calculate the equilibrium national income if the following changes. Consider each change

from your answer in a.

b) Investment expenditure increase by 25%

c) Government expenditure decrease by 10%

d) Marginal propensity to save increase to 0.3

e) Calculate the value of the multiplier ( base answer to part a)

Solutions

Part a)

Calculate the equilibrium national income.

Step 01

Economy type = 4 sector (Since the economy deals with imports and exports).

Step 02

National equilibrium formula for the four sector economy.

Y = C + I + G + ( X-M)

Step 3

Substitute the values given.

Y = C + 3500+1250+(1600-1900)

Step 04

How to find out consumption

Marginal propensity to save (MPS) = 0.20

We know MPC + MPS = 1, Therefore MPC = 1- MPS (0.20) thus MPC = 0.80

At equilibrium = Savings = Investment , Therefore, Investment = 3500mn

If Investment = 3500 = Savings at the equilibrium.

There fore Savings = 3500mn , MPS = 0.2 = 3500 , Then

What is consumption = 3500 x 0.80 = 14000

0.20

Step 05

Substitute consumption to the formula and then calculate the equilibrium national income

Y = C +I+G+(X-M)

Y = 14000 + 3500+1250+(1600-1900)

Y= 18450 mn


Part b to d

Section Change item

Old value

New value

Calculation Formula National income

b Investment

+ 25%

3500 4375 C=4375/0.2*0.8

C= 17500

Y=17500+4375+1250

+(1600-1900)

22,825.00

c Gvt exp

- 10%

1250 1125 Y=14000+3500+1125

+(1600-1900)

18,325.00

d MPS

+ to 0.3

0.20 0.30 C=3500/0.3*0.7

C= 8166.66

Y=8166.66+3500

+1250+(1600-1900)

12,616.66

Part e

Calculating the Multiplier

Answer based on original figures (part a)

Multiplier = 1 = 1 = 5

MPS 0.2

The value of the multiplier is 5 times. National income increase due to multiplier =

18450mn x 5 = 92,250mn

8. The Concept of Full Employment

Full employment is a situation where all the factors of production in the economy are

employed fully in production. Let us look at how an economy could move towards full

employment based on the equilibrium national income concept.

Illustration 08 –Full Employment Level in the Economy

Planned expenditure

Y YF National Income

The above diagram explains the equilibrium national income at E=Y (1), the output is at Y

and the economy is incurring consumption and investment expenditure. (E=C+I) You will see

that the economy is not at full employment level as YF (full employment level) is further

away.

E=C+I

E=C+I +G

Deflationary gap

E=Y

(2)

E=Y

(1)

Inflationary gap

E=Y

(3)

Y=C+S

E=C+I +G 1


The government however can increase government spending and take the equilibrium to E=Y

(2) level where it will reach the full employment level. The gap between E=Y (1) and E=Y

(2) is called the deflationary gap. A deflationary gap exists when there is insufficient demand

available in the economy to generate full-employment equilibrium. In other words there is not

enough being brought to provide jobs for everyone who wants them.

However, if planned expenditure (aggregate demand) increases further above the full

employment level then it will lead to a demand-pull inflation. The gap between E=Y (2) and

E=Y (3) is called the inflationary gap. This occurs when there is too much demand in the

economy. This excess level of demand will tend to lead to demand-pull inflation. So full

employment has a direct link to the aggregate demand in the economy (AG = Consumption +

Government Expenditure + Investment Demand)

♪ My Short Notes


Chapter 11

Fiscal Policy and Monetary Policy

1. Fiscal Policy

Fiscal policy refers to a government’s policy on its expenditure and on taxation issues in

dealing with the national income. Fiscal policy is said to be an important tool in stabilizing

the economy of a country.

Fiscal policy essentially uses two types of tools. These tools are

• Government Expenditure

• Taxation

The government taking the above two tools could carry out an expansionary or an

contractionary effect on the equilibrium national income.

1.1 Expansionary Fiscal Policy

Expansionary fiscal policy refers to the increase in the aggregate demand (or the consumption

function) of the economy leading to an expansionary effect on the equilibrium national

income. The tools that could be used for this effect would be

• Increase of Government Expenditure

• Reduction of Taxes

By the above, the government could reduce the deflationary gap in the economy. Illustration

01 will indicate how the equilibrium national income could have an expansionary effect.

Illustration 01 – Expansionary Fiscal Policy at Work

Planned expenditure

E=C+I+G

Deflationary gap

Y YF National income

E=C+I +G 0 E=Y

(2)

E=Y

(1)

E=C+I +G 1

Y = C+S


1. Fiscal Policy

2. Monetary Policy


The expansionary fiscal policy causes the

• Consumption function to move upwards

• Allows the economy to reach the full employment level.

• Reduces the deflationary gap

• Brings about the expansionary effect on the equilibrium national income.

Let’s try to understand how the above happens with the two remedies stated.

a) Increase in Government Expenditure

Illustration 02 – Expansionary Fiscal Policy and Increase in Government Expenditure

Government expenditure will also have an indirect effect on the multiplier. Let us say the

government spends on a highway project. Due to this, people who are involved in that project

will get an income.

Based on the marginal propensity to consume, that income will be spent on consumer goods.

The recipients of that money will further spend on other goods having a multiplying effect on

the national income.

What this means, is that the aggregate demand of the country will increase and will cause the

consumption function to move upwards having an expansionary effect on the equilibrium

national income.

Both of the above situations will have an expansionary effect on the equilibrium national

income.

b) Reduction in Taxes

Illustration 03 will indicate how the reduction in taxes will lead to an expansionary effect on

the equilibrium national income.

Increase in

government

expenditure

Will increase the

aggregate

demand in the

economy

Will lead to an

upward shift in

the

consumption

function

Will Increase the

output to the full

employment level

Expansionary

effect on the

equilibrium

national income


Illustration 03 – Expansionary Fiscal Policy and Reduction in Taxes

Reduction in Taxes

Increase disposable income of consumers Increase ability to save

Money available for investment increase

Consumption expenditure will increase Investment expenditure will increase

Aggregate Demand will increase

Consumption function will increase and will move upwards (output will also move to full

employment level)

Expansionary effect on the equilibrium national income

c) Expansionary Fiscal Policy on the Government Budget

Expansionary fiscal policy will create a budget deficit.

Budget Deficit = Government Revenue < Government Expenditure

Expansionary Reduction in government revenue Increase in government

Fiscal Policy through reduction in taxes expenditure

The following table will indicate an example to highlight the above.

Government Income

( Taxation)

Government

Expenditure

Government Budget

Pre – Expansionary

Fiscal Policy

1000 Million 1000 Million 0 Deficit

Post Expansionary

Fiscal Policy

500 Million

(Reduction in taxes)

1500 Million

(Increase in Gvt

Expenditure)

(1000 Million)

Budget Deficit

When there is a budget deficit the government will have to borrow from the public in order to

cover its expenditure. This will have a further impact on the interest rates of the economy.


d) Situations to use the Expansionary Fiscal Policy

i) To cure a Recession in the Economy

Economic recession is a continuous decrease in the aggregate demand through a reduction in

investment demand. The reduction in aggregate demand will cause the consumption function

to move downwards, below full employment level bringing down the equilibrium national

income.

This reduction in investment demand will further bring down the consumer demand as there

would be loss of employment and a reduction in purchasing power among the consumers

aggravating the recession further. This will cause a deflationary gap in the economy. The

following diagram will show a recessionary situation in the economy.

Illustration 04 – Economic Recession

Planned expenditure

E=C+I+G

Deflationary gap


The expansionary fiscal policy could be used to cure economic recession by inducing the

aggregate demand to move towards the full employment point.

ii) To achieve Full Employment levels in Reducing Unemployment

If the economy is not in the full employment level of output, what it indicates is that there is

unemployment in the economy. In order to reduce the levels of unemployment through

expansionary fiscal policies, the aggregate demand will increase in the economy creating new

job opportunities.

This increase in the equilibrium national income will help a country to control its

unemployment problems to a large extent.

1.2 Contractionary Fiscal Policy

Contractionary fiscal policy refers to the decrease in the aggregate demand (or the

consumption function) of the economy leading to a contractionary effect on the equilibrium

national income. The tools that could be used for this effect would be.

E=C+I +G 1 E=Y

(1)

E=Y

(2)

E=C+I +G 0 Y


• Reduction in Government Expenditure

• Increase of Taxes

By the above, the government could reduce the inflationary gap in the economy. Illustration

05 will indicate how the equilibrium national income could have an expansionary effect.

Illustration 05 – Contractionary Fiscal Policy at Work

Planned expenditure

E=C+I+G

Inflationary Gap

YF Y2 National income

(Please note the increase shown of Y2 national income is only in money terms as physical

output cannot increase after full employment level in the economy)

The contractionary fiscal policy causes

• The Consumption function to move downwards

• Allows the economy to settle at full employment level.

• Reduces the inflationary gap

• Brings about the Contractionary effect on the equilibrium national income.

a) Decrease in Government Expenditure

Illustration 06 – Contractionary Fiscal Policy and Decrease in Government Expenditure

E=C+I +G 1 E=Y

(1)

E=Y

(2)

E=C+I +G 0

Y

Decrease in

government

expenditure

Will decrease

the aggregate

demand in the

economy

Will lead to an

downward shift

in the

consumption

function

Will decrease the

output coming

back to the full

employment level

Contractionary

effect on the

equilibrium

national income


b) Increase in Taxes

Illustration 07 – Contractionary Fiscal Policy and Increase in Taxes

Increase in Taxes

Decrease disposable income of consumers Decrease in the ability to save

Money available for investment decrease

Consumption expenditure will decrease Investment expenditure will decrease

Aggregate Demand will decrease

Consumption function will decrease and will move downwards (output will move down to

full employment level)

Contractionary effect on the equilibrium national income

c) Contractionary Fiscal Policy on the Government Budget

Contractionary fiscal policy will create a budget surplus .

Budget Surplus = Government Revenue > Government Expenditure

Contractionary Increase in government revenue Decrease in government

Fiscal Policy through increase in taxes expenditure

The following table will indicate an example to highlight the above.

Government Income

( Taxation)

Government

Expenditure

Government Budget

Pre – Expansionary

Fiscal Policy

1000 Million 1000 Million 0 Deficit

Post Expansionary

Fiscal Policy

1,500 Million

(Increase in taxes)

500 Million

(Decrease in Gvt

Expenditure)

1000 Million

Budget Surplus

When there is a budget surplus there are few things that a government can do

• Retiring public debt – This is where the government pays back the loans it had to take

earlier to cover its deficit. However if the government does this it will have an impact on

its anti inflationary policy, as by money going to the public, their purchasing power will

increase, thus , aggregate demand could increase.

• Impounding the surplus – This is where the government keeps the surplus fund idle.


d) Situations to use the Contractionary Fiscal Policy

If you refer Illustration 05, C+I+G0 consumption function and Y2 national income would

create an inflationary situation in the economy. You may notice that Y2 is above YF which is

the full employment level.

As we understood , the physical output cannot be increased after the YF level (Y2 reflects the

value of National Income and it has increased only through prices). So when aggregate

demand is higher than the full employment level, the obvious reaction would be an increase

in price (due to excess demand situation). This is why there is an inflationary gap.

Through the contractionary fiscal policy, aggregate demand will be reduced (reduced

government expenditure and increased taxation bringing C+I+G 1 to YF level) bringing the

equilibrium national income back to the full employment level allowing the prices to

stabilize.

2. Monetary Policy

Monetary policy refers to the tools which the Central Bank exercises for its control over

money, interest rates and credit conditions. The tools available for the monetary policy are as

follows

• Open Market Operations

• Changing the Bank Rate

• Changing the Cash Reserve Ratio

With the above tools, the Central Bank intervenes in the economy in stabilizing various

macroeconomic aspects.Based on the final impact the Monetary Policy would create, it could

be classified into two types as follows.

2.1 Expansionary Monetary Policy

Expansionary monetary policy refers to a situation where the Central Bank tends to expand

the money supply in the economy and/or lowers interest rates so as to stimulate aggregate

demand in the economy. The final outcome would be an expansionary effect on the

equilibrium national income/output. Please refer illustration 08 for the graphical

representation of the expansionary monetary policy.

You may note that the expansionary monetary policy would increase the aggregate demand

increasing the consumption function resulting in the upward movement of the equilibrium

national income. It would also help an economy to reach the full employment level.


Illustration 08 – Expansionary Monetary Policy at Work

Planned expenditure

E=C+I+G

Deflationary gap


Let us understand how the monetary policy tools could be used to achieve expansionary

monetary policy.

a) Open Market Operations

Illustration 09 – Expansionary Monetary Policy and Open Market Operations

Central Bank buys securities from the open market.

You will see from the above diagram that through the Central Bank buying securities in the

open market, it would have an expansionary effect national income.

E=C+I +G0 E=Y

(2)

E=Y

(1)

E=C+I +G1

Y

Central bank

Securities

Money

Commercial banks & the Economy

Securities in the open market

(treasury bills)

Increase money supply into the banking

system

More money available in the banking

system for investments

Increase investments/( increased

investment demand-low interest rates)

Increase in aggregate demand

Expansionary effect on National Income


b) Central Bank Lowering its Lending Rate to Commercial Banks

Central bank is the bank of all banks in the economy. Like individuals borrowing money,

banks often borrow money from the Central Bank. The Central Bank, by lowering its lending

rate, could create an expansionary effect on the national income.

Illustration 10 – Expansionary Monetary Policy and Bank Lending Rate

c) Central Bank Reducing the Statutory Cash Reserve Ratio

Every commercial bank is supposed to keep a minimum % from all its deposits as stipulated

by the Central Bank. By altering this ratio the credit creation could be changed by

commercial banks in the economy.

Illustration 11 – Expansionary Monetary Policy and Cash Reserve Ratio

From all of the above activities the Central Bank can have an expansionary effect on the

national income as explained. If this happens, the economy would also move towards the full

employment level.

Lowering

central bank

lending rate

Banks borrowing

more money

from CB

Increased

money supply

will reduce

interest rates

Cheap borrowing

will induce

consumption and

investment demand

Expansionary

effect on the

equilibrium

national

Lowering

cash reserve

ratio by the

central bank

Banks would

have more money

to lend (increase

in money supply)

Increased

money supply

will reduce

interest rates

Cheap borrowing

will induce

consumption and

investment demand

Expansionary

effect on the

equilibrium

national


d) Situations to use the Expansionary Monetary Policy

As described earlier it could be used for the following

i) To Cure Economic Recession

As understood, economic recession would be a reduction in the aggregate demand in an

economy. By implementing the expansionary monetary policy an economy would be able to

recover from recession by increasing the aggregate demand based on what was presented

above.

ii) To Reduce Unemployment

Also through expansionary monetary policy, it can be seen that an economy would move

towards full employment level.

2.2 Contractionary Monetary Policy (this is also called a tight Monetary Policy)

Contractionary monetary policy seeks to reduce the money supply through contraction of

credit and raising the cost of credit in reducing investment demand thus reducing aggregate

demand in the economy. The final outcome would be a contractionary effect on the

equilibrium national income/out put.

Illustration 12 – Contractionary Monetary Policy at Work

Planned expenditure

E=C+I+G

Inflationary gap

YF Y2 National income

As you may notice the objective of the contractionary monetary policy would be to decrease

the aggregate demand resulting in the downward movement of the equilibrium national

income. It would bring the economy back to the full employment level from an overheated

status.

Let us see how the monetary policy tools could be used to achieve the contractionary

monetary policy.

E=C+I1 +G1 E=Y

(1)

E=Y

(2)

E=C+I +G0

Y


a) Open Market Operations

Illustration 13 – Contrationary Monetary Policy and Open Market Operations

Central Bank sells securities to banks, other depositary institutions and the general public

through open market operations.

.

You will see from the above diagram that through the Central Bank selling its securities in

the open market , it would have a contractionary effect on the on the national income.

b) Central Bank Increasing its Lending Rate to Commercial Banks

The Central Bank by increasing its lending rate could create a contractionary effect on the

national income.

Illustration 14 –Contrationary Monetary Policy and Bank Lending Rate

Central Bank

Securities

Money

Commercial Banks & the Economy

Selling securities to banks/public

Reduce money supply from the

banking system

Less money available in the banking

system for investments

Decrease investments

Decrease in aggregate demand

Contractionary effect on national income

Increasing

central bank

lending rate

Banks borrowing

less money from

CB

Reduced

money supply

will increase

interest rates

Expensive

borrowing will

reduce consumption

and investment

demand

Contractionary

effect on the

equilibrium

national income


c) Central Bank Increasing the Statutory Cash Reserve Ratio

Illustration 15 –Contrationary Monetary Policy and Cash Reserve Ratio

d) Situations to use the Contractionary Monetary Policy

i) To Manage Inflation

As you may understand the economy will be experiencing high levels when the aggregate

demand is above the full economy level of output.

The national income has only expanded on monetary terms as out put cannot be increased

any more above the full employment level.

So in order to reduce this excess aggregate demand and to bring down the general price levels

contractionary monetary policy measures could be taken.

Summary of the Policy Actions

Policy Tools Expansionary

Effect

Contractionary

Effect

Fiscal

Policy

Government Expenditure Increase Decrease

Taxation Decrease Increase

Monetary

Policy

Open Market Operations Buy securities Sell securities

Bank Lending Rate Decrease Increase

Cash Reserve Ration Decrease Increase

Increasing

cash reserve

ratio by the

central bank

Banks would

have less money

to lend (decrease

in money supply)

Reduced

money supply

will increase

interest rates

Expensive

borrowing will

reduce consumption

and investment

demand

Contrationary

effect on the

equilibrium

national income



While you were having tea in the university campus, you happen to hear the following

conversation between two of your colleagues.

Chandana : Why did our Economics master say that inflation is not always harmful to the

economy?

Upul : Well! he did not explain why he said that, but I liked his argument which he

said that the contractionary monetary policy is the best recourse to cure

inflation since the use of the contractionary fiscal policy may have political

repercussions with the masses.

a) Critically debate the statement made by the economics master where he suggested that

fiscal policy may have political repercussions with the masses in curing inflation.

8 marks

b) Explain how the contractionary monetary policy could cure inflation

7 marks


A colleague in office has read the following paper article and finds it difficult to understand

as to what it means.

“Inflation is not always harmful to business. But the present level of inflation in Sri Lanka

may move closer to a double digit level. The government of Sri lanka is planning to use the

contractionary monetary policy to bring this situation under control”

After hearing that you have been following a course in marketing studying economics as a

subject, he approaches you to clarify the above statement;

a) Explain how the contractionary monetary policy could bring down inflationary pressures

in an economy.

7 marks



Mr. Muragasu an ordinary factory worker has been working very hard for the last 20 years.

Every year he has been getting salary increments for his hard work. However Mrs.

Muragasu has always been complaining that however hard her husband works and gets

salary increments every year, there is no change in the net effect of their family’s ability to

meet their day to day needs. She blames the cause for this to ever increasing prices of

products.

a) If the government is to ease the pain on families like Muragasu in Sri Lanka, what kind

of a policy should they follow to control inflation? Explain how the policy that you are

suggesting would help the above type of families to meet their day to day requirements

better.

12 marks

b) What would be the repercussions to the government by following such a policy in

managing its budget

5 marks

♪ My Short Notes



Foundation Level


for Marketing


L

ega

l A

spec

ts

Module Three


173

Chapter 12

Introduction to the Law of Contract


1. Definition 2. Formation 3. Invalidation 4. Discharge 5. Remedies

1. Definition A contract can be defined as an agreement between two or more parties that is binding in law.

This means that the agreement generates rights and obligations that may be enforced in the

courts. The normal method of enforcement is an action for damages for breach of contract,

though in some cases the court may compel performance by the party in default.

Therefore in any discussion of the nature of a contract it is necessary to emphasise the feature

of a binding obligation. When there is an agreement that arises from offer and acceptance and

provided that the other necessary factors, consideration and intention to contract, are present,

there is a contract.

If a contract is a legally binding agreement, the first question to consider is the method by

which the courts ascertain whether a contract has been formed. Traditionally, the courts were

concerned with whether there had been a meeting of the minds of the two parties, or

consensus ad idem. That is to consider whether one party (the offeror) has made an offer

which has been accepted by the other (the offeree) so as to conclude a contract. The approach

is now objective, i.e. would a reasonable observer assume an agreement to have been

concluded on certain terms.

As can be seen, there are three basic elements in the formation of a valid simple contract.

First, the parties must have reached agreement (offer and acceptance); secondly, they must

intend to be legally bound; and thirdly, both parties must have provided valuable

consideration. In Carlill v Carbolic Smoke Ball Co. [C.A.1893], court was of the view that an

advertisement published, is an ‘offer’ made to world at large and is not a merely an invitation

to treat. Lord Parker C.J. considering the contractual obligations in respect of displayed

goods, in Fisher v Bell [1961], held that “the display of an article with a price on it in a shop

window is an invitation to treat”. The same principle has been applied by the Court of Appeal

in Pharmaceutical Society of Great Britain v Boots Cash Chemists (Southern) Ltd. [C.A.


174

1953] to the display of goods in self-service stores. These matters are dealt in Section 2 in

detail.

In addition, the parties must have the legal capacity to contract and, in some cases, there must

be compliance with certain formalities.

A contract consists of various terms, both express and implied. A term may be inserted into

the contract to exclude or restrict one party’s liability.

