Legal Concepts of Marketing

Foundation Level
Recommended Study Text
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)
Economic & Legal Concepts for

Marketing
Graduate/Postgraduate
Diploma in Marketing
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.
CONTENTS
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
iii
DETAILED CONTENTS
Module One
Micro 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

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

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
v
DETAILED CONTENTS

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

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
vi
DETAILED CONTENTS
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

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

1. Fiscal Policy
157
2. Monetary Policy
163
vii
DETAILED CONTENTS
Module Three
Legal Concepts
1. Definition
173
2. Formation
174
3. Invalidation
190
4. Discharge
201
5. Remedies
206

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

1. Introduction
225
2. Regulations on Internal Trade
225
3. Establishment of a Consumer Affairs Authority
230

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
viii
Foundation Level
Economic & Legal Concepts
for Marketing
Module One
Micro Economics
Chapter 01
Fundamental Concepts of Economics
This chapter will cover
1.
2.
3.
4.
5.
Understanding Micro and Macro Economics

What is Economics? A few Definitions
Fundamental Concepts of Economics
Production Possibility Curve (PPC)
Factors of Production
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)
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
Scarcity
Choice
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 cram, which is Rs90. If you desire to buy
both, you will require Rs185. But you have only Rs100. There is a scarcity. Therefore
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
Revenues
Cost
Opportunity cost
Profit
Economic profit
2,000,000
(1,200,000)
(500,000)
300,000
Accounting Profit
2,000,000
(1,200,000)
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
A
Consumer 1000
Goods (Y)
C
600
B
60
100
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.
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
A
Consumer 1000
Goods (Y)
C
D
800
E
500
60
B
100
80
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
b
Consumer
Goods (Y)
a
c
b
Capital goods ( X)
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 havenots or irrespective of the income group to produce it for the whole economy.
10
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
11
My Short Notes
12
Chapter 02
Price Theory
1.
2.
3.
4.
5.
6.
Introduction to Price Theory

Theory of Demand
Theory of Supply
Establishment of Market Price
Price Controls
Importance of the Price Theory for Marketing Decision Making
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.
13
Individual Demand Schedule

Price/unit in (Rs)
Qty demanded (units)
1
50
2
40
3
30
4
20
5
10
Market Demand Schedule

Price/unit in (Rs)
Qty demanded (units)
1
5000
2
4000
3
3000
4
2000
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
Demand Curve
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
A
A to B
A to C
Price(Rs)
10
20
5
Money income Rs( constant)

1000
1000
1000
Ability to buy(units)/qty demanded

100
50
200
14
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
A
A to B
A to C
Concerned product
Price Quantity Utility
Utility
(Rs) Demand
per 1 Re
5
1000
50
10
50
10
500
5
50
2.50
1250
20
Price
(Rs)
5
5
5
Substitute product
Quantity Utility
Utility
Demand
per 1 Re
500
50
10
50
1000
10
50
250
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)
15
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
Contraction of Demand
4
3
Extension of Demand
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
16
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. Lets 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)

Price
Quantity Demand
(Rs)
500
5
250
10
750
2.50
A
A to B
A to C
Substitute Product (coffee)

Price
Concerned product ( Tea)

Price
Quantity Demand
(Rs)
5
500
5
750
5
250
Concerned Product (Tea)

Price
A
Increase in
demand
B
10
C
A
5
Decrease in
demand
5
C
2.5
250
500
750
QD
250
B
A
C
500
750
QD
17
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.
18
Illustration 04 Prices of Complementary Products and the Demand of the Product

Concern
Situation
Complementary Product( Tyres)

Price
Quantity Demand
(Rs)
1000
500
750
1000
1250
250
A
A to B
A to C
Concerned product ( Tubes)

Price
Quantity Demand
(Rs)
50
1000
50
750
50
1250
Complementary Product (Tyres)

Price
Concerned Product (Tubes)

Price
A
B
1000
Increase in
demand
B
A
50
C
250
Decrease in
demand
500
750 1000 1250
QD
C
A
B
750 1000 1250
QD
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.
19
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
A
A to B
A to C
Price of the product (Rs)

100
100
100
Consumer income (Rs)

10,000
8,000
12,000
Relationship between consumer

income and quantity demand
Income
Quantity demand
Price
A
C
Increase in
Demand
Increase
Increase
Decrease
Decrease
With out a change to the price of the

product concern
Decrease in
demand
100
Quantity Demand
100
80
120
80
100
B
120
A
QD
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
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.
20
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
Price of the
product(Px)
Prices of
substitutes(Py)
Prices of
complementary
products (Py)
Consumer
income (Yd)
Relationship
to level of
demand
Term used
Negative
Py, Yd,
Ct&f , W
Extension of
demand/contraction
of demand
Positive
Px, Yd,
Ct&f , W
Increase in
demand/decrease in
demand
Px, Py,
Ct&f , W
Increase in
demand/decrease in
demand
Px, Py,
Ct&f , W
Increase in
demand/decrease in
demand
Px, Py, Yd,

W
Increase in
demand/decrease in
demand
Px, Py, Yd,

Ct&f
Increase in
demand/decrease in
demand
Negative
Positive
Depends on
Consumer tastes
taste
& fashions
towards
(Ct&f)
the product
Weather
conditions (W)
Constant
variables
Depends on
the product
Movement of the
demand curve
Movement along
(upwards or
downwards)
Shift in the demand
curve(outwards or
inwards)
Shift in the demand
curve( outwards or
inwards)
Shift in the demand
curve(outwards or
inwards)
Shift in the demand
curve (outwards or
inwards)
Shift in the demand
curve (outwards or
inwards)
21
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
Price/unit in Rs
Qty Supplied (units)
1
10
2
20
3
30
4
40
5
50
Market Supply Schedule

Price/unit in Rs
Qty Supplied (units)
1
1000
2
2000
3
3000
4
4000
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
22
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?
Lets see the reasons. We assume here that the cost of the production is constant at each level.
Cost per unit
100
100
100
100
100
Price of the
product
100
200
300
400
500
Profitability
per unit
0
100
200
300
400
Quantity willing to
supply
0
1000
2000
3000
4000
Total profit
0
100,000
400,000
900,000
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.
23
Illustration 08 Contraction and Extension of Supply

Price/Units Rs
5
4
3
Extension of supply
2
Contraction of supply

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.
24
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
A
A to B
A to C
Price
(Rs)
50
75
25
Other product
Cost
Profit
(Rs)
(Rs)
20
30
20
55
20
5
QS
units
50
75
25
Price
(Rs)
50
50
50
Other Product
Price
Decrease in
supply
A
C
50
QS
units
50
25
75
Concerned Product
Price
75
Concerned product
Cost
Profit
(Rs)
(Rs)
20
30
20
30
20
30
50
25
Increase in
supply
A
0
25
50
75 QS
C
25
50
75
QS
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.
25
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)
100
100
100
A
A to B
A to C
Cost of the
product (Rs)
80
70
90
Profit per
product(Rs)
20
30
10
Quantity Supply
100
120
80
Relationship between cost of

production and quantity supply
Cost
Quantity supply
Price
Decrease in
supply
A
B
Increase
Decrease
Decrease
Increase
Without a change to the price of the

product concern
100
Increase in
C
supply
C
A
B
80
100
120
QS
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
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
26
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
Price of the
product(Px)
Positive
Prices of other
goods(Py)
Negative
Cost of
production
income (Fc
Change in
technology (T)
Negative
Weather
conditions (W)
Depends on
the
technology
change
Depends on
the product
Constant
variables
Py, Fc
T,W
Term used
Extension
of
supply/contraction
of supply
Px, Fc, T , Increase
in
W
supply/decrease in
supply
Px, Py, T ,
Increase
in
W
supply/decrease in
supply
Px, Py, Fc,
Increase
in
W
supply/decrease in
supply
Px, Py, Fc,
T
Movement of the
supply curve
Movement
along
(upwards
or
downwards)
Shift in the supply
curve (outwards or
inwards)
Shift in the supply
curve (outwards or
inwards)
Shift in the supply
curve (outwards or
inwards)
Increase
in Shift in the supply
supply/decrease in curve (outwards or
supply
inwards)
27
4. Establishment of Market Price