A contract may be invalidated by a mistake, or by illegality, and where the contract has been

induced by misrepresentation, duress or undue influence, the innocent party may have the

right to set it aside.

The discharge of contracts and the remedies available together with the above mentioned

matters are dealt within Section 2 of this Chapter.

2. Formation

Our whole economy is based on the freedom of individuals to contract and a system of laws

that enforces contracts freely entered into. But a lot of people may not be aware of what are

the essential elements required to make an enforceable contract. Many thereby question

whether a contract not in writing is binding. We are so accustomed to seeing contracts in

writing that many people assume that a contract must be in writing (and lengthy) before it is

enforceable. What then are the essential elements of a valid contract?

2.1 Intention to be legally bound

The case law in this area establishes that the intention to contract is a necessary independent

element in the formation of a contract, despite the arguments that there is no separate

requirement of intention to contract, if there is agreement and consideration. So it can be said

that intention to contract is a necessary element in the contractual bond. “Intention to

contract” is not the same thing as the “willingness to be bound”. “Willingness to be bound”

means the offeror’s readiness to perform his promise if the other party accepts it; “intention

to contract” means the readiness of each party to accept the legal consequences if they do not

perform their contract.

With agreements of a friendly, social or domestic nature, this intention is rarely present. In

fact, the law presumes that there is no such intention in the absence of strong evidence to the

contrary. Therefore an arrangement between friends to meet for a meal, or between husband

and wife for apportioning housekeeping duties, would not be legally binding contracts.


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‡ Case

Balfour v Balfour [C.A. 1919] The defendant was a civil servant stationed in Ceylon. He and his wife (the Plaintiff) came to England on leave. When his leave was over he went back to Ceylon alone, and his wife stayed in England on her doctor’s advice. The husband promised to pay her £ 30 a month. He did not keep this promise and his wife sued him. Held: husband not bound to pay the promised monthly allowance as arrangements between husband and wife are not contracts because the parties did not intend that they should be attended by legal consequences.

However, the presumption against contractual intention will not apply where the spouses are

not living together in amity at the time of the agreement. i.e. in arrangements between

husband and wife the circumstances may e such as to lead a court to hold that legal relations

are intended.

‡ Case

Merritt v Merritt [C.A. 1970] The husband left the wife and went to live with another woman. The wife pressed the husband to make arrangements for the future. The husband made certain oral promises and then on wife’s insistence wrote and signed that on the payment of the mortgage by the wife the husband will transfer the sole ownership of the house to the wife. Husband refused to transfer the house to the wife. Held. That the wife was now the sole beneficial owner of the house.

It seems that agreements of a domestic nature between parent and child are likewise

presumed not to be intended to be binding.

‡ Case

Jones v Padavatton [C.A. 1969] A mother agreed with her daughter, a secretary in the United States that if she would give up her job and read for the Bar in England the mother would provide maintenance for her. The daughter came to England and began to read for the Bat. Later the agreement varied where mother agreed to provide a house for the daughter. Held: that the arrangement was not intended to be legally binding and that the mother was entitled to possession of the house.


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Where members of a family have a business relationship with each other, there will be

contractual intention in relation to contracts of a business, as opposed to a domestic nature:

Snelling v John G. Snelling Ltd [1972]

As opposed to the above discussed social and domestic agreements, in commercial

agreements there is a presumption that the parties do intend to make a legally enforceable

contract. Thus it is not necessary, in the ordinary run of commercial transactions, for the

plaintiff to give affirmative evidence that there was such an intention. But the defendant may

defeat the presumption by reference to the words used by the parties and/or the circumstances

in which they used them.

‡ Cases

Esso Petroleum Ltd. v Commissioners of Customs and Excise [H.L. 1976] This case shows the difficulty of rebutting contractual intention where clear words are not used. Plaintiff distributed World Cup coins to be given free to any motorist who purchased a given amount of petrol. The House of Lords was divided on the issue of contractual intention. Kleinwort Benson Ltd. v Malaysia Mining Corpn [C.A. 1989] It was held that a “letter of comfort”, where a company stated that it was its policy to ensure that its subsidiary could meet its liability in respect of loans made to it, did not have contractual effect. The words in question were intended as a statement of existing fact and not as a contractual promise.

If the parties are still negotiating then obviously they do not intend to be legally binding yet.

Similarly, an ‘agreement’ where at least one vital term is left unsettled is clearly not binding

yet. Therefore an option to renew a lease ‘at such rental as may be agreed between the

parties’ would have no effect, because the parties still have some negotiating to do. However,

it might be different if the option was to renew ‘at a market rent’, because this could be

settled by outside evidence and without further negotiation.

Collective agreements between employers and trade unions as to wages and other terms of

employment are normally binding. They are presumed to be intended as working

arrangements and not binding contracts subject to the jurisdiction of the courts.

2.2 Forms

There is a common misconception that simple contracts must be in writing. In fact, most

contracts are made by word of mouth. It may be desirable to have a written agreement where

contractual obligations are at stake, or where the contract is to last for a long time. But this is


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only for purpose of proof and is not necessary for validity. Exceptionally, though, certain

types of agreement are only valid if made in a particular form.

Thereby, certain contracts like bills of exchange, cheques and promissory notes, contracts of

marine insurance, the transfer of shares in a company, and legal assignment of debts, must be

in writing or they will be void.

Hire purchase and other regulated consumer credit agreements may be unenforceable against

a borrower unless they are made in writing and include the conditions required by laws on

Consumer Credit. Contracts of guarantee need not be in writing but they are unenforceable in

the courts unless there is written evidence of the essential terms and they are signed by or on

behalf of the guarantor.

2.2 Agreement

Agreement is essential to any contract. Usually, an agreement is shown by the unconditional

acceptance of a firm offer. That is to enter into a contract; there must be a consensus ad idem:

there must be a meeting of the minds. An agreement can be found in the simplest of words or

conduct. For example, the contract for the construction of the Queen Elizabeth, one of the

largest liners in its days, was contained in a letter from the builder containing words to the

effect "We agree to build the Queen Elizabeth for 5 million pounds".

However, some agreements are not contracts; for example an agreement to meet at the Art

Gallery: what distinguishes contractual agreements from other agreements is the feature of

binding legal obligations. Some legal obligations (for example, in the law of torts) arise

without agreement: what distinguishes contractual obligations is the feature of agreement.

Although agreement is a basic element of every contract, it is not always of such a kind as it

would be so called in popular speech. First, the courts take an objective, rather than a

subjective, view of agreement, and if a person has so conducted himself as to give the

appearance that he has agreed, then he may be held to have agreed, even though, in his own

mind he has not. Secondly, where one of the parties holds a monopoly position the other

party has no real choice, can hardly be said, in a popular sense, to agree.

Thirdly, the law sometimes imposes terms upon one or both of the parties. The courts have

developed a doctrine of implied terms, holding that a term sometimes exists in a contract

even though it has not been expressly stated by the parties. In theory an unexpressed term is

only applied by the court where it arises from the presumed intention of the parties. Subject

to these qualifications, it is still broadly true to say that agreement is a necessary feature of a

contract.

It can be seen that in any discussion of the nature of a contract it is necessary to emphasize

the feature of obligation. An agreement which does not bind the parties- an agreement, that is

to say, which is not a legal obligation- is not a contract.


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2.3 Offer

To form a contract, there are no particular words that must be used by the parties. However,

there must be an offer by one side and an acceptance of the offer by the person to whom the

offer was made. Without both an offer and an acceptance, there can be no consensus ad idem

or a meeting of the minds which is essential to form a contract.

An offer is simply a statement or other indication that the individual is prepared to enter into a contract with another on certain terms and, if the offer is accepted as it stands, agreement is made. An offer may be express or implied from conduct. It may be addressed to one particular person, a group of persons, or the world at large, as in an offer of a reward.

‡ Case

Carlill v Carbolic Smoke Ball Co. [C.A., 1893] The defendants were the makers of a medicinal item called “the Carbolic Smoke Ball”. They issued an advertisement in which they promised to pay 100 pounds to anyone who caught influenza after having sniffed at the smoke ball for a specified period in a prescribed manner. They stated that they had deposited 1,000 pounds with their bankers “to show their sincerity”. Mrs. Carlill saw the advertisement, bought a smoke ball, sniffed at it in the prescribed manner and then caught influenza. She sued for the 100 pounds and succeeded. The defendants argued, inter alia that it was impossible to contract with the whole world. This argument was rejected by the court and it was held that the advertisement constituted an offer to the world at large, accepted by the plaintiff, who was entitled to the 100 pounds.

It is necessary to distinguish a true offer from an “invitation to treat”. The importance of the

distinction is that, if a true offer is made and accepted, the offeror is bound; on the other

hand, if what the offeror said or did is not a true offer, the other person cannot create a

contract by saying “I accept”; in other words, he cannot bind the offeror by saying “I accept”.

The distinction is important, but it is not always easy to make it as seen from the following

situations.

a) Invitations to Tender

The courts have held that an invitation to tender will not normally amount to an offer to

contract with the party submitting the most favourable tender. Thereby, if A asks a number of

suppliers to put in tenders for supplying particular goods or services, he is not making an

offer. This means that he is not bound to accept the lowest, or any other, tender. The position

is similar where A asks one supplier to put in an estimate for supplying particular goods or

services. It is not A who makes the offer; the offer comes from the supplier in the form of the

tender or estimate: See, Spencer v Harding (1870).


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On the other hand, there may be cases where the person inviting tenders may bind himself to

accept the highest bid.

‡ Cases

Harvela Investments Ltd v Royal Trust Co. of Canada (CI) Ltd. [ H.L.,1985] The first Defendants invited the Plaintiffs and the second Defendants to make sealed competitive bids for a parcel of shares, stating, “we bind ourselves to accept (the highest) offer”. The Plaintiffs bid $2,175,000 and the second Defendants bid $ 2,100,000 or $ 101,000 “in excess of any other offer”. The first Defendants believed that they were bound to accep the bid of the second Defendants, as being the higher bid. The House of Lords held that the invitation to tender amounted to an offer to sell to the highest bidder; however, the “referential” bid of the type adopted by the second Defendants was not permissible in a transaction of this kind and therefore the first defendants were bound to accept the plaintiffs’ bid. Blackpool & Fylde Aero Club Ltd v Blackpool Borough Council [C. A., 1990] Here the Defendants invited tenders for an airport concession, laying down clear procedure for the submission of bids. Due to an administrative error on the part of the Defendants, the Plaintiff’s bid – which had been properly submitted – was not considered. Held: that the Defendants were contractually bound to consider the Plaintiff’s tender.

b) Display of goods for sale

It is not clearly satisfied with the rule that the displaying of goods for sale is not the making

of an offer. Although the actual content of the rule seems somewhat arbitrary, the rule is,

however, now firmly established.

‡ Cases

Pharmaceutical Society of Great Britain v Boots Cash Chemists (Southern) Ltd. [C.A. 1953] The Society brought action against Boots alleging that Boots were breaking the law laid down in the Pharmacy and Poisons Act 1933 which requires the sale of any article containing any substance included in Part I of the Poisons List to be made under the supervision of a registered pharmacist. Boots had a self-service shop in Edgware. A customer went in and selected articles from the shelves went up to the cash-desk and paid for them. There was a registered pharmacist standing by the cash-desk but not by the shelves. If the sale took place when the customer picked up the article, then Boots were in breach of the law; if the sale took place at the cash-desk, then they were not. T


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Held: that the sale took place at the cash-desk. The display of articles on the shelves was not an offer, only an invitation to treat. The offer was made by the customer taking the article to the cash-desk. That offer could be, but need not be, accepted by Boots at the cash –desk. If it were so accepted the contract of sale would arise at that point, and so would be under the supervision of the registered pharmacist. Fisher v Bell [1960] Where the Defendant was charged with the offence of offering for sale a flick knife, Lord Parker C. J. stated that “the display of an article with price on it in a shop window is an invitation to treat”. The Defendant, who had displayed such a knife in his shop, was acquitted.

c) Advertisements

Advertisements of goods for sale are normally construed as invitations to treat. This point is

well illustrated in the following case.

‡ Case

Partridge v Crittenden [1968] P was charged with unlawfully offering for sale a wild live bird (a brambling), contrary to section 6 (1) of the Protection of Birds Act 1954. He had put in a periodical called Cage and Aviary Birds an advertisement which read “Bramblefinch cocks, bramblefinch hens, 25s, each”. A Mr. Thompson, having seen the advertisement, wrote up for a hen and enclosed the money. P sent him a hen. On those facts he was charged. It was held by Court that the advertisement was an invitation to treat, not an offer for sale, and that therefore the offence charged was not established.

There are situations, however, where an advertisement will be held to be an offer, not a mere

invitation to treat if they are of unilateral type. This is so, for example, where an

advertisement offers a reward for the return of lost property. If the finder returns the property,

knowing of the reward offer, he is entitled to the reward. It is not open to the owner to say: “I

was not making an offer, I was only inviting offers.” See Carlill’s case above.

d) Auction Sales

In an auction, the auctioneer’s request for bids is an invitation to treat and each bid is an

offer. The bidder is the offeror; his bid is the offer. The auctioneer accepts the offer by

striking the table with the hammer. It follows that the auctioneer can withdraw an item at any

time provided he has not accepted a bid.


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‡ Activity

Discuss the case Payne v Cave [1789] to understand at what point the offer is made.

Similarly, an advertisement that an auction will be held is not an offer: Harris v Nickerson

[1873]. However, in Warlow v Harrison [1859] it was stated, obiter, that an advertisement to

hold an auction “without reserve” would amount to an offer to sell to the highest bidder,

provided that the auction was held.

e) Sales of Land

In sales of land there are so many points to be settled between the parties that the courts are

inclined to treat as a mere step in the negotiations a communication which in other

circumstances might be held to be a definite offer.

A statement of the minimum price at which a party may be willing to sell will not amount to

an offer.

‡ Case

Harvey v Facey [P.C. 1893] The Plaintiffs cabled the Defendants, “Will you sell us Bumper Hall Pen? Telegraph lowest cash price.” The Defendants replied, “Lowest cash price for Bumper Hall Pen, Pounds 900.” The Plaintiffs then cabled the Defendants, “we agree to buy Bumper Hall Pen for the Pounds 900 asked by you. Held: that there was no contract as the second telegram did not constitute an offer. Clifton v Palumbo [C.A. 1944] The Plaintiff estate owner wrote to the Defendant: “I …. am prepared to offer you or your nominee my Lytham estate for Pounds 600,000…… I also agree that a reasonable and sufficient time shall be granted to you for the examination and consideration of all the data and details necessary for the preparation of the Schedule of Completion.” Held: that this letter was not a definite offer.

2.4 Acceptance

Acceptance, whilst the offer is still open, completes the contract. It may be defined as an

unconditional assent, communicated by the offeree to the offeror, to all terms of the offer,

made with the intention of accepting. Whether an acceptance has in fact occurred is


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ascertained from the behaviour of the parties, including any correspondence that has passed

between them.

Acceptance must be an absolute and unqualified acceptance of the offer as it stands with any

terms that may be attached to it. In other words, the offeree must accept the exact terms

proposed by the offeror unconditionally; i.e without introducing any new terms which the

offeror has not had the opportunity to consider. The introduction of new terms is referred to

as a “counter offer” and its effect in law is to bring to an end the original offer.

‡ Case

Hyde v Wrench [1840] The Defendant offered to sell a farm to the Plaintiff for pounds 1,000. In reply, the Plaintiff offered Pounds 950. This was rejected by the Defendant. Later, the Plaintiff purported to accept the original offer of Pounds 1,000. Held: there was no contract. The counter offer of Pounds 950 had impliedly rejected the original offer which was no longer capable of acceptance.

A counter-offer should be distinguished from a mere request for information.

‡ Case

Stevenson v McLean [1880] In response to an offer to sell goods at a stated price made by the defendants, the plaintiffs replied inquiring whether delivery could be made over two months. No reply was made to this request but the plaintiffs accepted the offer. Held: there was a binding contract; the plaintiff’s reply was a request for information and not a counter offer.

The counter-offer analysis has been applied to what has come to be called a “battle of the

forms”. A makes an offer on his own printed form containing certain terms, and B accepts on

his printed form which contains conflicting terms. At this stage there is clearly no contract,

although the courts have held that if B’s communication is acted on by A, e.g. by delivery of

goods, a contract may come into being on B’s terms on the basis that his counter- offer has

been accepted.

‡ Activity

To discuss the above point, see Butler Machine Tool Co. Ltd v Ex-Cell-O Corporation

(England) Ltd [C.A. 1979]


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Sometimes, an acceptance may be made ‘subject to a written agreement’ or ‘subject to

contract’. It must then be decided whether the parties intend to be bound immediately and the

later document is only for the purpose of recording this, or whether there is no intention to be

bound at all until the written agreement is made. See, Pitt v P H H Asset Management Ltd

[1993]

In sales and leases of land, it is customary for the agreement to be expressed as being “subject

to contract”. Where this phrase is used, there is a strong inference that each party is free to

withdraw until such time as a formal contract is prepared and approved. If, however, all the

circumstances show an intention that the agreement should be binding from the outset, then it

will be so binding notwithstanding that the expression “subject to contract” is used. In

modern conditions, a contract for the sale of land is not usually regarded as binding until

there has been an exchange of signed documents.

Another point to be noted in discussing the elements of acceptance is the place where an

acceptance is made. Since acceptance completes the contract, the place where the acceptance

is made is the place of the contract. This may be important if the parties are negotiating from

different countries. It may determine which country’s law shall apply and which country’s

courts shall have jurisdiction.

Acceptance must be communicated

As a general rule, acceptance will not be effective unless communicated to the offeror by the

offeree or by someone with his or her authority. An uncommunicated mental assent will not

suffice.

‡ Case

Brogden v Metropolitan Railway Co. [H.L. 1877] Brogden had four years supplied the railway company with coal without a formal agreement. The company wished to regularise the situation, and so they sent a draft form of agreement to Brogden. He inserted a new term into the draft and returned it, marked “approved”. The company’s agent put it in his desk and it lay there for two years. For two years Brogden sent, and the company paid for, deliveries of coal in accordance with the terms of the draft. The fact that the agent of the railway company put the amended draft contract in his drawer did not amount to acceptance, even though in his own mind he did accept the amendments. It would still not have amounted to acceptance if the agent had written on the draft, before putting it in his drawer, “Amendments accepted”.


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The communication of acceptance must be actually received by the offeror, and, where the

means of communication are instantaneous (oral, telephone, telex), the contract will come

into being when and where acceptance is received; Entores v Miles Far East Corporation.,

[C.A. 1955]

Moreover, communication must be carried out by the offeree or his properly authorised

agent; unlike revocation, acceptance cannot be communicated by an unauthorised though

reliable third party.

‡ Case

Powell v Lee [1908] The plaintiff applied for the headmastership of a school. The managers of the school decided, by a narrow majority, to appoint him. One of the majorities, without being authorised to do so, sent a telegram to the plaintiff telling him that he had been appointed. At a later meeting the managers rescinded their former resolution and appointed someone else. The plaintiff sued for damages for breach of contract. The court rejected the plaintiff’s claim.

The rule that acceptance must be communicated is subject to certain qualifications. First, the

offeror may indicate to the offeree that, if he wishes to accept, he may merely carry out his

side of the bargain without first informing the offeror. Thus an order for goods may be

accepted by delivery of the goods. In Carlill’s case it was held that the use of the smoke ball

itself was adequate acceptance without the need for prior communication of this to the

defendants.

In the above case it did not matter when acceptance took place; it was sufficient for the court

to decide that acceptance had at some time taken place. But in some unilateral contract

situations it is of great importance to decide when acceptance takes place. A difficulty arises

from the coming together in one situation of fact of two rules: (1) that an offer can be

withdrawn at any time before acceptance, and (2) that acceptance need not be communicated.

Goff L.J. in Daulia Ltd v Four Millbank Nominees Ltd [C.A. 1978] clarified the above in

following terms: “….. that the true view of a unilateral contract must in general be that the

offeror is entitled to require full performance of the condition which he has imposed and

short of that he is not bound, that must be subject to one important qualification, which stems

from the fact that there must be an implied obligation on the part of the offeror not to prevent

the condition becoming satisfied, which obligation…..must arise as soon as the offeree starts

to perform.”

The offeror may waive the requirement for acceptance to be communicated, as was

mentioned earlier. He may not waive the requirement of communication in the sense of

stating that silence is to amount to acceptance.


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‡ Case

Felthouse v Bindley [1862] The plaintiff wrote to his nephew offering to buy a horse and saying,” If I hear no more about him, I consider the horse mine at (a stated price).” The nephew did not reply but instructed an auctioneer to keep the horse out of sale of the nephew’s assets. The auctioneer, by mistake, included the horse in the sale and was sued by the plaintiff for conversion. Held: that the plaintiff had no title to sue since the nephew had not accepted his offer. The case shows that even where acceptance is by conduct, that conduct requires to be communicated; after all, it was clear from the nephew’s conduct that he mentally accepted his uncle’s offer, but that conduct was not revealed to the uncle.

The general rule that acceptance, to be effective, must be communicated, stems from the

basic principle that contract is based on agreement. If acceptance is not communicated the

circle of agreement is not, or is not seen to be, complete.

A further exception to the rule that acceptance must be communicated is where acceptance is

effected by post. The rule is that where acceptance by post has been requested or where it is

an appropriate and reasonable means of communication between the parties, then acceptance

is complete immediately the letter of acceptance is posted, even if the letter is delayed,

destroyed or lost in the post so that it never reaches the offeror.

‡ Case

Adams v Lindsell [1818] On September2, 1817, the defendants wrote to the plaintiffs offering to sell some wool and requiring an answer “in course of post”. The letter of offer had been wrongly addressed, and it did not reach the plaintiffs until the evening of September 5. That same day the plaintiffs posted a letter of acceptance, which reached the defendants on September 9. The evidence was that if the letter of offer had been correctly addressed, a reply could have been expected “in course of post” by September 7. On September 8 the defendants sold the wool to someone else. Held: that a contract came into existence on September 5, when the plaintiffs posted their letter of acceptance.

‡ Activity

Discuss the case Household Fire Insurance (etc.) Co. v Grant [1879] in the application of the postal rule.


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The “postal rule” is essentially a rule of convenience and is usually justified on the grounds

that if the offeror chooses the post as a means of affecting a contract, he or she must accept

the inherent risks. The postal rule will not apply in the situations given below where the court

may conclude that the contract comes into being when the letter of acceptance arrives. Where

the offer has lapsed by the time the letter of acceptance arrives, and then if the postal rule

does not apply, there may be no contract at all.

The postal rule will not apply:

1) where the letter of acceptance has not been properly posted, as in Re London and

Nothern Bank [1900], where the letter of acceptance was handed to a postman only

authorised to deliver;

2) where the letter is not properly addressed;

3) where the express terms of the offer exclude the postal rule, i.e. if the offer specifies

that the acceptance must reach the offeror;

4) where it is unreasonable to use the post; e.g. to reply by second class post to a verbal

or cabled offer, or to accept by post on the eve of a postal strike.

Although, there is no English authority on the point, it does not seem possible where the

postal rule applies, for the offeree, having posted his acceptance, to then revoke it by some

quicker means of communication, such as by telephone.

† Key Concepts

TERMINATION OF OFFER

Unless accepted, an offer has no legal effect. Apart from counter offer and express rejection, an offer may terminate in the following ways.

a) Revocation

An offer can be revoked at any time before it is accepted. In Routledge v Grant [1828] it was held that a promise to keep the offer open for a period of time will not be binding unless supported by consideration.

The revocation will only be effective if communicated to the offeree; the offeror cannot revoke his offer simply by a mental decision that he no longer wishes to proceed. This point is well illustrated by Byrne v Van Tienhoven [1880], the defendants made an offer to the plaintiffs by letter on October 1. The plaintiffs received the letter on October 11, and immediately accepted by telegram. Meanwhile on October 8, the defendants had sent a letter revoking their offer, which arrived on October 20. It was held there was a binding contract since revocation was ineffective until communicated but acceptance was effective as from October 11.

Unlike an acceptance, a revocation need not be communicated by the party himself. It is sufficient if the offeree learns from a third party that the offer has been revoked. Thus, in


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Dickinson v Dodds [C.A. 1876], Dodds offered to sell a house to Dickinson for Pounds 800, the offer “to be left over until Friday, June 12, 9 a.m.” on Thursday, June 11, Dodds sold the house to one Allan, and that same evening Dickinson was told of the sale by a man called Berry. Before 9 a.m. on June 12, Dickinson handed to Dodds a letter of acceptance. The Court of Appeal held that there was no contract; Dodds’ offer had been withdrawn before acceptance.

b) Lapse of Time

If an offer is stated to be open for a fixed time, then it cannot be accepted after that time. If no time is stated in the offer, then the offer lapses after a reasonable time. What is a reasonable time is a question of fact, depending on the means of the offer and the subject-matter of the offer. Thus an offer to buy perishable goods or a commodity where the price fluctuates daily will lapse fairly quickly.

In Ramsgate Victoria Hotel v Montefiori [1866], an offer to buy shares could not be accepted after the expiry of five months from when it was made; the offer was held to have lapsed.

c) Death

If the offeror dies before acceptance, there is authority that the offeree may validly accept providing (i) it is not a contract involving the personal service of the offeror, and (ii) the offeree has not been notified of the death. If the offeree dies before acceptance, then it seems the offer will terminate and cannot be accepted by his personal representatives.

2.5 Capacity

The law requires persons entering a contract to have ht necessary capacity. In general all

persons have full legal power to enter into any contract they wish and thus bind themselves.

Further, all persons of full age have contractual capacity. However, few groups of persons do

not have this power in full, and they are said to be under incapacity.

a) Minors

Incapacity is imposed by law upon a minor in an attempt to protect him from the

consequences of his inexperience. Persons below the age of 18 are regarded in law as minors.

Contracts made with minors fall into three categories: (i) some contracts are valid; (ii) some

contracts are voidable in the sense that they bonding on the minor unless he repudiates them.

Apart from these two groups, the general common law rule was that minors were not bound

by contracts they entered into unless they ratified them after reaching majority.

Two points are common to all kinds of minors’ contract: (i) a parent is not liable on his

child’s contracts, unless the child was acting as the parent’s agent; (ii) a minor’s contracts

cannot be validated by the consent or authorisation of his parent.


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(i) Contracts valid at common law

Contracts for the sale of necessary goods sold and actually delivered to the minor are binding

upon him or her. Necessity goods are those suitable to the minor’s condition in life and his or

her actual requirements at the time of delivery.

‡ Case

Nash v Inman [C.A. 1908] A Savile Row tailor sued a minor, a Cambridge undergraduate, for the price of clothes supplied, including 11 fancy waistcoats. The tailor failed in his action because he did not prove that the minor was not already adequately supplied with clothes. If it turns out that the minor was already adequately supplied, the plaintiff will fail even though he did not know this.

The minor’s obligation is to pay a reasonable price for the goods, not necessarily the contract

price. The minor is likewise bound to pay a reasonable sum for necessary services although in

this case the contract is binding even if only executory.

‡ Case

Roberts v Gray [C.A. 1913] The plaintiff was a famous billiards player, who agreed to take the infant defendant on a world billiards tour, and to pay for his board and lodging and travelling expenses. This was a contract for necessaries in the sense that its object was to teach the defendant the profession of a billiards player; a kind of education. Roberts expended time and trouble and incurred certain liabilities in making preparations. A dispute arose between the parties, and, before the tour began, Gray repudiated the contract. He was held liable in damages.

(ii) Contracts voidable at common law.

Certain contracts are voidable at the instance of the minor. These are contracts for the sale or

purchase of land; leases; contracts to buy shares; marriage settlements and partnership

agreements. Such contracts are enforceable by the minor, and binding upon him or her unless

repudiated during minority or within a reasonable time after attaining majority.

When a minor repudiates such a contract he is relieved of all liabilities (e.g. rent) which

accrue after the repudiation, but he can be sued for liabilities (rent) which have already

accrued.


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The minor can recover back money which he has paid under the contract only if there has

been a total failure of consideration.

‡ Case

Corpe v Overton [1833] A minor agreed to enter into a partnership and paid a deposit of pounds 100, the deposit to be forfeited if he failed to execute the partnership deed. He repudiated the contract, never did execute the partnership deed, and sued to recover back the pounds 100. He won, as there had been a total failure of consideration.

(iii) Other contracts.

At common law other contracts were also said to be “voidable” but in the sense that they

were not binding on the minor unless ratified by him or her on attaining majority.

b) Corporations

Corporation is, in law, a person; it is an artificial legal person. Some corporations are set up

under the provisions of a general Act of Parliament.

Companies registered under the Companies Act 1982 have capacity to enter into any contract

that is within the limits of the “objects” clause of the company’s Memorandum of

Association. This is a public document without which a company cannot be registered. At

common law, a company that contracted outside these limits acted ultra vires and any

transaction entered into was void: See Ashbury Railway Carriage and Iron Co. v Riche, [H.L.

1925].

However, the Companies Act provides that an ultra vires contract may be enforceable against

a company by a person dealing with the company in good faith, providing the transaction has

been decided upon by the directors.

Similarly, the contractual capacity of such corporations created by Act of Parliament (e.g.

Railway Authority) is to be found in the incorporating statute; any contract entered into

outside the powers contained in the statute is ultra vires and void.

A corporation created by charter has the same contractual powers as a natural person of full

age and capacity.


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c) Persons of unsound mind and drunkards

As a general rule, a contract with a person suffering from mental disability or drunkenness is

valid, unless the person is, at the time of the contract, incapable of understanding the nature

of the transaction and the other party is aware of this. In such circumstances, the contract is

voidable at the insane or drunken person’s option.

Where, however, the other (sane) party is unaware of the other’s disability, the contract will

be judged by the same standards as if the contract were between tow persons of sound minds;

See Hart v O’Connor. [P.C. 1985] thus the transaction would only be set aside if

unconscionable.

Sale of Goods Act 1979 provides that, where necessaries are sold and delivered to persons

under such disability will be liable to pay a reasonable sum.

3. Invalidation

3.1 Mistake

In certain circumstances, a contract may be void at common law due to a mistake made by

the parties concerning the contract. Even where the contract is valid at law, it may

nevertheless be voidable in equity on the grounds of mistake. A mistake which has the effect

of rendering a contract void is described as an “operative” mistake. A mistake as to law, as

opposed to a mistake of fact, will not be operative.

Mistake relating to Documents

Where a person signs a document, he is, as a general rule, bound by his signature. If he has

not read the document he is still, in general, bound by it. However, where a person has been

induced to sign a contractual document by fraud or misrepresentation, the transaction will be

voidable. Similarly, if one of the other forms of mistake discussed in this area are present the

contract may be void.

In the absence of these factors, the plea of non est factum (not my deed) may be available.

The plea is an ancient one and was originally used to protect illiterate persons. It eventually

became available to literate persons who had signed a document believing it to be something

totally different from what it actually was.

At this stage in its development, the plea was very wide indeed, and the courts set about

trying to bring it within more reasonable bounds. It became established law that the plea was

not available to a signer who was mistaken merely as to the contents of the document, not as

to its character or class. It is established that the plea was not available to a signer who was

negligent in signing.


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‡ Case

Saunders v Anglia Building Society (H.L. 1971)

An elderly widow wished to transfer the title of her house to her nephew by way of gift. Her nephew and a man named Lee prepared a document assigning the property to Lee and asked her to sign. She signed it unread as she had lost her spectacles and trusted her nephew. Lee mortgaged the property to the Building Society and disposed of the moneys raised for his own use. He defaulted on the repayments and the Building Society sought possession of the house, Saunders (the widow’s executrix) sought a declaration that the assignment to Lee was void by reason of non est factum. Both the Court of Appeal and the House of Lords held that the plea could not be raised because, (i) the transaction the widow had entered was not fundamentally different from what she intended at the time she entered it; and (ii) she had been careless in signing the document; she could at lease have made sure that the transfer was to the person intended by her.

The effect of Saunders is, if anything, to restrict the circumstances in which the plea of non

est factum can be successfully raised.

Where the parties are agreed on the terms of the contract but by mistake record them

incorrectly in a subsequent written document, the remedy of rectification may be available.

The court can rectify the error and order specific performance of the contract as rectified.

In order to obtain rectification the following must be established:

(i) There must be a concluded antecedent agreement upon which the written

document was based.

(ii) The written document must fail to record what the parties had agreed.

‡ Case

Frederick E. Rose ( London) Ltd. V William H. Pim Co.Ltd, [C.A. 1953] The parties had contracted for the sale of a type of horsebean and the written contract referred to “horsebeans”. The goods delivered were not of the type the parties had in mind. Rectification was refused since the written contract correctly recorded what the parties had agreed.

(iii) The written document must fail to express the common intention of the parties.

Common Mistake

Here, the parties, although apparently in agreement, have entered into a contract on the basis

of a false and fundamental assumption. It is described as common mistake since both parties

make the same mistake.


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(i) Mistake as to the existence of the subject-matter

This kind of case arises where the parties are at cross-purposes. The contract will be void at

common law if, unknown to the parties, the subject-matter of the agreement does not exist or

has ceased to exist.

‡ Case

Courturier v Hastie [H.L. 1856] A cargo of corn, en route to London, had to be sold at a port of refuge as it had begun to ferment. Unaware of this, the parties agreed a sale of the corn in London. It was held that the seller was not entitled to the price of the cargo.

Similarly, if unknown to the parties, the subject-matter of the contract does not exist at the

time that they make their agreement, the contract is void.

‡ Case

Galloway v Galloway [1914] A man and woman, believing they were lawfully married, entered into a separation deed. In fact the “marriage” was invalid and therefore the separation agreement was likewise void.

(ii) Mistake as to Title

In Cooper v Phibbs [H.L 1867], A agreed to let a fishery to B. Unknown to both parties, the

fishery already belonged to B. The agreement was set aside by the House of Lords. Thereby,

the contract will be void at common law in the (rare) situation where one party agrees to

transfer property to the other which the latter already owns and neither is aware of the fact.

(iii) Mistake as to Quality

If A contracts with B for the sale of a thing from A to B, the contract is void for mistake if the

thing does not exist or if the thing already belongs to B. the question now arises, can the

contract be held void simply because A and B were mistaken about the quality of the thing?

There is authority that an identical mistake as to the quality of the subject-matter is not

operative at common law.


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‡ Case

Bell v Lever Bros Ltd. [H.L. 1932] B, an employee of L, entered into an agreement to terminate his employment under which he was paid pounds 30,000 compensation. It was later discovered that B could have been dismissed without compensation due to certain breaches of contract by him and about which he had forgotten. The House Lords treated the case as a common mistake as to quality, but held the contract valid.

As the mistake in Bell v Lever Bros was fundamental, the case has been interpreted as

deciding that an identical mistake as to quality can never render the contract valid at common

law.

‡ Activity

Discuss the decision given in the case Leaf v International Galleries [C.A. 1950] on similar line.

Where a contract is void for common mistake, the court, exercising its equitable jurisdiction,

will refuse specific performance. Alternatively, the court may rescind any contractual

document between the parties, and in order to do justice between them, impose terms.

Further, where there is an identical mistake as to quality, although the agreement is valid at

law, it is apparently voidable in equity. See, Solle v Butcher [C.A. 1950]. In this case the

Courts held that the contract was not void, but voidable. So, a contract may be voidable for

mistake in circumstances where it is not void for mistake.

Non-Identical Mistake

Here, the parties do not both make the same mistake. A non- identical mistake is said to be

“mutual” where the parties misunderstand each other’s intention and are at cross-purposes,

and “unilateral” where only one party is mistaken and the other party is aware of the mistake.

Operative mutual mistake is illustrated in the following case.

‡ Case

Wood v Scarth [1858] The defendant offered in writing to let a pub to the plaintiff at pounds 63 per annum. After a conversation with the defendant’s clerk, the plaintiff accepted by letter, believing that the pounds 63 rental was the only payment under the contract. The defendant had intended that


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a pound 500 premium would also be payable and he believed that his clerk had explained this to the plaintiff. Held: that the contract as understood by the plaintiff would be enforced and the court awarded him damages.

If the contract is void at law on the ground of a mutual mistake, equity “follows the law” and

specific performance will be refused and, in appropriate circumstances, the contract will be

rescinded.

For a unilateral mistake to be operative, the mistake by one party must be as to the terms of

the contract itself. A mere error of judgement as to the quality of the subject-matter will not

suffice to render the contract void for unilateral mistake.

‡ Case

Smith v Hughes [1871]

The defendant was shown a sample of new oats by the plaintiff. The defendant bought them in the belief that they were “old” oats; he did not want “new” oats.

The court was of the view that the mistake was merely as to quality of the subject-matter and could not render the contract void, even if the plaintiff seller knew of the mistake.

Mistake as to Identity

Where one part is mistaken as to the identity of the other party, in certain circumstances the

contract may be void at common law. All the decided cases in this area are in fact instances

of unilateral mistake, as the non-mistaken party is aware of the mistake because he or she has

engineered it through his or her own fraud.

Where the contract is not void, it may be voidable for fraudulent misrepresentation and if the

goods which are the subject-matter have passed to an innocent third party before the contract

is avoided, that third party may acquire a good title.

For the contract to be void, the following requirements must be satisfied.

• The identity of the other party must be of crucial importance.

‡ Case

Cundy v Lindsay [H.L. 1878] The plaintiffs, linen manufacturers, received an order for a large quantity of handkerchiefs from a rogue called Blenkarn, who gave his address as “37, Wood Street, Cheapside, and London. In the correspondence, he imitated the signature of a reputable firm, Blenkarn and


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Co., a respectable firm, known by reputation to the plaintiffs and carrying on business at 123, Wood Street. The Plaintiffs were thus fraudulently induced to send goods to Blenkarn’s address, where he took possession of them and disposed of them to the defendants, innocent purchasers.

It was held that the contract between the plaintiffs and Blenkarn was void for mistake as the plaintiffs intended to deal only with Blenkarn and Co. No title in the goods passed to Blenkarn.

Identity was held not to be crucial in the following case.

‡ Case

Phillips v Brooks [1919]

A rogue called North entered the plaintiff’s shop and, having selected some jewellery, wrote a cheque and announced himself as Sir George Bullough of St. James’ Square, a wealthy man whom the plaintiff had heard. The plaintiff thereby allowed North to take away the ring. He then pledged the ring with the defendants, who had no idea of the fraud. In an action by the plaintiff to recover the ring from the defendants, it was held that the contract between the plaintiffs and North was not void for mistake, as the plaintiffs had intended to contract with the person in the shop, whoever it was. It was further held that the only mistake was as to the customer’s credit-worthiness, not his identity.

‡ Activity

The decision in Phillips v Brooks was followed in another matter, Lewis v Averay [C.A. 1972.] Despite these decisions in Ingram v Little C.A. 1961, identity was held to be crucial. Distinguish and discuss these cases to establish the points made on Mistaken Identity.

• The mistaken party must have in mind an identifiable person with whom her or she

intends to contract. See, King’s Norton Metal Co. v Edridge Merrett Co. Ltd., C.A.

1897.

• The other party must be aware of the mistake.

‡ Case

Boulton v Jones [1857]

Jones had had dealings with a man called Brocklehurst and, at a time when Brocklehurst owed money to Jones, Jones sent to Brocklehurst a written order for 50 feet of leather hose. On that very day Brocklehurst had transferred his business to his foreman, Boulton. Boulton executed the order by sending the goods to Jones on credit. Jones accepted and used the goods in the belief that they had been sent by Brocklehurst. When, later, Jones


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was asked for payment he refused. His argument was that he had intended to contract with Brocklehurst, ant that it mattered to him because of the set-off which he had against Brocklehurst and which he wished to utilise.

Held: that Jones was not liable for the price of the goods.

3.2 Misrepresentation

In the negotiations leading up to a contract, many statements may be made. Some of those

statements will be incorporated into the final contract, thus becoming contractual terms.

Other statements, though not incorporated into the main contract, may be held to constitute a

collateral contract. Other statements may not be incorporated into any contract at all.

Misrepresentation, therefore, may be defined as a false statement of fact (not of law or a mere

expression of opinion), made by one party to the other before the contract, and made with a

view to inducing the other party to enter into it.

If the statement is a contractual term or a collateral contract the remedy for non- compliance

is an action for breach of contract. If a mere representation proves false, the remedy will, in

most cases, lie in an action for rescission and/or damages for misrepresentation. An

actionable representation renders the contract voidable.

a) False Statement of Fact

A misstatement amounts to a misrepresentation only if it is a statement of fact.

i) Fact, not intention

A false statement by a person as to what he or she will do in the future is not

misrepresentation.

‡ Case

Edgington v Fitzmaurice [C.A. 1885]

Company directors raised money from the public by stating that the money would be used to expand the buseiness. In fact, their intention was to use the money to pay off the company’s existing debt.

The statement was held to be a fraudulent misrepresentation of fact.

Goff v Gauthier [1991]

The defendants eschanged contracts when they were told by the plaintiff’s solicitor that the sale would be called off if they did not do soand a contract for sale would be sent to another purchaser. Ther was in fact no such purchaserrr. This was held to amount a misstatement of fact as to the venfors intention.


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ii) Fact, not opinion

If the statement is a statement of opinion and not of fact that is not a misrepresentation.

‡ Case

Bisset v Wilkinson [P.C. 1927] The owner of a farm, which had never before been used as a sheep farm, states to a prospective purchaser that he belived it would support 2,000 sheep. This was held to be a statement of opinion, not fact.

However, if the maker of the statement possess special knowledge or skill in relation to the

subject-matter or is in a stronger position to know the truth, then a statement expressed as an

opinion may be held to be an implied misrepresentation of fact. See, Smith v Land and House

Property Corp [C.A. 1884].

iii) Fact, not Law

If the statement is a statement of law and not of fact it is not a misrepresentation. The

difficulty of distinguishing between a statement of law and statement of fact is illustrated in

Solle v Butcher [C.A. 1950] where a statement that a flat was “new” and therefore not subject

to the Rent Restrictions Act, was held to be a statement of fact.

iv) Silence as Misrepresentation

The general rule is that mere silence is not misrepresentation. In Fletcher v Krell [1873] s

woman applied for a post of governess without revealing that she was a divorce. It was held

that that did not amount to misrepresentation.

The rule is subject to the following exceptions.