4.1 Concept of Market Equilibrium.
Illustration 12 Market Equilibrium
D
Price/Units Rs
excess supply
S
5
4
3
2
excess demand
1

0
Point
A
B
C
D
E
Price ( Rs)
1
2
3
4
5
10
20
Demand (units)
50
40
30
20
10
30
40
50
Supply (units)
10
20
30
40
50
Excess
40
20
0
20
40
Remarks
Excess demand
Excess demand
Mkt equilibrium
Excess Supply
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.
28
Illustration 13 Changes in Demand & Supply Levels and impact on Market Quantities
and Prices
Demand Constant
Supply Increase
Demand Constant
Supply Decrease
Pr
Pr
D0
S0
S1
D0
S1
P0
S0
P1
P0
S1
P1
S0
S1
D0
Qty
Q0
Q1
Price - Decrease
Quantity - Increase
S0
Demand Increase
Supply Constant
Pr
D0
Qty
Q1 Q0
Price - Increase
Quantity - Decrease
Demand Decrease
Supply Constant
D1
Pr
D0
S0
D0
S0
P1
D1
P0
P0
P1
D1
S0
Q0 Q1
Price - Increase
Quantity - Increase
D0
Qty
S0
D0
Qty
Q1 Q0
Price - Decrease
Quantity - Decrease
Demand Decrease
Supply Increase
Demand Increase
Supply Increase
Pr
Pr
D0
D1
S0
D1
D0
S0
D1
S1
S1
P0
P0
D1
P1
S1
S0
S1
D1
Q0
Price - Decrease
Quantity No change
D0
Qty
S0
Q0
Price No Change
Quantity - Increase
Q1
D0
Qty
29
Practice Question 01
D1
Price
S2
D
S1
G
D2
H
I
S2
B
A
D
E
D1
S
S2
D2
Quantity
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 TVs 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 TVs
A4 An increase in the wages of the workers who manufacture TVs due to trade
union action
A5 A government advertising campaign to show the advantages of TVs
A6 A very sharp increase in cost of the TV license followed by an increase in
the wages of the workers who manufacture TVs
A7 An increase in consumer income followed by an improved technique in
manufacturing TVs
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
TVs
A10 An extra ordinary increase in temperature in the weather.
30
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
Price
P2
P
Maximum price
P1
Demand
QS
QD
Quantity
QS< QD = Excess demand
31
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
S0
Price
E
P
E1
Maximum price
P1
D1
QS
QD
D0
Quantity
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.
32
b) Subsidization Scheme
Illustration 16 Price Ceiling and Subsidization Scheme
S0
Price
S1
E
P
E1
Maximum price
P1
D0
QS
QD
Quantity
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
Price
Supply
Minimum price
P1
Tendency for the
price to fall
Demand
QD
QS
Quantity
QS> QD = Excess supply
33
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.
34
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
35
My Short Notes
36
Chapter 03
Theory of Elasticity
1.
2.
3.
4.
5.
Understanding Elasticity
Elasticity of Demand
Elasticity of Supply
Elasticity and Taxation
Elasticity and Marketing Decision Making
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
Elasticity of
demand
Elasticity of
supply
Responsiveness of quantity demanded

to changes in
Price of the
product
Income of
consumers
Prices of
other goods
Price
Elasticity of
demand
Income
Elasticity of
demand
Cross
Elasticity of
demand
Responsiveness of quantity supplied