• Where the statement is a half truth. Thus if A, whilst giving credit reference concerning

B, states that B is honest and trustworthy but does not disclose that B has been

bankrupt, A may be regarded as making a misrepresentation.

• Where a statement was true when made but, due to change of circumstances, has

become false by the time it is acted upon.

‡ Case

With v O’ Flanagan [C.A., 1936]

The defendant wanted to sell his medical practice. Negotiations for the sale to the plaintiff began in January. The defendant said that the practice was worth pounds 2,000 a year, which at the time it was. The defendant then fell ill, an dby May 1, when the contract of sale was signed, the practice had become worthless. It was held that the defendant’s silence in the face of this development was a misrepresentation.


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• Contracts “uberrimae fidei”, i.e. of the utmost good faith. In this type of contracts, there is

a duty to disclose all the material facts as one party is in a strong position to know the

truth.

• Parties in a fiduciary relationship. Where such a relationship exists between the parties to

a contract, a duty of disclosure will arise.

b) The meaning of inducement

To amount to a misrepresentation, the false statement must induce the contract. It can be said

to induce a person if he does not rely on the misstatement.

‡ Case

Attwood v Small [ H.L. 1838] A vendor offered to sell a mine and made exaggerated statements as to its capacity. The buyers appointed expert agents to investigate the mine. The agents reported wrongly that the statements were true. The contract of sale was then completed. It was then held that the buyers’ subsequent action must fail because they had not relied on the vendor’s statements, but on their own independent investigations.

If a person is given an opportunity to test the accuracy of a statement but does not take that

opportunity, he is not shut out from relief. See, REdgrave v Hurd [C.A. 1881]

c) Types of misrepresentation

i) Fraudulent Misrepresentation

This makes a contract voidable. The party who has been misled may “avoid” the contract. He

may also sue for damages. As spelt out in Derry v Peek, the essence of fraud is that a false

statement be made (i) knowingly, or (ii) without belief in its truth, or (iii) recklessly, careless

as to whether it be true or false.

ii) Negligent Misrepresentation

Developments in this area made distinction between negligent and wholly innocent

misrepresentation and now there is a remedy in damages for negligent misrepresentation.

In Hedley Byrne & Co. Ltd v Heller & Partners Ltd. [1964] the House of Lords stated, obiter,

that in certain circumstances damages may be recoverable in tort for negligent misstatement

causing financial loss. The liability depends on a duty of care arising from a “special

relationship” between the parties.


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iii) Wholly Innocent Misrepresentation

In the light of Hedley Byrne and Statute law, the word innocent may now be used to refer to a

statement made by a person who has reasonable grounds for believing in its truth.

d) Remedies for misrepresentation

i) The right to Rescind

Rescission, i.e. setting aside the contract, is possible whether the misrepresentation is

fraudulent, negligent or innocent.

Where a court orders rescission it will also order mutual restitution. The object here is to put

the parties back into their former positions as though the contract had never been made. The

injured party may rescind the contract by notifying the other party or by any other act

indication repudiation of liability.

An order of rescission may be accompanied by the court ordering an indemnity. This is

money payment by the misrepresentor to restore the parties to their position as if the contract

had never been made. The money payment should be distinguished from damages.

‡ Case

Discuss Whittington v Seale- Hayne [1900] to illustrate the distinction between an indemnity payable in respect of obligations created by a contract and damages.

The injured party may lose the right to rescind in the following circumstances.

• If the party who has been misled by a misrepresentation either declares his intention

to proceed with the contract or does some act from which such intention may be

inferred, he cannot afterwards claim rescission.

Lapse of time may be evidence of affirmation. In fraud, time begins to run from the

discovery of the truth. In the case of non-fraudulent misrepresentation, time runs from

the date of the contract, not the date of discovery of the misrepresentation; Leaf v

International Galleries, C.A. 1950.

• The injured party will lose the right to rescind if the parties cannot be restored to their

original position.

• Rescission cannot be ordered where the third party rights have accrued, bona fide and

for value.


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ii) Damages for misrepresentation

A claim for damages for fraudulent misrepresentation is to restore the plaintiff to the

position he or she would have been in had the representation not been made. In East v

Maurer, the plaintiff purchased a hairdressing salon on the basis of a fraudulent

misrepresentation. Damages were awarded for the profit the plaintiff might have made had

he bought a different salon in the same area. However, the basis of damages for breach of

contract is normally the loss of bargain basis.

A plaintiff may elect to claim damages for negligent misrepresentation under the principle

in Hedley Byrne v Heller.

Damages may not be claimed for a wholly innocent misrepresentation, i.e. one that is

neither fraudulent nor negligent. The only remedy for wholly innocent misrepresentation

is rescission, which may be accompanied by an indemnity.

3.3 Duress

Duress traditionally means actual violence or threats of violence to the person; it is a common

law doctrine. Duress renders a contract voidable.

The scope of duress at common law was very narrow and confined to unlawful physical

violence to the person or constraint of the other party. However, modern cases indicate a

more flexible approach.

In Pao On v Lau Yiu Long [P.C. 1980] the Privy Council referred to developments in the

modern legal systems and accepted in principle that the traditional doctrine of duress

(personal violence) could, given strong facts, be extended to provide a remedy in the event of

“economic duress”(commercial pressure). Also see, Barton v Armstrong [P.C. 1976].

3.4 Undue influence

Courts of equity regarded the common law doctrine of duress as narrow, and, under the

general doctrine of equitable fraud, they developed a much wider jurisdiction over contracts

made under pressure. There thus grew up the doctrine undue influence, designed to give relief

where, in circumstances not amounting to duress, a person enters into a disadvantageous

transaction either of gift or of contract. But a transaction will not be set aside on the grounds

of undue influence unless it was “wrongful”. It must be shown that the transaction was to the

obvious and unfair disadvantage of the person subjected to the dominating influence. The

cases fall into two categories.

• Where no special fiduciary relationship exists, the person pressed into the contract must

prove that undue influence was applied. In Williams v Bayley [H.L. 1866] it was

established that a promise to pay money will be set aside if obtained by a threat to

prosecute the promisor or his spouse or close relative for a criminal offence.


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• A transaction may be set aside on the ground that a presumption of undue influence arises

from the nature of the special fiduciary relationship between the parties. The dominant

party must prove that no undue influence has been exercised; it is irrelevant that the

dominant party obtained no personal benefit.

The presumption applies to the following relationships: parent and child, guardian and ward,

religious adviser and disciple, solicitor and client, trustee and beneficiary. It does not apply

between husband and wife.

A presumption of undue influence may also apply even if the relationship is not within one of

the above relationships but one party, by reason of the confidence reposed in him or her by

the other weaker party, is able to take unfair advantage.

‡ Case

Lloyds Bank Ltd. v Bundy [C.A. 1975] An elderly farmer gave the Bank a guarantee in respect of his son’s overdraft and mortgaged the farmhouse to the Bank as security. It was clear that the farmer had placed himself entirely in the hands of the assistant bank manager and had been given no opportunity to seek independent advice. Held: that the presumption of undue influence applied between the bank and the customer and the transaction was set aside.

Accordingly, courts look into two elements for a presumption of undue influence to be

established.

(i) There must be a fiduciary relationship where one party exercises dominance, and

(ii) The transaction must be actually disadvantageous to the weaker party.

‡ Activity

Discuss Westminster Bank v Morgan [H.L. 1985] to establish the above points.

4. Discharge

There are four ways in which a contract may come to an end: performance, agreement,

frustration and breach.

4.1 Performance

If both parties perform their obligations under the contract, the contract is discharged. The

general rule is that performance must be precise and exact. The hardship of this rule is

illustrated by Cutter v Powell [1975]


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‡ Case

In Cutter, where a seaman, having agreed to serve on a ship from Jamaica to Liverpool for 30 guineas payable on completion of the voyage, died in mid-voyage. The contract was constructed to be “entire” and therefore his widow could recover nothing in respect of the work done.

To mitigate the harshness of the general rule following exceptions are introduced.

a) Severable contracts

A contract will be “severable”, where some of the obligations in the contract may be

enforced independently of performance by the other party.

‡ Case

Roberts v Havelock [1832] A ship en route was damaged and had to be docked for essential repairs. The plaintiff carried out the repairs, but before he had completed the contract he requested payment for work carried out thus far. His action succeeded as the contract did not require him to complete all the repairs before he made a demand for payment.

b) Substantial performance

A party who performs his obligation defectively, but substantially, can enforce the contract;

Boone v Eyre [1779]. However, the substantial performer may himself be liable for damages

in respect of his partial performance.

‡ Case

Bolton v Mahadeva [C.A., 1972] The plaintiff agreed to install central heating in the defendant’s house for pounds 560. the system was defective in that the house was not heated adequately and noxious fumes were given off inside the house. The cost of remedying the defects was pounds 174. Held: that there had not been substantial performance and the plaintiff was not entitled to recover anything.

c) Voluntary acceptance of partial performance

Where performance by one party is only partial, the other party may accept the partial

performance. Here the partial performer will have a claim on a quantum meruit basis in

respect of work done.


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d) Prevention of Performance

A party may be wrongfully prevented by the other party from completing performance. The

injured party in such a situation may claim damages for breach of contract or claim on a

quantum meruit for the work done.

A ‘tender of performance’ is an offer of performance. Where one party is unable to complete

performance without the collaboration of the other party, he or she may make an offer or

“tender” of performance, which is rejected by the other party. The party tendering

performance will be discharged from further liability.

‡ Case

Startup v Macdonald [1843] The plaintiff, having agreed to deliver oil within the last 14 days of March, tried to send it at 8.30 p.m. on the last day of that month, but the defendant refused to take delivery. The plaintiff’s action for damages succeeded.

Where the contract does not fix a time for performance, as a general rule performance must

be effected within a reasonable time. Accordingly, time is not of the essence where a contract

fixes a date for performance unless it falls under one of the following.

• Where the contract expressly provides that time is of the essence;

• Where the contract was not originally one where time was of the essence, but it is

made of the essence by a party subjected to unreasonable delay giving notice to the

other party to perform within a reasonable time;

• Where it must be inferred from the nature of the subject-matter, that time is of the

essence.

4.2 Agreement

The contractual bond is founded on the agreement of the parties. The parties may, by

agreement, untie the bond. As a general rule, consideration will be required to render an

agreement to discharge or vary valid, and in some cases formalities will be required.

Where a simple contract is executory on both sides, an agreement to discharge or vary the

contract provides its own consideration. i.e. each party agrees to release the other from his or

her outstanding obligations under the contract.

Where a simple contract is executed on one side, a deed is required to effect a valid release of

the other party. In the absence of a deed, the other party must provide new consideration. See,

Elton Cop Dyeing Co. v Broadbent and Son Ltd., C.A. 1919.


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If the contract is one that requires written evidence, to be enforceable, the contract may be

validly discharged by an oral agreement, with no requirement of written evidence; Morris v

Baron [1918]

At common law, a contract by deed could only be discharged in the form in which it was

made. However, in equity, such a contract may be validly discharged or varied by an oral

agreement.

4.3 Frustration

Under the doctrine of frustration, the parties to a contract are excused further performance of

their obligations if some event occurs during the currency of the contract, without the fault of

either party, which makes further performance impossible or illegal, or which makes it

something radically different from what was originally undertaken. The extent of the doctrine

is discussed under following categories.

a) Impossibility

A contract may become impossible to perform where the subject-matter is destroyed.

However, total destruction of the subject-matter is not necessary; Taylor v Caldwell [1863]

Similarly, a contract is frustrated if a thing or person required for its performance cases,

through some extraneous cause, to be available for that purpose; Nickoll and Knight v Ashton

Eldridge Co [1901]. Thus a charterparty may be discharged if the ship is damaged; a contract

for the sale of goods may be discharged if the goods are requisitioned; a contract of service

may be discharged if one of the parties becomes ill.

b) Illegality

If during the currency of the contract, a change in the law renders further performance illegal,

the contract will be frustrated.

c) Radically Different

Frustration may occur where, due to some extraneous event, further performance, though

technically possible, would become something radically different from that originally

envisaged by the parties.

‡ Case

Krell v Henry [C.A, 1903] The plaintiff agreed to let a room to the defendant for coronation day. It was understood by both parties that the purpose of the letting was to view the procession. It was held that the cancellation of the coronation frustrated the contract; the viewing of the procession was the “foundation of the contract”.


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A contract will not be frustrated where a change of circumstances renders it more onerous to

perform but not radically different; Davis Contractors Ltd v Fareham U.D.C., [H.L., 1956]

The court have however, imposed certain limits on the doctrine.

a) Self induced frustration

Where the alleged “frustrating” event is brought by the fault of one of the parties, the

frustration is said to be self-induced and the party at fault will be liable for breach of contract.

The contract will not be discharged by frustration. See, Maritime National Fish Ltd v Ocean

Trawlers Ltd, [P.C., 1935].

b) Express provision

Where a contract contains an express provision dealing with the possibility of a frustrating

event, the doctrine of frustration does not apply and the risks are allocated in accordance with

the terms of the contract.

c) Event foreseen

If the event which is alleged to have frustrated the contract was foreseen, or should have

been, by one party but not by the other, the party cannot rely on frustration; Walton Harvey

LTd., v Walker and Homfrays Ltd.,[C.A. 1931].

However, if both parties foresaw or should have foreseen the event, but made no provision in

the contract to deal with it, the contract may nevertheless be frustrated; W.J. Tatem Ltd v

Gamoa [1939].

‡ Activity

Discuss and compare the decisions in Chandler v Webster, [C.A.,1904] and Fibrosa S.A. v

Fairbairn Lawson Combe Barbour Ltd., [H.L., 1948] to establish the legal effects of frustration.

4.4 Breach

A breach of contract occurs where a party fails to perform, or shows an intention not to

perform, one or more of the obligations laid upon him by the contract. It should be noted that

whilst some breaches entitle the innocent party to sue for damages only; others, more serious,

entitle the innocent party, in addition to claiming damages, to treat him or herself as

discharged from the contract. These breaches may be described as “repudiatory” breaches.

After such a breach, the innocent party has an election, to accept the breach as a repudiation

of the contract or may decide to affirm the contract. If decided to treat the breach as


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repudiatory, this state of affairs must be communicated to the other party; Vitol S.A. v Norelf

Ltd., [C.A. 1995].

A breach may occur before performance is due. i.e. where the party intimates that the he or

she does not intend to perform his or her part of the contract, which is described as an

“anticipatory breach”. In Frost v Knight [1870], the defendant, having agreed to marry the

plaintiff on his father’s death, broke off the engagement during the father’s lifetime. It was

held that the plaintiff was at that point entitled to damages.

The innocent party therefore has an immediate right of action; he or she may sue for breach

of contract at once (accept the repudiation) or he or she may await the date of performance

and hold the other party to the contract.

5. Remedies

5.1 Damages

The object of awarding damages for breach of contract is to put the injured party, so far as

money can do it, in the same position as if the contract had been performed. i.e. compensation

for “loss of bargain” or loss of expectations under the contract.

Exceptionally, damages are awarded to compensate the plaintiff for expenses for expenses

incurred in reliance on the contract, which have been wasted by the defendant’s breach. See,

Anglia Television Ltd v Reed [C.A., 1971]; C and P Haulage v Middleton, [C.A. 1983]

Damages for mental distress

Although damages in contract may be recovered for physical inconvenience and pain and

suffering caused by personal injury, it was always thought that damages could not generally

be recovered for mental distress; Addis v Gramophone Co. Ltd, [H.L. 1909]

However, where the contract is for a holiday, recreation or entertainment, it is clear that

substantial damages may be recoverable for disappointment, vexation and mental distress;

Jarvis v Swann Tours, [C.A. 1973]

Remoteness of damage

The injured party may sometimes get less than the loss, which he has suffered. There is a

general principle of exclusion called the principle of “remoteness of damage”. The idea is

that it is not just or practicable to award damages for every consequence, however unusual,

which may flow from a breach of contract.


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‡ Case

Hadley v Baxendale [1854] The plaintiffs were millers who contracted with the defendant carriers to take a broken mill shaft to the repairers, as a pattern for a new shaft. The plaintiffs had no spare shaft. Although the defendants had promised to deliver within a day, they in fact delayed, and the shaft was not delivered until a week later. The plaintiffs sued the defendants for damages for loss of profits arising from the fact that the mill was out for longer than anticipated, due to delay. Held: that the defendants were not liable for the loss of profits. The plaintiff’s loss did not arise “naturally” because the plaintiffs might well have possessed a spare shaft; neither was it “in the contemplation of the parties,” as the defendants were unaware that the shaft entrusted to them was the only one, which the plaintiffs possessed. Accordingly, loss of profits was too remote ahead of damages.

‡ Activity

Similarly, discuss Victoria Laundry (Windsor) Ltd. V Newman Industries Ltd., [C.A. 1949] to establish the above principle.

Quantification

The rule is that if there is a market for the goods, then prima facie the loss is quantified by

reference to the market.

Where there is no market, if it is the seller who defaults, and the buyer has contracted to resell

the goods, it is generally accepted that the resale price may be taken as representing the value

of the goods, and the damages will be the difference between the sale and resale prices.

Where there is no market and it is the buyer who defaults, by refusing to accept delivery, the

extent of the damages will depend on the supply position. See, W.L. Thompson Ltd v

Robinson Gunmakers Ltd. [1955] ; Charter v Sullivan [C.A. 1957].

Mitigation

There is a duty on the plaintiff to take all reasonable steps to mitigate the loss caused by the

breach of contract. Recovery cannot be made for any part of the loss which the defendant can

prove to have resulted from a failure to mitigate; British Westinghouse Electric Co. v

Underground Electric Railway Co. of London, [H.L. 1912]


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Reasonableness is at heart of this principle. The injured party is not required to act with

lightning speed, or to accept any old offer of other employment that comes along, or to

embark on some difficult course. See, Pilkington v Wood [1953]

‡ Activity – Mini Case

Milly owns a factory manufacturing clothing. In January, the heating system of the factory broke down and she was forced to lay off the work-force. Milly engaged Fixit Ltd to repair the system. They agreed to complete the necessary work within one week. Owing to supply problems, the work was not completed within the week and Fixit offered to install a temporary system which would enable half-day working at the factory. Milly rejects this offer. In the event, the repair work took months and as a result Milly lost a highly remunerative contract to supply knit-wear to the armed forces. Milly is now claiming a total of pounds 8,000 by way of lost profits. Advise Fixit Ltd. as to their liability in damages.

5.2 Specific Performance

It is an order issued by the court to a defendant to perform a promise that he has made. The

court has power to award damages in addition to, or instead of, specific performance. The

remedy is subject to certain limitations.

a) Specific performance will only be granted where damages are an inadequate remedy.

Thus, it will not, in general, be awarded of a contract for the sale of goods. In Cohen v

Roche [1927], the court refused to grant specific performance to a buyer of a set of

Hepplewhite chairs. This remedy is most commonly ordered in relation to the breach

of contract for the sale of land, since, land being unique, damages will not usually be

adequate compensation. See, Beswick v Beswick, [H.L. 1968]

b) Specific performance will not be granted where the constant supervision of the court

would be required.

c) Specific performance will not be awarded where the contract involves personal

services, e.g. a contract of employment.

5.3 Injunction

An injunction is a decree by the court ordering a person to do or not to do a certain act. In the

law of contract it can be used to restrain a party from committing a breach of contract.

There is a general principle that an injunction will not be granted if its effect would be to

compel a party to a contract to do something which could not have been made subject to an

order of specific performance, e.g. to require performance of a contract for personal services.


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‡ Case

Page One Records Ltd v Britton [1968] The manager of the Troggs pop group sought an injunction restraining them from appointing, in breach of contract, anyone else as manager. The injunction was refused, on the ground that to grant it would in effect compel performance of a contract for personal services.

Despite this principle in Hill v C.A. Parsons & Co. Ltd [C.A., 1972] granted an interlocutory

injunction to the plaintiff, restraining his employer from treating the employment as at an

end.

An injunction may be granted to restrain a breach of a negative stipulation in a personal

services contract providing it does not actually compel performance.

‡ Case

Warner Bros Pictures Inc. v Nelson [1937] A film actress Bette Davis agreed with the plaintiffs not to act for any other film company for a year; during that period she did work for another company. The court granted an injunction, but only to the extent of restraining her from acting for third parties.


George owned a painting, which he believed to be a reproduction of a work by Sergeant, the famous English water- colourist. He sold the painting to Harry, who also believed it to be a reproduction, for pounds 80. Harry, having consulted an expert after acquiring the painting, discovered that the painting was a genuine original work by Sergeant. Harry intended to sell it to a London dealer. Ian. After a telephone conversation with Ian concerning the merits of the painting, Harry sent it to him with a letter offering to sell it. Unfortunately, the price quoted in the letter was pound 80 instead of pounds 800 (the true value of the picture). Harry’s Secretary had inadvertently omitted a nought. Ian sent Harry a cheque for pounds 80 and now refuses to return the painting to him. George, having now discovered that the painting is genuine, wishes to recover it. Discuss the legal position of the parties.


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XYZ Co., who manufactures oil rigs, wrote to M Ltd, an oil company, offering to construct an oil rig for pounds 1,000,000. The offer was made on a form containing XYZ’s standard terms of business. One of the terms contained in the document was that the initially agreed contract price might be varied according to the cost and availability of materials. M Ltd. replied, in a letter containing their standard terms of business, stating that they wished to order the rig. These terms did not include a price variation clause but contained a statement that the order was not valid unless confirmed by return of post. XYZ duly confirmed by a letter dated May 1, which was delayed in the post as it bore the wrong address and did not arrive until May 14. Meanwhile, on May 12, M posted a letter to XYZ cancelling the order, which arrived on May 13. XYZ ignored this letter and pressed on with the construction of the rig. It was completed one year later at a price of pounds 2,000,000. M Ltd. refuses to take delivery. Advise M.

♪ My Short Notes


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Chapter 13

Sale of Goods


1. Understanding the Elements, Formalities of Sale of Goods

2. The Terms of Contract of Sale of Goods

3. The General Rule on Transfer of Title

4. Duties of the Seller

5. Duties of the Buyer

1. Understanding the Elements, Formalities of Sale of Goods

1.1 Introduction

Sri Lankan Law on sale of goods is set out principally and is governed by the Sale of Goods

Ordinance No. 11 of 1986 (the Ordinance) and rules of English Law. A contract for sale of

goods is a contract whereby the seller transfers or agrees to transfer the property in goods to

the buyer for “a price”. [Section 2 (1) of the Ordinance]

1.2 What is a Contract of Sale of Goods

A contract for sale of goods includes both an actual ‘sale’ and an ‘agreement to sell’. A

contract wherein, the property in the goods is transferred from the seller to the buyer, the

contract is called “a sale”, but where the transfer of the property in the goods is to take place

at a future time or subject to some condition to be fulfilled thereafter, the contract is called

“an agreement to sell”. [Section 2(3)] An agreement to sell becomes a sale when the time

elapses or the conditions are fulfilled subject to which the property in the goods is to be

transferred.

1.3 Definition of Goods

Section 59 of the Ordinance defines the term “goods”. It thus includes all movables other

than money. Goods include growing crops and things attached to or forming part of the land

which are agreed to be severed before sale or under the contract of sale.

‡ Activity

In the above context, discuss whether a CD software, as opposed to the physical part of the

CD in which a software is embodied, are ‘goods’ within the meaning of the Sale of Goods

Ordinance. [Toby Constructions Products Pty Ltd. v Computer Bar (Sale) Pty Ltd.(1983)

NSWLR 48 ]

Note whether license acquired from the software house for the use of the software can be

termed a ‘sale’.


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Goods can be classified as follows.

a) Future goods (in instances of agreement to sale)

b) Existing goods

- specific goods

- ascertained goods

- unascertained goods

1.4 Consideration for sale

The consideration for the sale must be money; otherwise the contract becomes one of barter

or exchange. However it can be partly in money and partly in goods or some other articles of

value.

‡ Cases

Aldridge v Johnson (1857) 26 LJQB 296

A contract where 50 heads of buffaloes changed hands for 100 quarters of barley, the

difference in value being payable in money, was held to be a contract for the sale of goods.

1.5 Capacity to Contract

According to Section 3 of the Ordinance, capacity to buy and sell is regulated by the general

law concerning capacity to contract, and to transfer and acquire property. Thus it is the

Roman- Dutch common law of Sri Lanka that would govern these matters. However, where

necessaries are sold and delivered to a minor or to a person who by reason of mental

incapacity or drunkenness is competent to contract, such minor or other person should

nevertheless pay a reasonable price thereof.

1.6 Formalities and enforceability

No formalities are necessary for entering into a contract of Sale of Goods. Section 4 of the

Ordinance enumerates that a contract of sale may be made in writing, or by word of mouth,

or partly in writing and partly by word of mouth, or may be implied from the conduct of the

parties.

However, no contract for the sale of goods to be in force by action unless

- the buyer shall accept part of the goods sold and actually received the same, or

- the buyer has paid the price or a part thereof, or

- a note or memorandum in writing of the contract is made and signed by the

party or his agent in that behalf.


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2. The Terms of Contract of Sale of Goods

Conditions and warranties embodied to a contract by the parties may be express or implied.

Express conditions and warranties are those that are expressly provided in the contract.

Implied conditions and warranties are those which are implied by law or custom; these will

prevail in a contract of sale unless the parties agree to the contrary.

2.1 Title

In every contract of sale, unless the circumstances of the contract are such as to show a

different intention, there is an implied condition on the part of the seller, that

a) in case of a sale, he has a right to sell the goods, and

b) in case of an agreement to sell, he will have a right to sell the goods at the time when the

property is to pass. [Sec. 13 (a)]

The words ‘right to sell’ contemplate not only that the seller has the title to what he intends to

sell, but also that the seller has the right to pass the property. If the seller’s title turns out to be

defective, the buyer may reject the goods. If the seller has no title, he is liable in damages to

the buyer.

‡ Case

Rowland v Divall (1923) 2 K.B.500

R bought a motor car from D and used it for 4 months. D had no title to the car. As a

consequence R had to surrender the motor car to the true owner. R sued to recover the total

purchase money paid to D.

Held: R was entitled to recover the purchase money in full, notwithstanding that he has

used the car for 4 months.

‡ Cases

Mohamed Esak v Marikar 21 N.L.R. 289

It was held in this case that the correspondence between the parties might constitute a

“written memorandum” thus satisfying the requirement of contract being in the form of a

note or memorandum and be signed by the party, and that payment by cheque (which was

dishonoured later) forms part of the requirement that the buyer has paid the price or a part

thereof.


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The following warranties are implied in every contract of sale, in the absence of any

expressed agreement to the contrary.

- The buyer shall have and enjoy quite possession of the goods [Section 13 (b)]. If the

buyer’s right to possession and enjoyment of the goods is in anyway disturbed as a

consequence of the seller’s defective title, the buyer may sue the seller for damages

for breach of this warranty.

- The goods are free from any charge or encumbrance in favour of any third party, not

declared or known to the buyer before or at the time when the contract is made

[Section 13(c)]

2.2 Sale by Description

In a contract of sale by description, [Section 14] there is an implied condition that the goods

shall correspond with the description. The term ‘sale by description’ can include one of the

following situations.

a) Where the buyer has not seen the goods and buys them relying on the description

given by the seller.

b) When the goods sold are described in the contract and the buyer contracts in reliance

on that description.

‡ Case

Re Moore & Co. and Landauer & Co. (1921) 2 K.B. 519

M sold 3100 cases of Australian canned fruits to L with 30 cans each on one case. M

delivered the total quantity, but half the cases contained only 24 cans and the remainder 30

cans. L rejected the goods. There was no difference in the price for cases packed 24 cans

and cases packed with 30 cans.

Held: as the cases delivered did not correspond with the descriptions of those ordered L

could reject whole of 3100 cases.

c) Packing of the goods may sometimes be a part of the description. Where the goods do

not conform to be the method of packing described (by the buyer or seller) in the

contract, the buyer can reject the goods.

2.3 Sale by Sample as well as by Description

In a contract for sale be sample as well as by description, the goods supplied must correspond

both with the sample as will as with the description [Section 14]. A majority of cases where

samples are shown are sales by sample as well as by description.


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‡ Case

Nichol v Godts (1854) 10 Ex. 191

N agreed to sell to G oil described as ‘foreign refined rape oil, warranted only equal to

samples’. N delivered to the quality of the samples, but it was not ‘foreign refined rape

oil’.

Held: G could refuse to accept the goods.

2.4. Sale by Sample

A contract of sale is a contract for sale by sample where there is a term in the contract,

express or implied to that effect. Thereby under the ordinance, it is an implied condition;

- that the bulk shall correspond with the sample in quality [Section 16 (2) (a)]

- that the buyer shall have a reasonable opportunity of comparing the bulk with the

sample [Section 16 (2)(b)]

- that the goods shall be free from any defect, rendering them unmerchantable, which

would not be apparent on reasonable examination of the sample.

2.5 Merchantable Quality

Where the goods are bought by description from a seller, who deals in goods of that

description (whether or not as the manufacturer or producer) there is an implied condition

that the goods shall be of merchantable quality. [Section 15(2)]

Merchantable quality ordinarily means that the goods should be such as would be

commercially saleable under the description by which they are known in the market at their

full value.

‡ Case

Niblett v Confectioners Materials Co. (1921) 3 K.B. 387

It was held in this case that removing the wrappings of tins of condensed milk made the

sale of the tins commercially impossible and is unmerchantable.

However, if the buyer has examined the goods there shall be no implied condition as regards

defects which such examination ought to have revealed.


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‡ Case

Thornett and Fehr v Beers & Son (1919) 1 K.B. 486

B wanting to buy glue from T was given all facilities to inspect the barrels stored with glue

at T’s warehouse. B did not have any of the barrels opened and looked only at the outside.

He then purchased glue.

Held: An examination of the inside of the barrels would have revealed the nature of the

glue. Therefore, there was no condition as to merchantable quality as B had an opportunity

of making the examination.


V presented to his friend C a beautiful frock as a gift. V had bought the frock from the

‘Trendy Corner”, a retail stockist of elegant garments. The proprietor of ‘Trendy Corner’

had in turn purchased a number of frocks from Indi Industries Ltd., after carefully

examining few samples. C contacted a skin disease after wearing the frock.

Advise V and C about the legal issues arising in this case.

2.6 Fit for purpose

There is no implied condition or warranty as to the fitness for any particular purpose of goods

supplied under a contract of sale. The condition of fitness [Section 15(1)] shall apply only, if;

a) the buyer, expressly or by implication makes known to the seller the particular purpose

for which the goods are required,

b) the buyer relies on the seller’s skill or judgment,

c) the goods are of a description which the seller ordinarily supplies in the course of his

business ( whether he be the manufacturer or not), and

d) the goods supplied are not reasonably fit for the buyer’s purpose

‡ Cases

Frost v Aylesbury Dairy Co. Ltd (1905) 1 K.B. 608

The milk supplied by A to F contained germs of typhoid fever and F’s wife was infected

and died.

Held: The purpose for which the milk was supplied was sufficiently made known to A by

its description, and as the milk was not reasonably fit for consumption, A breached the

condition for want of fitness for the purpose.

Griffiths v Peter Conway Ltd.


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A tweed coat purchased by Mrs. G caused her to suffer dermatitis. She had unusually

sensitive skin. The coat would not have affected anyone with normal skin.

Held: Since G’s abnormality had not been made known to the seller, P was not liable.

However, if the buyer relies on his own skill and judgement or on that of his advisors and not

on the judgement and skill of the seller, no condition shall be implied. If such reliance of the

buyer is partly on his own judgement and that of the seller, the condition of fit for purpose is

implied, if his reliance on the seller was a substantial and effective inducement to his

purchase.

Although there is no implied condition or warranty as to the quality or fitness for any

particular purpose of goods supplied under a contract of sale, such condition may be annexed

by the usage of trade. In certain sale contracts, the purpose for which the goods are purchased

may be implied from the conduct of the parties or from the nature or description of the goods.

In such cases, the parties enter into the contract with reference to those known usage.


M purchased a sewing machine from L. After bringing the sewing machine home M

discovered that it could not do any zigzag stitching although when buying the sewing

machine M clearly told the salesgirl that M needed a zigzag machine with all necessary

accessories. Two days after the purchase M received by post a sale invoice from L which

had on its reverse in small print an exemption clause which read as follows:-

“L does not assume any responsibility regarding the quality of the sewing machine,

and in particular does not warrant that it would be suitable for the purposes of the

buyer. All implied conditions contained in the Sale of Goods Ordinance are hereby

excluded”

Advice M about the chances of successfully instituting action against L for damages for

breach of the implied condition contained in Section 15(1) of the Sale of Goods Ordinance.

3. The General Rule on Transfer of Title

Nemo dat quod non habet Rule

“No one can give what they don’t have” is a legal rule, sometimes called the nemo dat rule

that states that the purchase of a possession from someone who has no ownership right to it

also denies the purchaser any ownership title. [Section 22 (1)] This rule usually stays valid

even if the purchaser does not know that the seller has no right to claim ownership of the

object of the transaction bonafide.


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‡ Activity

Research and discuss the topic on ‘mistaken identity’ in line with the recent hearing on

Shogun Finance v Hudson (2004)

Exceptions to the Rule

1) Estoppel [Section 22 (1)]

If a true owner stands by and allows an innocent buyer to pay money to a third party (who

profess that he has a right to sell), the true owner will be later stopped from denying the

third party’s right to sell.

2) Sale under Statutory Power [Section 22(2)]

A sale under statutory power or under a court order will be valid notwithstanding the fact

that the seller had no title.

3) Sale under voidable title [Section 23]

Where the seller of the goods has a voidable title, but his title has not been avoided at the

time of the sale, the buyer acquires good title to the goods if he bought it in good faith and

without notice of the seller’s defect title.

4) Stolen Goods [Section 24]

Where goods have been stolen and the offender is convicted, the property in stolen goods

re-vests in the owner or his representative, notwithstanding any intermediate dealing with

them [Section 24 (1)]. However, where goods have been obtained by fraud or other

wrongful means not amounting to theft, the property in goods shall not re-vest in the

owner or his representative, by reason of the conviction of the offender [Section 24 (2)].

5) Sale by seller in possession of goods or documents of title [Section 25 (1)]

Where a person who sold goods continues to posses the goods or documents of title to

them, any sale or pledge by him to another buyer who takes it in good faith, without

notice of previous sale or pledge, will have good title to the goods.

6) Sale by buyer in possession of goods or documents in title [Section 25(2)]

If a person who has bought or agreed to buy goods, obtains without the sellers consent

possession or documents to the title of the goods, sells or pledges it to a third party who

takes it in good faith and without notice of such lien or other right of the original seller in

respect of the goods, will have good title to the goods.


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† Essentials for Transfer of Property

The two essential requirements for transfer of property in the goods are:

1) Goods must be ascertained. Unless the goods are ascertained, the property therein

cannot pass from the seller to the buyer. Thus, where there is a contract for the sale of

unascertained goods, no property in the goods is transferred to the buyer unless and

until the goods are ascertained. [Section 17-18].

2) Intention to pass property in goods must be there: in a sale of ascertained goods the

property in them is transferred to the buyer at such time as the parties to the contract

intend it to be. Regard shall be had to the terms of the contract, the conduct of the

parties and the circumstances of the case. [Section 19]

4. Duties of the Seller

a) To be willing to give possession of the goods to the buyer [Section 28] and make

arrangement for transfer of property in the goods to the buyer.

b) To ascertain and appropriate the goods to the contract of sale.

c) To pass an absolute and effective title to the goods to the buyer.

d) To deliver the goods in accordance with the terms of the contract. [Section 27]

e) To put the goods in a deliverable state and to deliver the goods as and when applied for

by the buyer. [Section 29(1)] See, Arunachalam Chetty v Service Reeve & Co. 12 NLR

188

f) To deliver the goods within the time specified in the contract or within a reasonable time

and a reasonable hour.[ Section 29(2)]

g) To bear all expenses of and incidental to making a delivery (upto the stage of putting the

goods into a deliverable state) [Section 29(5)]

h) To deliver the goods in the agreed quantity. [Section 30]

i) To deliver the goods in instalments only when so desired by the buyer.[Section 31]

j) To arrange for insurance of the goods while they are in transmission or custody of the

carrier. [ Section 32(2)]

k) To inform the buyer in time, when the goods are sent by a sea route, so that he may get

the goods insured [Section 32(3)]

5. Duties of the Buyer

a) To accept the delivery of goods, when the seller is willing to make the delivery as per

the contract. [ Section 27]

b) To pay the price in exchange for possession of the goods.[Section 28]

c) To apply for the delivery of the goods.

d) To demand delivery of the goods at a reasonable hour.[Section 29(4)]


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e) To accept delivery of the goods in instalments and pay for them, in accordance with

the contract.[Section 31(2)]

f) To bear the risk of deterioration in the course of transit, when the goods are to be

delivered at a place other than where they are sold. [Section 33]

g) To inform the seller in case the buyer refuses to accept or rejects the goods[Section

35]

‡ Case

Perkings v Bell (1893) 1 Q.B. 193

P sold barley to B by sample, delivery to be made at T railway station. B resold the barley

to a third party. The barley was delivered at T and B, after inspecting a sample of it, sent it

to the third party who rejected it as not being in accordance with the sample. B claimed

that he is entitled to reject the goods.

Held: B’s act in inspecting a sample and then sending it to the third party amounted to an

acceptance of goods. He cannot thereafter reject the goods.


Thiran ordered some furniture from E.A. Nanda Ltd., but could not find a lorry to take

delivery of the goods from the seller on 6th

June, which was the agreed date for delivery.

When Thiran went to collect the goods on 8th

June, he was informed that the furniture

ordered by him had perished in an accidental fire which burnt down part of the showroom

on 7th

June. Thiran refused to pay the balance sum which he had agreed to pay on delivery.

Advise Thiran.


Julian took his friend Jane to Modern Jewels to buy a necklace for their engagement. They

really liked a particular necklace, but Jane wanted the red stones in the centre to be

replaced with little purple ones. Modern Jewels agreed to get this done as instructed in

time for the engagement, which was fixed for 7th

July.

Julian paid an advance of Rs. 55,000/- and agreed to pay the balance sum of Rs. 45,000/-

when taking delivery on 3rd

July. However, as Jane became terribly sick on 3rd

July, Julian

could not go to Modern Jewels to collect the necklace and pay for it. When he went to

Modern Jewels on the morning of 5th

July, Julian learnt that Carlo had pretended to be

Julian and collected the necklace after paying the balance due with some forged currency

notes.

When Carlo was apprehended, it was found that he had sold the necklace to Dave for Rs.

30,000/-. Advice Julian as to


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(i) whether the property in the necklace had passed to Julian, and if so, at what

point of time;

(ii) whether Julian is bound in law to pay Modern Jewels the balance sum of

Rs. 45,000/-;

(iii) whether Julian can recover the necklace from Dave; and

(iv) whether your advice with respect to issue (iii) would be different if Carlo

had stolen the necklace from Modern Jewels and had been later convicted

of this offence?


R purchased a “Minipower” computer from E. The sales invoice issued by E contained an

exemption clause which read as follows:-

“E does not assume any responsibility regarding the memory or speed of the computer,

and in particular does not warrant that it would be suitable for the purposes of the

buyer. All implied conditions contained in Section 15 of the Sale of Goods Ordinance

are herby excluded.”

After bringing the computer home R discovered that it was a clone having only 64 MB of

Random Access Memory (RAM) and not a genuine “Minipower” computer. When buying

the computer R had clearly told the sales girl that for her work she needed minimum 256

MB of RAM, and the sales girl has recommended the “Minipower” computer as the ideal

choice. A week after the purchase, the Police seized the computer in the course of an

investigation commenced in connection with a trade mark violation complaint made by

Minipower International Corp., which owned the “Minipower” trade mark. Advise R in

regard to the following issues:-

(i) What implied conditions and warranties contained in Section 13 of the Sale

of Goods Ordinance have been breached by E in this transaction?

(ii) Can R succeed in an action for breach of the implied condition contained in

Section 14 of the Sale of Goods Ordinance?

(iii) What facts should R prove to win a damage claim under Section 15(1) of

the Sale of Goods Ordinance?

† Remedies of Unpaid Seller

Real Remedies

I. Where the property in the goods has passed to the buyer

a) Right of Lien A lien is a right to retain possession of goods until certain charges in respect of the

goods are paid. An unpaid seller who is in possession of the goods is entitled to

retain them until payment of the price in the following cases. [Section 40]

- the goods have been sold without any stipulation as to credit

- the goods have been sold on credit, but the term of credit has expired

- the buyer becomes insolvent


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The right of lien is linked with possession of the goods and not with the title. It is not

affected even if the seller has transferred the documents of title till he remains in

possession of the goods. However, an unpaid seller loses his right of lien [Section

42]

- If he delivers the goods to a carrier or to the bailee for the purpose of

transmission to the buyer, without reserving the right of disposal.

- The buyer or his agent obtains possession lawfully.

- By waiver

c) Right of Stoppage in Transit [Section 43-45]

The right arises to the unpaid seller after he has parted with the possession of the

goods. The seller has the right to resume possession of the goods while they are in

the course of transit and to retain them until payment or tender of the price.

The right of stoppage in transit is available to an unpaid seller, when the buyer

becomes insolvent and the goods are in transit.

d) Right of Resale [Section 46 -4 7]

The rights of lien and stoppage in transit, would not have been of much value if the

seller had no right to resell the goods, because the seller cannot continue to hold the

indefinitely.

An unpaid seller may resell the goods :-

- When the goods are of perishable nature, without giving any notice to the

buyer, of the resale.

- In case of other goods, when after giving a notice to the buyer of his

intention to resell the goods, the buyer does not pay the price within a

reasonable time.

- Where the seller has expressly reserved the right of resale in the contract. No

notice to the buyer is required in that case.

II. Where the property in the goods has not passed to the buyer

e) Right of withholding delivery [Section 39 (2)]

Where the property in the goods has not passed to the buyer, the unpaid seller has

the right to withhold delivery of goods, which is similar to and co-extensive with his

rights of lien and stoppage in transit which he would have had if the property had

passed.

Personal Remedies

a) Suit for Price [ Section 48]

When the property in the goods has passed to the buyer and the buyer wrongfully

neglects or refuses to pay the price, the seller is entitled to sue him for the price.

Further, under a contract of sale the price is payable on a certain day irrespective of

delivery or passing of property, and the buyer refuses or neglects to pay on that

day, the seller may sue him for the price.