to changes in
Advertising
Expenditure
Advertising
to sales
elasticity of
Demand
Price of the
product
Price
Elasticity of
supply
37
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
PED co-efficient =
P
X
P
P
QD
P
QD
QD
= Initial price
= Initial quantity demanded
= Change in price
= Change in quantity demanded.
Example one
Price
Quantity Demanded
10
20
100
50
QD
PED co-efficient =
P
X
P
=
QD
50 (50 100)
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.
38
Example two
Price
Quantity Demanded
10
15
100
25
QD
PED co-efficient =
P
X
P
=
QD
75 (25 100)
10
5 (15-10)
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
PED = 0
PED = 0 to 1
PED = 1
1 < PED < Infinity ()
PED = Infinity ()
Elasticity Type
Perfectly Inelastic demand
Inelastic Demand
Unitary elastic
Elastic demand
Perfectly elastic demand
i) Perfectly Inelastic Demand (PED = 0)

Demand Schedule
Price
10
20
Quantity Demanded
100
100
Calculation of PED
QD
=
Demand Graph
P
X
P
Price
QD
20
0
10
0 x
10
100
10
0.1
100
Quantity
39
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
Price
100
120
Quantity Demanded
1000
900
Calculation of PED
QD
P
=
X
P
QD
Demand Graph
Price
120
100
20
x 100
1000
5 x
0.1
0.5
100
900 1000
Quantity
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
Price
100
120
Quantity Demanded
1000
800
Calculation of PED
QD
=
Demand Graph
P
X
P
Price
QD
120
200
20
10 x
x 100
1000
100
0.1
800
1000
Quantity
40
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
Price
100
110
Quantity Demanded
1000
800
Calculation of PED
QD
=
P
X
P
=
Demand Graph
200
10
Price
QD
x
20 x
100
1000
110
100
0.1
800
1000
Quantity
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
Price
10
10
Quantity Demanded
100
200
Calculation of PED
QD
=
Demand Graph
P
X
P
100
0
=
=
Infinity
Infinity
Price
QD
x
10
100
x
10
0.1
100
200
Quantity
41
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.
42
e) Price Elasticity of Demand and Pricing Decisions

Situation
Price
Change %
of Price
A
10
A-B
11
10%
A-C
9
10%
Elasticity Co-efficient Elastic
Quantity
Demand
1000
800
1200
Change %
of QD
20%
20%
Revenue/consumer
expenditure
10,000
8,800
10,800
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 (AC) Total revenue/consumer expenditure increases.
Situation
Price
Change %
of price
A
10
A-B
15
50%
A-C
5
50%
Elasticity co-efficient Inelastic
Quantity
Demand
1000
900
1100
Change %
of QD
10%
10%
Revenue/consumer
expenditure
10,000
13,500
5,500
ii) For goods which has an inelastic demand

When price of the product increases (AB) Total revenue/consumer expenditure increases
When price of the product decreases (AC) 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
YED co-efficient =
Y
X
QD
See the following table for different YED values.
43
Consumer
Income (Rs)
1000
2000
Demand (units)
YED coefficient
Income Elastic
type
Nature of
Goods
100
150
0.5
Income Inelastic
Normal
goods
1000
1500
100
200
Income elastic
2
Normal
goods
1000
1500
100
80
Negative income
elasticity
Giffon Goods
-0.4
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.
44
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
10
8
Demand of A
100
20
XED co-efficient
Prices of Y
10
8
Demand of A
100
90
XED co-efficient
0.5
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.
45
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.
46
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
PES co-efficient =
P
X
P
P
QS
P
QS
QS
= Initial price
= Initial quantity supplied
= Change in price
= Change in quantity supplied.
Example one
Price
Quantity supply
10
20
100
150
QS
PES co-efficient =
P
X
P
=
QS
50 (150 100)
10 (20-10)
x 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
Price
Quantity Demanded
10
12
100
125
QS
PES co-efficient =
P
X
P
=
25 (125 100)
2 (12-10)
QS
x
x
10
100
12.5 x 0.10 = 1.25
47
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
PES = 0
PES = 0 to 1
PES = 1
1 < PES < infinity ()
PES = Infinity ()
Elasticity type
Perfectly Inelastic Supply
Inelastic Supply
Unitary Elastic Supply
Elastic Supply
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.
48
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. Gamunus
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. Gamunus 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
1
2
3
4
5
Quantity Supply
( curve S)
100
200
300
400
500
Taxation
Price which the