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b) Suit for damages for Non- Acceptance [Section 49]

An action lies where the buyer wrongfully neglects or refuses to accept the goods.

The measure of damages is the estimated loss resulting from the buyers’ breach of

contract. i.e. the loss of profit on the sale when the goods have a fixed retail price

and the supply exceeds the demand. In Thompson Ltd. v Robinson (Gunmakers)

Ltd. (1955) Ch. 177, R contract to buy a “vanguard” motorcar from T. R refused to

accept delivery. Since there were no shortage of the specific motorcar it was held

that T were entitled to the profit they would have made if not for the refusal, as

they had sold one car less than they anticipated.

When there is an available market for the goods, the measure of damages is the

difference between the contract price and the market price.

† Buyer’s Remedies against the Seller for Breach of Contract

Personal Remedies a) Suit for Damages for Non- Delivery [Section 50]

When the seller wrongfully neglect or refuses to deliver the goods to the buyer, the

buyer may sue the seller for damages for non-delivery. This is in addition to the

buyer’s right to recover the price, if already paid, in case of non-delivery. See

Patrick v Russo-British Grain Export Co. (1927) 2 K.B. 535

b) Suit for Price

Where the buyer has paid the price and the goods are not delivered to him, he can

recover the amount paid.

c) Suit for Specific Performance [Section 51]

When the goods are specific or ascertained, a buyer may sue the seller for specific

performance of the contract and compel him to deliver the same goods. The court

orders for specific performance only when an order for damages would not be an

adequate remedy. Specific performance is generally allowed where the goods are of

special significance or value. E.g. a rare painting, a unique piece of jewellery, etc.

d) Suit for Breach of Warranty and Condition

On a breach of condition, the buyer is entitled to reject the goods. However, the

buyer cannot reject goods if,

- he waives the breach of condition and elects or is compelled to treat it as a

breach of warranty; or

- the contract is not severable and he has accepted the goods or part of them; or

- the contract is for specific goods, and the property has passed to the buyer.

When there is a breach of warranty by the seller, the buyer cannot reject the goods.

The buyer may,

- set up the breach warranty in extinction of the price payable by him, or

sue the seller for damages for breach of warranty.


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♪ My Short Notes


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Chapter 14

Law Related to Consumer Protection


1. Introduction

2. Regulations on Internal Trade

3. Establishment of a Consumer Affairs Authority

1. Introduction

The Consumer Affairs Authority Act No.9 of 2003 (the Act) seeks to combine competition

and consumer protection laws and establishes a new Consumer Affairs Authority (the

Authority) and Consumer Affairs Council (Council), which are entrusted with consumer

protection as well as market regulation of internal trade. It repeals the Fair Trade Commission

Act No. 1 of 1987 (FTCA), the Consumer Protection Act (CPA) No 1 of 1979 and the

Control of Prices Act No. 29 of 1950. With the introduction and operation of the Act, the

Department of Internal Trade which handled consumer protection issues and the Fair Trade

Commission will now cease to exist and will be replaced by the Authority and the Council.

Consumers thereby, now have an opportunity to complain about counterfeit items in the

market. The Act allows the aggrieved consumer, who realises a product he has purchased is a

counterfeit because it is not of the same quality as the genuine item, to take action. Some

consumers knowingly purchase counterfeit items but some are misled as to the quality of the

product. The Act aims primarily to protect the consumer and ensures that, once a consumer

has purchased an item by being misled by the manufacturer or trader and realises it to be a

counterfeit, there is an opportunity for that consumer to bring it to the attention of the

Authority.

The Act therefore, is an attempt to give effect to the policy of the Government of Sri Lanka to

provide for the better protection of consumers through the regulation of trade and the prices

of goods and services and protect traders and manufacturers against unfair trade practices and

restrictive trade practices. Further, to promote competitive pricing wherever possible to

ensure healthy competition among traders and manufacturers of goods and services.

2. Regulation of Internal Trade

Price marking, labelling and other issues

Under Part II of the Act, provision is made for the Authority to regulate trade. Section 10 of

the Act empowers the Authority to issue “Direction” in the form of general or special, as and


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when considered necessary to do so in the interests of the consumer. General directions are

issued to manufacturers or traders in respect of labelling, price marking, packeting, sale or

manufacture of any goods. Special directions are conditions imposed relating to manufacture,

marketing, labelling or sale of articles.

Traders who contravene the Directions issued by the Authority are prosecuted in Courts and

are punished under the Consumer protection law, as manufacturers and traders are legally

bound to comply with the Directions issued by the Authority. With the introduction of

various reforms in the area of Consumer protection, in the last few years, the Authority,

previously the Department of Internal Trade has successfully accomplished many complex

tasks.

‡ Example

The Commissioner of Internal Trade made it an offence for jewellers to weigh jewellery by

using seeds normally called ‘Madati’ and they were required to get the set of weights

tested and stamped by the Department of Weights and Measures. The Commissioner

directed that all jewellers should issue a receipt providing the following information: (a)

the name and address of the jeweller; (b) the name and address of the customer; (c)

description of article sold; (d) the carat content of the gold article sold; (e) price charged;

and (f) the date of sale. These measures proved to be successful in preventing consumer

exploitation by professional jewellery traders.

Further, any person who removes, alters, erases, defaces any label, description or price mark

on any grounds in respect of which a special or a general direction has been issued or sells

any such goods on which the label, description or price mark has been removed, altered,

erased or defaced, shall be guilty of an offence under the Act. Similarly, any person who sells

or offers to sell any goods above the price marked on the goods in accordance with a

direction issued, is guilty of an offence.

For the purpose of this Act, unless the context otherwise requires “goods” means any food,

drink, pharmaceutical, fuel and all other merchandise. A “trader” therefore would be a person

who sells or supplies goods wholesale to other persons; sells or supplies goods at retail prices

to consumers; imports goods for the purpose of sale or supply; or would be a person who

provides services for a consideration.

The Authority may if it thinks necessary, enter into such written agreements with any

manufacturer or with a person who sells or supplies goods wholesale or at retail prices, to

provide for the maximum price above which any goods should not be sold and to provide for

other conditions as to the manufacture, supply, storage, distribution, transportation,

marketing, labelling or sale of any goods. [Section 14]


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With the introduction of the Act, the Authority either of its own motion or on representations

made to it by any person or body of persons, may review any question relating to the price of

any goods or the charge for any service and thereafter report to the Minister on the same.

A further regulation imposed on every trader is where it is now made compulsory for the

traders to exhibit in his place of business, a notice notifying the maximum retail or wholesale

price, of the goods available for sale in his place of business other than the price of any goods

which is marked on the goods itself or on the rapper or pack containing the good. [Section 26

of the Act.

Section 28 provides for the issue of receipts to purchasers at the time of sale. Every trader

who sells any goods shall on demand issue to the purchaser a receipt setting out;

- the date of the sale;

- the quantity of goods sold;

- the price paid for such quantity;

- nature of the transaction. i.e. whether the sale was wholesale or retail; and

- any other specification that may be imposed under any law relating to the issue of

receipts by a trader.

Determining standards and specifications relating to goods and services

Section 12 of the Act empowers the Authority to determine standards and specifications

relating goods and services as a measure of regulating internal trade. By notification

published in the Gazette the Authority will adopt such standards and specifications prescribed

by the Sri Lanka Standards Institution relating to the production, manufacture, supply,

storage, transportation and sale of any goods and to the supply of any services, for the

purpose of protecting the consumer and ensuring the quality of goods sold or services

provided.

Every written agreement entered into between the Authority and the manufacturer or trader tp

provide for the standards and specifications of any goods manufactured, sold or offered for

sale, will be binding on every authorised distributor of such manufacturer or trader and

whoever who contravenes such agreement shall be guilty of an offence under Section 14 of

the Act.

Acting under the powers vested thereby under Section 10 (1) of the Consumer Affairs

Authority Act, the Consumer Affairs Authority directs the manufacturers of and the traders to

mark the maximum retail price; to specify the batch number; and to specify the expiry date on

the article or on the pack or on the container or on the wrapper in following named articles.

flour sold in packs or containers; soap (toilet, medical toilet, carbolic, shaving, soft, liquid,

baby laundry; laundry powder; baby products; confectioneries such as cakes and sweets sold

in packs or containers; toothpaste; batteries; sugar sold in packs or containers; bread sold in

packs; dry fish and maldive fish sold in packs or containers; cheese sold in packs or


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containers; eggs sold in packs or containers; curd; liquid milk, powdered beverages sold in

packs or containers; bottled water; soya products etc.

Similarly, the Authority by powers vested in it has issued directions to all traders in and

manufacturers of Liquid Petroleum Gas (LPG) to mark on such cylinder the name of the

manufacturer/trader who filled/refilled the said cylinder, adhere to the standards,

specifications and codes of practice laid down by the Sri Lanka Standards Institution in

regard to the filling, refilling and selling of LPG.

No trader in Sri Lanka, who has in his possession or custody any goods for sale of such, can

refuse to sell such goods and will be an offence under Section 15 unless otherwise proved

that on the occasion in question, he supplied a reasonable quantity of the goods, or had not a

sufficient quantity in his possession to supply the quantity requested by the customer; or that

he carried on business in the goods as a wholesale trader only, and that the sale of the

quantity demanded by the buyer would have been contrary to the normal practice of a

wholesale business; or the sale of the goods on that occasion in question would have been

contrary to any provisions of the written law or any general or special direction issued to him

by the Authority under Section 10 of the Act. Also, no customer can be denied of possession

of goods by any trader who kept in his possession or under his control such goods for

purpose of trade within Sri Lanka.

It is an offence punishable under the Act for a trader to conceal in his place of business or in

any other place, any goods in such quantity as is in excess of the normal trading requirements

of such trader. As a result of which no trader can have in his possession in his place of

business or in any other place any goods in excess of such quantity required for his personal

consumption and of the members of his household or the quantity required in the normal

trading activities of such trader.

Specified Goods

An addition in the Act No. 9 of 2003 from the previous laws that were applicable in the

protection of the consumer is the inclusion of Section 18, which prohibits the increase of the

retail or wholesale price of ‘specified articles’ without the prior approval of the Authority.

The Minister of Commerce and Consumer Affairs thereby exercises the price control function

and where the Minister is of opinion that any goods or services are essential to the life of the

community. The Minister in consultation with the Authority may by Order published in the

Gazette prescribe such goods or services as specified goods or specified services as the case

may be.

Until September 1992, price controls were in operation for bread, wheat flour and

pharmaceutical drugs. In September 1992, the price controls on bread and wheat flour were

removed. At present, only full cream milk powder, LP Gas, wheat flour, mosquito coils, box

of matches and cement are identified as ‘specified articles’ under Section 18 of the Act, thus


229

being subjected to any price controls by the Authority. As can be seen, at present there is no

price control on pharmaceutical drugs.

The Authority, within thirty days of application by the manufacturer or trader for an increase

of price of specified article, will hold an inquiry and authorise the increase if such price

increase is reasonable. Failure to give a decision within thirty days will allow the

manufacturer the opportunity to affect the price increase without the approval of the

Authority. Provided however, where the delay in giving the decision by the Authority, within

the stipulated period was due to the failure of the manufacturer or trader to give any

assistance required by the Authority in carrying out its inquiry into the application, the

Authority can make an interim order preventing the said manufacturer or trader from

increasing the price during the period of investigation and until the final determination of the

application.

The Council with its price control powers can look into the matter only where the goods or

services are supplied at an excessive price and the charge of such price is a major public

concern and where there is evidence of the existence of a monopoly situation, market

manipulation or any other market imperfection. The Director- General is given power to refer

such matters of excessive pricing to the Council where the goods or services in question are

of general economic importance or where a category of consumers are significantly affected

by such price. Upon the conclusion of an investigation, if the Council decides that the price

concerned is excessive it is empowered to fix the maximum price above which such goods

cannot be sold or services cannot be provided.

It is notable that under the previous law, the Fair Trading Commission could fix the

maximum price of only ‘specified articles’, which included only pharmaceuticals. However,

the present Act has given the Authority the power to fix prices in relation to ‘any goods sold

or services provided’ thereby considerably expanding its price control powers.

As another measure of ensuring price controls, any member of the public or any association

of persons or any organisation may if they see that goods are being sold or services are being

provided at an excessive price, request the Director- General to refer the matter to the Council

for an investigation [Section 22]. On the contrary, the Minister or the Authority may, either of

his/its own motion or on representations made to him by a person or body of persons

refer/review any question relating to the price of any goods or the charge for any service.

Any trader who, in the course of a trade or business engage in any type of conduct that is

misleading or deceptive or in the promotion of the supply of goods or services falsely

represents that goods are of a particular standard; goods are new; represents that goods or

services have sponsorship, approval, performance, uses or benefits they do not have; makes

false statements concerning the existence of, or amounts of price reduction or price increase;

makes misleading statements concerning the existence or effect of any warranty or

guarantee; be guilty of an offence under this Act.


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3. Establishment of a Consumer Affairs Authority

As discussed, the Authority is vested with wide ranging powers, from an overall supervisory

power to regulate trade, to entering into written agreements with manufacturers concerning

the various specifications and conditions of trade. It is also vested with the powers of the

District Court in determining consumer complaints. A separate Consumer Affairs Council is

established by Section 39 of the Act.

The Council as both the power to investigate matter, and may determine matters relating to

anti- competitive practices, based on investigations conducted by the Authority. Further, a

person or body dissatisfied with a determination by the Authority may refer the matter to the

Council.

It can also make determinations with respect to excessive price of goods or services, and

recommend the maximum price above which, such goods should not be sold or services

provided. The Director- General of Consumer Affairs refers such matters to it for

determination, and Section 22 provides for interested citizens or groups to also refer these

matters to the Director General.

To ensure Consumer protection, the Authority therefore is entrusted with the power to inquire

and investigate into matters relating to monopolies, mergers and anti-competitive practices

and refer such matter to the Council for determination under whose realm the public interest

test lies. As a result which most marketers could be restricted in their business practicing.

However, the orders that the Council could make where it concludes that the monopoly,

merger or anti-competitive practices operated against the public interest are limited when

compared with the powers exercised by the Fair Trading Commission. Where it decides such

practices exist, the Council can only appoint a person to carry out activities of the firm,

terminate the anti-competitive practice and take any other action it considers necessary. The

Fair Trade Commission’s power to divide a business by sale or otherwise is not given to the

Council under the new regime.

Since monopolies, mergers and anti-competitive practices are not prohibited per se, the

Authority has to examine restrictive business practice on a case-by-case basis to ascertain

whether they are operating against the public interest. For the purpose of such investigations,

an anti-competitive practice shall be deemed to prevail, where a person in the course of

business, pursues a course of conduct which of itself or when taken together with a course of

conduct pursued by persons associated with him, has to have the effect of restricting,

distorting or preventing competition in connection with the production, supply or acquisition

of goods in Sri Lanka.


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‡ Activity

Discuss the Clear Communications Ltd v Telecom Corporation of New Zealand et al [1992

High Court of New Zealand] to establish the methods that can be used to identify

Monopolies in a country.

On an application made by the Authority, the Council shall, on being satisfied that an anti-

competitive practice exists but such anti-competitive practice does not operate or is not likely

to operate against public interest, by an order made, authorise such anti-competitive practice.

If the Council is of the view that anti-competitive practice exists and that it operates against

public interest, provide for the termination of such practice in the manner as may be specified

in the order.

With such powers vested on the Authority to investigate unhealthy business practices by

marketers, such monopoly power need not be discouraged as long as it is not misused and

does not reduce the competition in other markets. There are instances where a monopoly by

its very success could attract others to the same business. As an example, Celltel had a

monopoly on portable telephones until late 1992, and their success encouraged competitors

such as Call-link and Mobitel to enter the market. If there are allegations or suspicions of a

monopoly being detrimental to the public interest, then it is that which the Authority should

investigate.

To ensure further protection of the consumer, the Authority may, if it is satisfied that any

person contravened any of the provisions of the Act or any direction given thereunder, issue

such person a warning in writing.

The Authority for the proper discharge of its function under this Act and in the protection of

the Consumer, may require the manufacturers, importers, distributors and exporters of any

goods or services,

- to maintain records in respect of matter as the Authority may consider necessary

for the proper discharge of its function under this Act and in such form as may be

determined by the Authority;

- to furnish to the Authority returns in respect of such matter as the Authority may

consider necessary for the proper discharge of its function.

Further, the Authority may by notice in writing require any trader, manufacturer or as such

any other person, within such period as shall be specified in the notice, to furnish any

information or to produce any document as shall be specified in such notice.

Section 58 of the Act gives powers to the Authority, for the purpose of ascertaining whether

the provisions of this Act or any regulation made thereunder are being complied with, to

enter, inspect and search at all reasonable hours of the day the premises in which any


232

manufacturer or trader is carrying on his business or any other premises where any goods are

being stored or exposed for sale; to seize and detain any goods found in such premises in

contravention of the provisions of the Act; to inspect, take copies of or seize and detain any

records or documents required to be kept by law in respect of such business.

‡ Activity

Discuss the offences and penalties that can be levied on a trader, manufacturer and other

service providers under the Act to safeguard the interests of the Consumer.

♪ My Short Notes


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Chapter 15

Law related to Intellectual Property


1. Introduction

2. Patent Rights

3. Marks and Trade Names

4. Copy Rights

1. Introduction

The present law, the Intellectual Property Act No. 52 of 2003 (hereinafter referred to as “the

Act”) was enacted and implemented to address the pressing need to have an effective system

in this area which became a pressing need in the context of the liberalised economic policies

in Sri Lanka. The Act was enacted to revise, consolidate, amend and embody the law relating

to copyright, industrial designs, patents, trade marks and unfair competition and to provide

for better registration, control and administration thereof.

What is Intellectual Property Law?

Intellectual property is considered to be a form of property, with some unique features of its

own. It shares several characteristics associated with “property” as specified in general in the

law property. i.e. intellectual property is an asset and has a monetary value. It can, like any

other form of property, be owned, transferred, sold or licensed. The proprietor of intellectual

property has the right, subject to certain restrictions, to use and alienate his intellectual

property and to restrain other from interfering upon his rights.

Intellectual property is a kind of intangible property as it may not be identified or defined by

its own physical parameters. Therefore, intellectual property is any product of human intellect

that is unique and un-obvious with some value in the marketplace. Intellectual property laws

cover ideas, inventions, literary creations, unique names, business models, industrial

processes, computer program code, and more.

2. Patent Rights

Patent is the grant of a property right to the inventor, issued by the State through the Patent

and Office upon the successful registration of certain inventions. It is granted for patentable

inventions which may be, or may relate to, a product or process in a field of technology.

[Section 62 (1) & (2) of the Act].An invention is patentable if it is new, involves an inventive

step and is industrially applicable. [Section 63].


234

The following, notwithstanding that they are inventions within the legal definition, are not

patentable [Section 62(3)]: discoveries, scientific theories and mathematical methods; plant

or animal varieties or essentially biological processes for the production of plants or animals,

except micro-biological processes and the products of such processes; schemes, rules or

methods for doing business performing purely mental acts or playing games; methods for the

treatment of the human or animal body by surgery or therapy, and diagnostic methods

practised on the human or animal body; an invention which is useful in the utilisation of

special nuclear material or atomic energy in an atomic weapon; an invention, the prevention

within Sri Lanka of the commercial exploitation of which is necessary to protect the public

order, morality including the protection of human, animal or plant life or health or the

avoidance of serious prejudice to the environment.

Rationale underlying Patents

It is desirable in the public interest that industrial techniques should be improved. To

encourage improvement, and to encourage also the disclosure of improvements in preference

to their use in secret, any person devising an improvement in a manufactured article, or a

method of making it, or a new substance and/or the process of making that substance, may

upon disclosure of the details to the Patent Office of a country, be given a monopoly for a

certain period of time. After that period expires, it passes into the public.

The temporary monopoly is justified on the grounds that if it had not been for the inventor

who devised and disclosed the improvement, nobody would have been able to use it at that or

any other time since its existence, and the manner of production may have remained

unknown. Further, the giving of the monopoly encourages the putting into practice of the

invention, for the only way the applicant can make a profit is by putting it into practice, either

by using it himself and deriving an advantage over his competitors by its use, or by allowing

others to use it in return for royalties.

Basic elements of Patent

Novelty [Section 64]

An invention is new if it not anticipated by prior art. Prior art shall consist of anything that is

disclosed to the public anywhere in the world, in writing, orally, by use or in any other way,

prior to the filing or priority date of the patent application claiming invention.

A disclosure to the public is disregarded where the disclosure occurred within 1 year before

the date of the patent application and such disclosure was by reason of acts done by the

applicant/his predecessor in title; and disclosure occurred within 6 months preceding the date

of application and such disclosure was due to any abuse of right of the applicant/his

predecessor in title.


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Disclosure need not be made to the public at large. If disclosed to any other person who is

free in law and equity to use it as he pleases is sufficient. Invention is disclosed if it is made

available for anyone to see.

Inventive step [Section 65]

Invention is considered as involving an inventive step if, such inventive step would not have

been obvious to a person having ordinary skill in the art, having regard to the prior art

relevant to the patent application claiming the invention.

Invention must not be obvious to an unimaginative person skilled in the art; Windsurfing

International v Tabor Marine.

Industrial Application [Section 66]

An invention is industrially applicable if it can be made/used in any kind of industry. In other

words it is not what can be made by the industry but what can be made/used in any kind of

industry. i.e. it must not only be produced but it must also have a use; Chiron v Murex.

Right of Patent

Right to a patent belongs to an inventor. Where there are two or more inventors the right

belongs to them jointly to the extent to which two or more inventors have made the same

invention independently of each other, the person whose application has the earliest filing

date or the earliest validly claimed priority date, shall have the right to the patent so long as

the application is not withdrawn or rejected. [Section 67]

However, where the essential elements of the Y’s invention has been unlawfully copied from

an invention, the right to the patent of which belongs to X, X can demand that the patent

application or patent be assigned to X within five years of the application for patent. [Section

68]

Invention by employee, pursuant to a commission, belongs to the employer or the person who

commissioned the work. There must not be any contrary provision in contract of employment

or for the commission of work [Section 69]. Where employee whose contract of employment

foes not require him to engage in any inventive activity, invents in the field of activity of his

employer, using data or means placed at his disposal by the employer, the right accrues to the

employer.

Rights of Owner of Patent [Section 84]

The owner of a patent has exclusive rights in relation to a patented invention to exploit the

patent invention, assign or transmit the patent and to conclude licence contracts. However, no

person can exploit, assign or conclude licence contracts without consent of owner of patent.


236

Exploitation of a patented invention means when patent is granted in respect of a product in

making, importing, offering for sale, selling, using the product and stocking for such

purposes; when patent is granted in respect of a process for using of the process, making,

importing, selling, using and stocking products produced by using the process.

‡ Activity

What is an invention? Analyse a patentable invention.

Limitations of rights of patent owner [Section 86]

1) Rights of owner extend only to acts done for industrial or commercial purposes and

not for acts done only for scientific research.

2) Rights of owner do not extend to the presence or use of products on foreign vessels,

aircrafts, spacecrafts, land vehicles which temporarily or accidentally enter the waters

or airspace or the territory of Sri Lanka.

3) Rights of owner do not extend to acts in respect of articles which have been put in the

market by the owner of the patent or by a manufacturer under licence.

4) Any person may make an application for the purpose of obtaining a licence to exploit

a patent in the manner provided in the Act.

5) Where a person, at the time of application for patent was in good faith making the

product or using the process which is the subject of the invention in Sri Lanka and had

in good faith made serious preparations in Sri Lanka towards the making of the

product in Sri Lanka, he can exploit the product despite the grant of the patent to the

owner. However, the product must be made or the process must be used in Sri Lanka

[Section 87].

6) A patent or an application of patent can be assigned or transmitted in writing and

signed by or on behalf of the contracting parties. Such assignment/transmitted must be

recorded on the register in order to enforce such against third parties. Owner of patent

can assign or transmit to another person or enterprise in respect of the whole or part of

his rights [Section 88].

7) – An owner of a patent (the licensor) can grant to another person or enterprise (the

licensee) a license in respect of the whole or part of his rights to exploit the patent. [

Section 90]

- A license contract must be in writing signed by or on behalf of the contracting

parties. [ Section 91]

- A licensee is entitled to exploit patent within Sri Lanka. However, he is not

entitled to assign or transmit his right under license contract or grant sub-

licenses. [Section 92]

- A licensor can grant further licenses to third parties in respect of the same

patent and exploit patent by him. [Section 93]


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- Any term or condition in a license contract imposing burdens on licensee

which are not necessary for the protection of the patent are invalid. [Section

94]. However, conditions imposing obligations on licensee to abstain from

acts prejudicial to the validity of the patent and restrictions on scope, extent,

duration of exploitation, geographical area and quality and quantity of

products are valid.

Surrender and Nullity of Patent

The registered owner of a patent may surrender the patent by a declaration in writing signed

by him or any person authorised by him or on his behalf. [Section 98]

The court may on application by any person showing a legitimate interest declare the patent

null and void if,

- the subject of the patent application does not fall within meaning of

“Invention”

- invention is not a patentable invention

- the subject is excluded from protection of patent

- the subject is excluded from protection pf patent for being contrary to public

order

- any drawings required for the understanding of the claimed invention have

not been furnished

- Right to the patent does not belong to person to whom it was granted.

Procedure for grant of Patent

An application for the grant of a patent must be made to the Director-General in the

prescribed form and must contain a request for the grant of the patent, a description of the

patent, a claim, a drawing where required, an abstract, a declaration that the applicant/his

predecessor in title has not obtained a patent abroad before the application was filed relating

to the same as that claimed [Section 71].

An application for the grant of a patent must not be entertained unless the prescribed fee has

been paid to the Director- General [Section 72]. The Director- General shall record as the

filing date, the date of receipt of the application. [Section 77]

The right to a patent belongs to the inventor or inventors as discussed. A patent is valid for 20

years after the filing date of application for its registration. After two year from the date of

grant of the patent, it must be renewed each year until the expiration of the term of the patent.

[Section 83]


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‡ Activity

Discuss the relevant provisions in the Act on the procedure for grant of a patent.

3. Marks and Trade Names

A mark means a trademark or a service mark. A trademark means any visible sign serving to

distinguish the goods of one enterprise from those of other enterprises whereas a service mark

means any visible sign serving to distinguish the services of one enterprise from those of

other enterprises [Section 101].

The function of a mark s to distinguish goods or services of different enterprises i.e. it

indicated the source and symbolises the quality of the goods and services. It also

individualises the goods or services of their owners, enabling them to reach the consumer

efficiently and promote their trade. A mark requires its owner to maintain the quality of

goods or services thus playing a vital role in the protection of consumers’ rationalisation of

trade and commercialisation of products.

The exclusive right to a mark under the Act is acquired by registration. Thus the law protects

only a registered mark. The registration of a mark may be granted only to the person (a

natural person or any body of persons, corporate or incorporate) who has first fulfilled the

conditions of a valid application or who can validly claim the earliest priority for his

application. A mark may consist, in particular, of arbitrary or fanciful designations, names,

pseudonyms, geographical names, slogans, device, relief’s, letters, numbers, labels,

envelopes, emblems, prints, stamps, seals, borders and edging, combinations or arrangements

of colours and shapes of goods or containers[Section 102].

It is interesting to note here that the Act does not totally deny protection to unregistered

marks. It has attempted to protect the interests of the owners of unregistered marks to a

reasonable extent. The use of a mark, even though not registered in Sri Lanka, may play an

important role in safeguarding the interests of the owners of such mark. Section 160 of the

Act protects the unregistered marks within the framework of unfair competition.

‡ Cases

Sumeet Research & Holding Ltd., v Elite Radio & Engineering Co. Ltd., [ 2 SLR 393

(1997)]

It was held that a victim of an act of unfair competition (who may be the owner of an

unregistered mark) can invoke the jurisdiction of the court against the registered owner of a

mark and the registration of a mark does not give the owner a license to engage in acts of

unfair competition.


239

In Mohamed Oomer v Noordeen it was stated that in an application for registration of

trademark be it a trade name, the burden of proof is always on the applicant to establish that

the mark is registered.

Accordingly, a trade name, which means the name or designation identifying the enterprise of

a natural or legal person, is protected in Sri Lanka whether or not it is registered. As will be

discussed, a name is admissible as a trade name unless it is contrary to morality or public

order or is likely to offend the religious or racial susceptibilities or likely to mislead the

public or the trade circles as to the nature of the enterprise identified by the names.

Admissibility of a mark

The admissibility of a mark and registrability of a mark are, although inter-related, two

concepts. The concept of registration embraces both admissibility and formal requirements of

a valid application.

Marks inadmissible on objective grounds [Section 103]

a) Shapes and Forms

A mark which consists of shapes and forms imposed by the inherent nature of the goods or

services by their industrial functions shall not be registered.

b) Descriptiveness

A mark is not registrable if it consists exclusively of a sign or indication which may serve

in the course of trade, to designate the kind, quality, quantity, intended purpose, value, place

of origin, time of production or of supply of the goods. A mark which exclusively consists of

descriptive signs or indications, are not admissible. However, the addition of a mark

consisting of descriptive matter or terms is not always prohibited. A descriptive element

combined with other elements maybe admitted as a mark if it can be distinguished from

goods of different enterprise.

It is not always easy to decide whether the particular sign is descriptive or not. It is a matter

of fact. In Electrix v Electro Lux [1959] it was held that a word does not become non-

descriptive by being misspell. It was further held in this case that if a mark is purely

descriptive it is not registrable even though there is evidence of extensive use.

c) Generic Signs or indications

A mark which consists exclusively of a sign or an indication which has become in the current

language or in the bona fide and established practices of the trade in Sri Lanka, a customary

designation of the goods or services concerned is not registrable.

d) Marks incapable of distinguishing goods or services


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A mark is not admissible if it for other reasons incapable of distinguishing the goods or

services of one enterprise from another. A mark must always consist of a distinctive

character. A mark devoid of distinctive character cannot serve as a mark because it is not

capable of distinguishing the goods or services of different enterprises.

e) Immoral, scandalous and antisocial marks

A mark consisting of any scandalous design contrary to morality or one which would offend

religious or racial susceptibility of a community shall not be registered.

f) Misleading marks

A mark shall not be registered if it is likely to mislead the public or the trade circles as to the

nature, source, manufacturing process, characteristics and suitability for their purpose of the

goods or services concerned.

g) names of individuals and enterprises

A mark which does not represent in a special or particular manner the name of an individual

or enterprise, it shall not be registered.

h) Geographical names and surnames

a mark which is according to its ordinary signification (ordinary meaning of a word as

understood by the average consumer of a particular country or trade, e.g. if a name has been

given due to the connection of the goods to a particular place, it can become the geographical

name in its ordinary significance) a geographical name or surname, it is not registrable.

Marks inadmissible by reason of third party rights [Section 104]

A mark which resembles another in such a way that it is likely to mislead the public or mark

already validly registered or filed by third party or subsequently filed by a person validly

claiming the property or for identical or similar goods or services where the use of the mark

is likely to mislead the public; is not admissible.

If there is a possibility of deceiving the public registration can be refused. It is not necessary

to show there was intention on the part of the person using the mark; Suby v Suby Ltd. To

determine if there is “misleading similarity”, intention of the party is not important. If mark is

likely to mislead the public, the propounded mark is not admitted even if user of mark is

innocent.


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In determining ‘deceptive similarity’ the following case law has to be considered.

- meaning of “likely” generally means a probability of confusion. The applicant is not

expected to show possible instances where confusion can arise if there is a probability of

confusion, mark can be refused. In Berlei v Bali Brassiere Co, a phonetic resemblance

was held to exist between Berlei and Bali for brassieres.

- each case to be decided on its own facts.

• In Sahib V Muthalip a registered mark consisting of 2 ovals and the word “Moulana”,

applied to sarongs. Held, that the accuser’s mark forged the complainant’s mark. Thus

calculated to deceive. Trade mark was so like the other that it was likely to deceive the

public. Similarly in Coca – Cola Co v Pepsi-Cola, in Coca-cola, “Coca” was a distinctive

feature and in Pepsi-cola “Pepsi” was a distinctive feature. Thus, there was no deceptive

similarity between the two trade names.

- to determine if there is any misleading similarity from one mark to another depends on

judicial perception.

- owner of mark can use his mark in any colour or size of his choice. E.g. in Stassen Export

Ltd v M/s Hebtulabhoi & Co. Ltd. there was a phonetic resemblance between registered

trade marks “Rabea” for tea and words and “ Chai El Rabea” for the same product.

- to determine deceptive similarity, the law requires mark to be considered as a whole. In

Lukmanjee v Aktiebalage it was held that although there were some differences in details

of marks, applicant’s mark which had three cups with the words “Three cups” was

calculated to deceive purchasers that they were buying goods carrying the opponents

trade mark, which was three stars with words “three stars”. Registration refused.

Duration of Registration of a Mark

The registration of a mark expires after a period of then years from the date of registration.

The date of registration is considered to be the date of application. The registration may be

renewed for consecutive period of ten years.

‡ Activity

See Chapter XXI of the Act for a discussion on requirements of application and procedure

for registration.


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Rights of the Registered Owner of a Mark

The registered owner of a mark will have exclusive rights in relation to the mark to use the

mark; to assign or transmit the registration of the mark; to conclude licence contracts.

[Section 121]. However, the registration of the mark will not confer on the registered owner

the right to preclude third parties, from using their bona fide names, addresses, a geographical

name, pseudonyms etc. in so far such use is confined to the mere identification and cannot

mislead the public as to the source of goods or services and from using the mark in relation to

goods lawfully manufactured, imported, offered for sale, sold used or stocked in Sri Lanka

under the mark. [Section 122]

‡ Activity

“A mark shall not be registered which, for other reasons, is incapable of distinguishing the

goods or services of one enterprise from those of other enterprises”. Discuss.

4. Copy Rights

Copyrights, like patents, give the copyright owners a monopoly of sorts over their work of art

or literature. The Copyright Act confers on creators of original works a limited monopoly in

their works of authorship to advance an important public purpose. It is intended to motivate

the creative activity of authors and inventors by the provision of a special reward, and to

allow the public access to the products of their genius after the limited period of exclusive

control has expired.

If someone uses the copyrighted information without authorization, the copyright owner can

then sue and receive compensation for any losses suffered.

Protected works [Section 6]

The rights of the authors of original literary, artistic and scientific works are protected in Sri

Lanka. It includes books, pamphlets, other writings, lectured, addresses, sermons, other

works of same nature, dramatic, musical works photographic works, woks of drawing,

painting, architecture, sculpture, engraving, audio visual works, computer programmes etc.

the list is not exhaustive. The work shall be protected irrespective of the quality and the

purpose for which they were created.

Derivative Works [Section 7]

Translations, adaptations, arrangements and other transformations of literary , artistic,

scientific work; collections of literary, artistic, scientific work as encyclopedia’s or

anthologies which by reason of the selection and arrangement of their contents constitute


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intellectual creations and are protected as original works. Further works derived from Sri

Lankan folklore are also covered.

In the above, requirement for originality is concerned with not the idea but the expression of

the idea. The idea need not be novel. What is required is that the manner of expression of the

idea is a novel one. Thereby, the standard of originality is rather low; Prasad Gupta v Prasad

Singh.

In University of London Press v University of Tutorial Press Ltd [(1916) 2 Ch.D 601] it was

stated that the word original does not mean that the work must be the expression of original

or innovative thought. Copyrights are not concerned with the originality of ideas but with the

expression of thought. That the law does not require that the expression must be in

original/novel form, but the work must not be copied from another work that it shall originate

from the author. In Wijesinghe Mahanamahewa and others v Austin Canter [(1980) 1 C.A. L.

R. 620-625] the Court of Appeal followed the decision in University of London Press.

Copyright protection is available without formalities such as registration; British Oxygen v

Liquid Air Ltd. In Sri Lanka publication of work is not a pre-requisite for copyright

protection.

Works not protected by Copyright [Section 8]

Protection will not extent to laws and decisions of courts and administration bodies and

official translations; news of the day published, broadcast or publicly communicated by other

means; ideas; and simple works, See British Northrop v Texteam Blackburn

‡ Activity

“The copyright law protects original expressions of ideas in literary and artistic domain”.

Discuss with special reference to the definition of ‘originality’ in literary and artistic

works.

Types of Rights protected

Copyright consist of a bundle of statutory rights which may be exploited independently.

These rights are exclusive rights belonging to the author of the work. Two types of rights are

protected by copyright.

1) Moral Rights.

Protects personality of the author. As per Section 10 of the Act, an author of a protected work

shall have the right to, claim authorship of his work in connection with any of the acts where

under the exercise of Economic rights require his authorship to be indicated, except when

work is included incidentally, accidentally, when reporting current events by means of

broadcasting. Further the right to object to and seek relief in connection with any distortion,

mutilation, other modification or any other derogatory action in relation to his work where


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such action is prejudicial to his reputation.Moral rights shall be protected for the life of the

author and for a further period of seventy years [Section 13]. After his death it is exercisable

by his heirs. Moral rights are exercisable even where the authors or heirs do not have any

economic rights over the work. These rights are not transferable.

2) Economic Rights

It enables the owner of copyright to derive economic benefits from the work. The owner of a

copyright of a protected work shall have the exclusive right to carry out or to authorise the

following acts in relation to the whole work or a part thereof. [Section 9]

a) reproduce the work – it is the exclusive right of author/owner of copyright to reproduce the

work.

‡ Cases

Wasantha Obeysekera v Alles

A reproduction is not confined to a copy of a complete work.

Reproduction in its normal sense does not carry the reproduction of the whole work.

Not every reproduction is a perfect reproduction.

There must be high degree of similarity for one thing to be said to be a reproduction of

another. To establish the point on reproduction it suffices for a reproduction if it makes a

substantial use of the features of the original work in which copyright subsists.

b) make a translation, adaptation, arrangement, or other transformation of the work – the right

extends to whole or substantial part of the work.

c) communicate the work to the public by performance, broadcasting, and television or by

any other means.

Economic rights of an author [Section 13] shall be protected during the life time of the author

and for a further period of seventy years from the date of his death. In the case of a work of

joint authorship, the economic right shall be protected during the life of the last surviving

author and for a further period of seventy years from the date of the death of the last

surviving author. A work published anonymously the right is protected for seventy years

from the date on which the work was first published or failing publication within seventy

years from the making of the work. However, where before the expiration of the seventy

years, the author’s identity is revealed or is no longer in doubt the above will apply as the

case may require. In the case of work of applied art, the right is protected for twenty –five

years from the date of the making of the work.

Ownership of Copyright

Both moral and economic rights are owned in the first instance by the author/authors who

created the work. Authors of a work of joint authorship are considered as co-owners of the


245

said right. In the absence of proof to the contrary, the physical person whose name is

indicated as the author on a work in the usual manner shall be presumed to be the author of

the work. In the case of a work created in the course of employment or as a commissioned

work, owner of the copyright (person on whom economic rights are vested), unless the parties

have agreed otherwise will be the employer or the person who commissioned the work.

[Section 14 and 15]

Transfer of Copyright

Economic rights can be transferred in whole or in part. Any transfer shall be in writing and

signed by the transferor. A transfer in whole or part shall not include or deemed to include

any other rights. The transfer of ownership of the only copy or one or several copies of a

work shall not imply or deem to imply the transfer of the copyright in the work.

Moral rights are not transferable.

‡ Activity

Examine briefly the challenges posed to the current copyright law in Sri Lanka by

integrated computer networks such as Internet.


‘A’ is a cartoonist employed by a Newspaper Company ‘B & Co. Ltd.’ one of the cartoon

of ‘A’ has won an international award. He is interested in securing copyright protection for

the award-winning cartoon. Advise him.

Fair use

This is an exception to copyright safeguarded in the Act. The use of protected work does not

amount to a violation of copyright as long as it amounts to fair use. What constitutes ‘fair

use’ will be decided on the facts and circumstances of the particular case.

Acts of fair use

1) Works that have been lawfully published; the private reproduction of a published

work in a single copy, the use of the work for research purposes shall be permitted

without the authorisation of the owner f the copyright.

2) Can reproduce/ communicate to the public any article in newspaper, periodicals,

broadcast televised work on current economic/political/ religious topic, if the source

of work is clearly indicated, unless when it was first published it had an express

condition prohibiting such use.

3) Reproduction or communicating to the public of work of art, architecture, if the works

are permanently located in a place that can be viewed by the public.


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4) Reproduction of literary, artistic, scientific works which are already lawfully made

available to the public by public libraries, non commercial documentation, scientific

institution, educational establishments.

5) Reproduction in the press of a political speech delivered in public.

6) Allowing works to be used for purposes of criticism or review of themselves or

another work. Provided that the source is sufficiently acknowledged. e.g. Display of a

foreign TV stations logo can suffice for acknowledgment; Pro Sieben v Carlton.

Following does not amount to fair use

• Publishing an unpublished work, if it is known to have been improperly obtained.

• The wholesale borrowing to be dressed up as critical quotation.

Enforcement of Copyright

Any person who infringes or is about to infringe any of the rights protected under the

copyright law, can be prohibited by an injunction from continuing such infringement and may

also be liable in damages. [Section 22]. Infringement of copyright is a crime punishable by

the Magistrate Court.

‡ Activity –Mini Case

The company “A” is a manufacturer of the product “X”. the company “B” is also engaged

in the manufacture and sale of a similar product. These products are marketed under the

respective trademarks belonging to two companies. The company “A” commences a trade

promotional program using particularly electronic media. One of their advertisements

gives the impression to the consumers that their products are superior and the products of

the company “B” are inferior. The company “B” intends to take legal action against the

company “A”. Advise the company “B”.

‡ Activity- Mini Case

Explain the doctrine of fair use as recognised by the provisions of the Intellectual Property

Act No. 36 of 2003


Examine the protection available to the undisclosed information under the provisions of

the Intellectual Property Act No.36 of 2003.

Chapter 16 – Other Legal Aspects Relevant to Marketing

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Chapter 16

Introduction to Other Legal Aspects relevant to

Marketing


1. Law of Agency

2. Introduction to Company Law

3. Industrial Dispute

1. Law of Agency

Agency is the relationship, which arises when one person is authorised to act as the

representative of another person. The person authorised is the agent; the person authorising is

the principal. The function of the Agent being to create a contractual relationship between the

principal and third parties. e.g. the function of a travel agent is to create a contract between

the holiday maker and the airline.

In Sri Lanka even though English law would apply generally with regard to the Law of

Agency, the matter of the capacity of the parties in a contract of Agency would be governed

by Roman Dutch Law principles. The general rules are as follows:

a) the Principal must have capacity as understood by Roman Dutch Law for the

contracts between himself and the Agent and those between himself and the third

party to be enforceable.

b) The third party must have capacity as understood under Roman Dutch Law in order

that the contract with the Principal is to be enforceable.

c) The Agent generally does not require contractual capacity to act as an Agent. Hence a

minor or bankrupt could act as an Agent and bring about a binding contract between

the Principal and the third party.

An Agent’s authority may be ‘actual’, ‘apparent’, and ‘necessary’ or may be conferred

retrospectively by ‘ratification’.

Actual Authority

Actual authority may be express or implied. Where the principal expressly appoints an agent

to do some act or enter into some contract on his behalf the agent has express authority. If the

instructions are not clear he should get a clarification but if he cannot contact the principal he


248

can act on a reasonable construction of the instructions even though it may not be what the

principal intended.

‡ Case

Boden v French 1851 10 CB 886

The principal instructed his agent to sell coal so as to get him a certain price,15s a ton net

cash. The agent sold at a price which would realise 15s 6d a ton, but he gave the purchaser

two months credit.

Held: that this did not amount to a breach of the contract of agency, since the conduct of

the agent could reasonably be considered by him as coming within the general terms of the

agency.

An agent is impliedly authorised to such things as are normally incidental to carrying out his

express instructions.

‡ Case

ANZ Bank v Ateliers Constructions Electriques de Charterois [1966] 2 WLR 1216

A Belgian Company was transacting business in Australia through an Australian agent.

The Australian agent even though he had no express authority to do so used to bank the

cheque which were written in favour of the principal into his own bank account since the e

principal had no bank account in Australia. The principal knew of this fact.

Held: that the agent had the implied authority to do so.

Where a person is appointed to a particular position and it si usual for a person of that type to

have certain contractual powers, the principal by appointing that person to such position

would be impliedly taken to have conferred on the agent those powers as well.

‡ Case

Panorama Developments v Fidelis Furnishing Fabrics [1971] 3 AER 116

A company Secretary ordered some taxis some of which were used to take the customers

of the firm to Heathrow Airport but some of which he used for his own purposes.

Held: that the Company Secretary was not a mere Clerk and must be regarded as having

implied authority to sign contracts connected with administrative side of the Company’s

affairs.


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Where an agent is employed to act for his principal in a certain place, market, or business,

then the agent is impliedly authorised to act according to the usages and customs of such

market place or business.

‡ Case

Bayliffe v Butterworth [1847] 1 Exch 425

The principal authorised a broker (A) to sell shares for him. A sold them to X another

broker but failed to deliver the shares. X bought other shares at the market price and

claimed the difference from A, who paid X and sued the principal for the sum. There was a

custom among the brokers at Liverpool where the transaction tool place for the brokers to

be responsible to each other on such contracts and the principal knew of such custom.

He was liable to reimburse A.

If the agent exceed his authority that was limited by the principal expressly, he would be

liable to the principal. But a third party who is not aware of such restriction and who deals in

good faith will not be affected and the principal would be bound to him.

‡ Case

Watteau v Fenwick [1893] 1 QB 346

H, the Manager of a public house ordered cigars from the plaintiff for the bar. The

evidence showed that H had been specifically prohibited by the owners from buying cigars

on credit from the plaintiff.

Held: that the contract had been entered into by H within the course of his usual authority

as Manager of the public house and that the owners were bound by the contract

notwithstanding the prohibition as the plaintiff had no knowledge of the prohibition.

Apparent Authority

Apparent authority arises where circumstances make it appear to others that a person has

authority to act as agent of another person. This is also known as agency by estoppels. The

requirements for agency by estoppel to arise were laid down in Rama Corporation Ltd. V

Proved Tin and General Investments Ltd. [1952] 2 QB 147; there has to be a representation;

and a reliance on a representation; and an alteration of a party’s position resulting from such

reliance.

‡ Case

Lloyd v Grace Smith & Co. [1912] AC 716


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A solicitor’s managing clerk dealt with a client’s property and fraudulently persuaded her

to sign documents that gave him all her estate.

Held: that the solicitors were liable to the client, because by allowing the clerk to deal with

matters of this kind, they had represented that he had authority to get clients to agree to

transfers of their property.

A third party will obtain a contract with the principal by virtue of apparent authority.

However, the principal will be able to sue the agent for damages and the agent will not be

entitled to remuneration or indemnity, as there was no actual authority.

Necessary Authority

A person may acquire authority to act for another even without his consent in circumstances

of necessity. Thus the master of a ship, where it is necessary for the continuance of the

voyage, may borrow money on the ship owner’s credit, and so bind the ship owner.

‡ Case

Great Nothern Railway v Swaffield [1874] LR 9 Ex 132

The plaintiffs were a railway company delivering a horse on behalf of the defendants. Due

to no fault of the plaintiffs delivery was delayed and the plaintiffs kept the horses in livery

stables of X.

Held: that the defendants were liable to pay the plaintiff livery charges.

For agency by necessity to arise the following conditions must be fulfilled.

- a genuine emergency should have arisen which threatens the property, e.g. the goods are

perishing or the premises are destroyed and the goods are exposed to weather .

- it is impossible to communicate with the owner to get instructions; see Springer v Great

Western Railway [1921] Vol 1 KB 257

- the agent should act in good faith.

Ratification

If A, without authority, purports to contract with X on behalf of P, P can subsequently adopt

the contract. This subsequent adoption is called ratification.

‡ Case

Keighly Maxsted v Duran [1901] AC 240]

X was authorised to buy wheat on the joint account of X and Y below a stated price. X


251

bought from a seller at above the price and did not disclose that he was acting on Y’s

behalf as well. Y later purported to ratify the contract and he was sued by the seller for the

price.

Held: that for relationship of principal and agent to exist and affect third parties it must be

based upon knowledge on the part of all concerned and since this was not so that Y would

not be liable.

Duties of an agent

1) the agent must do what he has undertaken to do.

‡ Case

Turpin v Bilton [1843]5 Man & G 455

An agent was instructed to insure his principal’s vessel but failed to do so. In consequence

when the vessel was lost the owner was uninsured.

Held: that the agent was in breach of his contractual duty to act and therefore was liable in

damages to the principal.

2) the agent is obliged to obey the lawful instructions of his principal in the performance of

his work. See,Bertram Armstrong v Godfrey [1830] 1 Knapp 381

3) the agent must do the work personally and cannot delegate his work to a sub agent or

servant.

4) the agent must carry out his work with ordinary skill and diligence,

5) Fiduciary duty – the agent must conduct himself in a trustworthy manner in the best

interest of his principal.

‡ Activity

Discusses the cases, McPherson v Watt [1877] 3 App 254; Keppel v Wheeler [1927] Vol 1

KB 577; Boston Deep Sea Fishing Co v Ansell [1888] 39 Ch D 339

6) the agent must handover to the principal all profits resulting directly or indirectly from the

agency.

7) an agent is estopped from denying his principal’s title to money or gods on the ground that

he has superior title.

Rights of an Agent

1) Right to commission or remuneration. See, Christie Owen and Davies v Rapacioli.

2) Right of indemnity


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3) Lien – the agent has a lien over all goods belonging to the prinicapl, which is in the

custody of the agent. See, Re Bowes, Earl of Strathmore v Vane [1886] 33 CHD586

Effect of agency relations between the principal and Third Party

A principal is called a disclosed principal when his existence is known to the third party at

the A enters into the contract with X. the general rule here is that a disclosed principal,

whether named or unnamed, is liable and entitled on the contract, and the agent is not.

‡ Case

Jordan v Norton [1838] 4 M& W 155

A father informed the owner of a horse that his son only had authority to take delivery of

the horse provided that a certain warranty was given. The owner failed to give the warranty

but delivered the horse to the son.

Held: that since the owner had express notice of the limitations imposed upon the son’s

authority the father was not bound.

A principal is said to be undisclosed where his existence is not known to the third party at the

time of contracting.

‡ Case

Archer v Stone [1898] 78 LT 34

The agent was specifically asked by the defendant whether he was acting for the plaintiff

and the agent untruthfully replied ‘no’.

Held: that since the defendant had been induced to contract by the misrepresentation;

specific performance would not be granted against him.

The Relationship between the Agent and the Third Party

The general rule is that an agent is neither liable nor entitled under contract which he makes

on behalf of his principal. However, the exception to this rule is as follows:

- an agent is liable on the contract if he shows an intention to undertake personal liability.

- Trade usage or custom may lead to an agent becoming personally liable and entitled. See,

Fleet v Murton [1871]

- Where an undisclosed principal comes into the contract the agent is liable and entitled

along with the principal.

‡ Case

Lily Wilson & Co. v Smales, Eeles & Co. [1892] 1 QB 456]


253

A shipbroker signed a charter party ‘by telegraphic authority as agent’. The custom in the

trade was that such a signature merely meant that if the telegram he received was correct

then the agent had authority to sign the charter party.

Held: that this did not amount to a warranty of authority since the third party knew that the

agent was relying on the correctness of a telegram which he himself had received and

therefore was not liable for a mistake in the telegram.

Termination of Agency

The contract between the principal and the agent may come to an end in the following ways.

- Complete performance of the contract

- Notice. If the contract of agency provides that it may be determined by notice being

given, then the giving of such notice as provided in the contract will bring the agency to

an end.

- Agreement

- Frustration

- Breach.


Tiger Woods Ltd. (TWL) is setting up a golf course and housing complex at Victoria

overlooking the reservoir. 20 perch blocks are being sold at Ts. 1.5 Mn each. The

purchaser of a block would be entitled to membership of the golf club, which is being

built. The blocks are being sold privately by the promoters to a group of exclusive

individuals. R has just won a lottery has seen golf being played on TV and wants to buy a

block very badly. S her agent approaches TWL and without disclosing who the purchaser

is, manages to purchase a block and the money is paid by her, when she goes for the

ceremonial execution of the deeds at the Golf Club she is informed that TWL was never

willing to sell a block to her.

Advise R

2. Introduction to Company Law

The law that applies in Sri Lanka is the Companies Act No. 17 of 1982 (herein after referred

to as the Act). A company can do business, have its own money and property, engage

workers, borrow and owe money, enter into contracts, and sue and be sued like an individual.

Law regards a registered company as a person just as it regards human beings.

Characteristics of a Company

A. Legal entity distinct from its members


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The fundamental principle is that it is a legal entity distinct from its members (shareholders).

It is capable of enjoying rights and being subject to duties which are not same as those

enjoyed or borne by the members. i.e. it has ‘legal personality’. In other words a company is

separate and distinct from those who own it – the shareholders, and those who manage and

direct it- the directors. Further, the company’s existence is unaffected by changes in

membership.

‡ Case

Salamon v Salamon & Co. [1897] AC 22 (HL)

Salamon formed a Company, which comprised of himself, his wife, daughter and 4 sons.

The wife, daughter and 4 sons held 1 share each. Salamon sold his own business to the

Company and obtained 20,000 shares of the nominal value of L 1 each and a debenture for

L 10,000 secured on its assets. The company was wound up and the question, which arose,

was as to whether Salamon as a person was distinct from Salamon & Co, and whether

Salamon as a secured debenture holder got preference over the other shareholders.

Held: that the Company was separate from Salamon and that his claim to be a secured

creditor was valid.

Lee v Lee’s Air Farming Ltd. [1961] AC 12 (PC)

Lee who was a pilot formed a Company for operating a aircraft. He beneficially owned all

the shares and was also its Managing Director. He obtained insurance for his workman

under the relevant Act. He was killed in a flying accident and his widow clamed

compensation.

Held: that the company and Lee were distinct legal entities and that he could become a

servant of the Company. Furthermore in his capacity as Managing Director he could give

himself directions, as a pilot ad therefore there was nothing to preclude a relationship of

master and servant.

However, the Statues and the Court have sometimes have been willing to go behind the

corporate personality to the individual members. This is referred to as ‘lifting the veil of

incorporation’. In the following circumstances this doctrine had been applied.

1) Agency and the “alter ego” doctrine

Even though a company is a separate entity it is possible that it can be treated as an agent of

the holding company or other controlling power. In Sukthew Singh v Bhagtaran [1975] AIR

SC 1331 it was stated that merely because a Corporation has legal personality of its own, it

does not follow that the Corporation cannot be an agent or instrumentality of the State if it is

subject to the control of Government in all important matters of policy”.


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‡ Case

Trade Exchange Limited v Asian Hotels Corporation Limited. [1981]

The petitioner was seeking a writ against the Respondents for the renewal of a contract to

operate a jewellery shop in the hotel. The CWE owned 95% of the shares of the

Respondent Company and the government too had granted some loans to the Company.

Held: that the mere fact that 95% of the share capital was contributed by the Government

does not make any difference, the Company and its shareholder being as aforesaid distinct

entities, the fact that the Government or a Government Corporation holds all its shares or

95% of its shares does not make the Respondent Company an agent of the Government.

2) Fraud

‡ Case

Jones v Lipman [1962] 1 WLR 832

Lipman having entered into a contract to sell land to Jones, attempted to prevent Jones’

right to specific performance by forming a Company and transferring the land to it. The

court granted specific performance against both Lipman and the Company.

3) Single economic unit

‡ Case

Scottish Co-operative Wholesale Society v Mayer [1959] AC 324

The members of the Company petitioned court that the affairs of the Company were being

conducted in a manner oppressive to members. The appellant company argued that it could

not be considered to have acted oppressive since if at all it was not that company but only a

subsidiary of it, which had acted oppressively.

Rejecting the above argument courts stated that every step taken by the subsidiary was

determined by the policy of the parent and the statute warrants the courts in looking at the

business realities of the situation and does not confine them to a narrow legalistic view.

4) Determination of residence

The courts look beyond the veil of incorporation in order to determine the residence of a

company for taxation purposes.


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5) National Security

‡ Case

Daimler Tyre Co. v Continential Tyre Co. [1916] 2 AC 307

The English Courts lifted the veil of incorporation to find that all the shareholders of a

English Company were Germans.

Held: that a contract entered into with this Company was void as it were in essence a

contract entered into with an alien enemy.

B. Memorandum of Association

The Memorandum of Association is the registered company’s charter and defines its

constitution and powers. It informs shareholders, creditors and all persons dealing with the

company, and what capital it has.

Section 2 of the Act provides that a minimum of two, seven or fifty persons in private, public

or peoples company respectively may by subscribing their names to the Memorandum of

Association form an incorporated company with or without limited liability.

The Memorandum of a Company would normally have the name of the company; the district

in which the registered office is situated; the objects of the company; the amount of the share

capital.

Section 4 of the Act requires setting out the primary objects of the Company in its

Memorandum. These will be the objects, which the subscribers or promoters intend that the

company should carry out during the period of 5 years from the date of commencement of

business by the Company. The ancillary powers proposed to be exercised for the purpose of

carrying out the primary objects should also be stated.

The objects clause in the Memorandum protects the shareholders who are made aware of the

purpose for which their money could be used and protects persons dealing with the Company

who are made aware for the Company’s contractual powers.

C. The ‘ultra vires’ doctrine

Given the limitations in drafting objects clauses where main focus is to protect the

shareholders, such clause would be disliked by outsiders such as capital providers and other

prospective investors who deal with the company since they run the risk of the transaction

would be outside the powers of the Company. Therefore even if an action or transaction of a


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company may be legal in itself, if it is ultra vires or beyond the powers of the company and is

therefore void.

‡ Case

Ashbury Railway Carriage & Iron Co v Riche [1875] LR 7 HL 653

A company was formed to make, sell or lend on hire railway carriages and wagons; the

directors contracted to purchase a concession for making a railway.

Held: that the contract was ultra vires and that subsequent assent of the shareholders could

not ratify it.

Introductions Ltd v National Provincial Bank [1970] Ch 199

The Company was incorporated and its main object was providing foreign visitors with

accommodation and entertainment. The objects clause also provided that the Company

could “borrow or raise money in such manner as it thinks fit” and stated that each object

was an independent object. A Bank lent money to the Company for pig breeding and took

debentures as security. The question was as to whether the debentures were binding on the

Company.

Held: that the debentures were void and the bank could not enforce it.

D. Articles of Association

The internal management of the Company is resulted by the Articles of Association. The

following principles are noted in discussing the Articles of Association of a company.

- the Articles constitute a contract between the company and the members,

- the Articles grant rights and impose obligations on members in their capacity as

members. See, Hickman v Kent or Romney Marsh Sheep Breeders Association [1951] 1

Ch 881

- Members cannot rely on the Articles in their capacity as outsiders.

‡ Activity

Discuss and contrast Eley v Positive Government Life Assurance Co. 1876 1 Ex D 88 with

Cumbria Newspaper Group v Cumberland & Wetmorland Herald Newspaper & Printing

Co. [1986] 2 AER

- the Articles also becomes a contract between a member and other members.

Articles must be registered with the Memorandum and signed by the subscribers to the

Memorandum. [Section 8 of the Act]


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Types of companies

a) a company limited by shares

In which case the liability of a member to contribute to he company’s assets is limited to the

amount, if any, remaining unpaid on his shares. A registered company under this category

would be a private, public or a people’s company. Further, members are not personally liable

for the company’s debts, except in certain instances.

b) a company limited by guarantee

In which case the liability of a member is limited to the amount which he has undertaken to

contribute in the event of the company being wound up.

c) an unlimited company

In which case the liability of a member is unlimited.

d) offshore companies

It is a company, which is registered in Sri Lanka but carrying on its business overseas and not

in Sri Lanka.

3. Industrial Disputes

An amicable dispute resolution has been very much apart of, not only in traditional Sri

Lankan culture but also of the Asian Culture. In recent times there has been focus on

improving the system by channelling disputes that arise in a commercial environment to non-

adjudicative forums of resolution through alternative methods. This widespread interest in

looking at alternative methods of resolving disputes is because of the disenchantment with

the adjudicatory process. In many advanced jurisdictions the Alternative Dispute Resolution

(ADR) movement is fast gaining headway as the better way or has already done so.

What is ADR?

Alternative Dispute Resolution is basically a reference to all the ‘other’ processes that are

available for the resolution of disputes other than the adjudicatory/litigation process. The

basic feature of litigation is that it is rigid and is ‘adversarial’ in nature. Alternatives are

necessary more ‘settlement’ oriented. In other words it is the level of ‘user satisfaction’ that

will determine its acceptance as an effective process and not on what should be sought and

achieved by those who access the adjudicatory processes.

Among the many ADR processes, Arbitration, Mediation, Conciliation and Negotiation are

some effective mechanisms a marketer, customer and other various stakeholders could adopt

in the case of a dispute.


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Arbitration

The enactment of the Arbitration Act No. 11 of 1995 provides for party independence

excluding any court interventions. It was introduced to fulfil the need for expeditious

resolution of commercial disputes. The process of Arbitration involves a neutral third party

hearing both sides of the case and delivering a judgment, decision or award. Parties agree in

advance whether or not the judgement will be binding; where in most cases it is.

Mediation

The concept is institutionalised in Sri Lanka through the Commercial Mediation Centre of Sri

Lanka Act No. 44 of 2000. The Commercial Mediation Centre established there under is now

statutorily mandated to promote the wider acceptance of mediation and conciliation for the

resolution and settlement of commercial disputes. This ADR method was taken at the request

of the private sector community, which expressed a dire need for a more expeditious and

efficient dispute resolution mechanism in relation to commercial matters.

Mediation involves an impartial third party steering a process, which is aimed at helping the

parties reach an agreement. All parties must be trained and skilled in the tools and techniques

to help achieve agreement and create a positive environment conducive to such agreement.

Conciliation

This is similar to mediation, but here the neutral party plays a less active role, nudging the

parties towards a solution rather than coming up with concrete suggestions.

Why a marketer should not rush to court in case of a dispute.

As discussed alternative dispute resolution mechanisms has the potential not only to resolve

disputes but also to avoid them. Resolution of commercial disputes through these

mechanisms enables disputing parties not only to find their own solutions to the problems but

also to continue relationships that would have been scarred and ruined through the adversarial

approach taken by courts in litigation. Following advantages of ADR also allows a Marketer

to be in business effectively and efficiently.

- Time saving. ADR results in disputes being resolved much more rapidly, both in terms of

the time taken to start the process, and the speed of resolution thereafter.

- Cost saving. As ADR is faster, the costs involved are considerably reduced. As ADR

focuses on issues rather than law, the reduced need for legal expertise also helps to keep

costs low.

- Finality. Some ADR mechanisms are entered into on the condition that the outcome is

binding, and there is no right of appeal in respect of the arbitrator’s award.


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- Confidentiality. ADR proceedings are generally confidential, and held in private. This

helps to eradicate the possibility of unwanted publicity, which would be bad for

continued business relationships.

- Flexibility in solutions available and control. ADR can be organised in anyway, which is

acceptable to the parties involved. The location and the timing are also under the control

of the parties. As ADR can deal with complex issues in flexible ways, there is a strong

argument that some forms of ADR not only lead to procedural justice, but that the

outcomes are more likely to be acceptable as a consequence.

‡ Activity

Discuss the risks a Marketer will face in adopting an ADR mechanism in the case of a

commercial dispute.

♪ My Short Notes

Legal Concepts of Marketing

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