supplier gets
0
1
2
3
4
1
1
1
1
1
New quantity supply

( curve S1)
0
100
200
300
400
S1
Price
S
5
4
3
2
1
100
200
300
400
500
Quantity
49
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
Price
S
b
4
CBT
PBT
3
2.5
D
80 100
Quantity
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.
50
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
S1
Price
S
b
CBT
3.5
3
PBT
2
60
100
Quantity
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
51
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
Price
10
8
INELASTIC DEMAND
Quantity
100
150
Total revenue
1000
1200
Price
10
12
Quantity
100
90
Total revenue
1000
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
B
Price/Rs
A
A
B
Quantity
52
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 consumers 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.
53
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 Firms 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.
54
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 ones 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 companys 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 industrys 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.
55
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 products market development.
b) The extent to which competitors react to the companys advertising, either with their own
advertising campaigns or by increased merchandising.
c) The quality and quantity of the companys 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 companys 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.
56
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
B
Price/Rs
A
B
Quantity
57
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
Rs 1000
Rs 1500
Rs 2000
Likely Demand in Units (Monthly)

200 units
100 units
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
58
Chapter 04
Cost, Revenue and Profit Maximization Rules
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
3.1 Profit Maximizing Output
3.2 Normal and Super Normal Profits
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
1000
2500
5000
Total Variable Cost (Rs)

10,000
25,000
50,000
Chapter 04 Costs, Revenue and Profit Maximizing Rules
59
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
Cost (Rs)
TVC
50,000
25,000
10,000
1000
2500
5000
Output
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
1000
2500
5000
Total Fixed Cost

100,000
100,000
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)
100,000
FC
1000
2500
5000
Output
60
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

TC
Cost ( Rs)
150,000
TVC
125,000
110,000
TFC
100,000
50,000
25,000
10,000
1000 2500 5000
Output
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
61
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
Average
Cost
(Rs)
130
120
110
100
90
80
70
60
50
40
30
20
10
0 10 20 30 40 50 60 70 80 90 100
Table
B
Output
(units)
Total
Cost
(Rs)
10
20
30
40
50
60
70
80
1100
1600
1750
2000
2500
3120
3990
5120
Average Cost
(Rs)
B/A
110
80
58
50
50
52
57
64
Output
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
62
Activity
Draw the marginal cost curve in the given graph area based on the information provided in
the table
Graph
Marginal
Cost
(Rs)
130
120
110
100
90
80
70
60
50
40
30
20
10
Table
B
Output
(units)
Total
Cost
(Rs)
Marginal Cost
(Rs)
B/A
10
20
30
40
50
60
70
80
1100
1600
1750
2000
2500
3120
3990
5120
50
15
25
50
62
87
113
0 10 20 30 40 50 60 70 80 90 100 Output
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
Marginal
/Average
Cost
(Rs)
130
120
110
100
90
80
70
60
50
40
30
20
10
A
Output
(units)
10
20
30
40
50
60
70
80
Table
B
C
D
Total Cost Average Marginal
(Rs)
Cost
Cost
1100
1600
1750
2000
2500
3120
3990
5120
110
80
58
50
50
52
57
64
50
15
25
50
62
87
113
0 10 20 30 40 50 60 70 80 90 100 Output
63
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
SAC1
Cost (Rs)
SAC7
SAC2
SAC6
SAC3
Each
represents
one plant/
machine
SAC5
LAC
SAC4
Out Put
LAC is falling
Economies of scale
LAC is constant
LAC is increasing
Diseconomies of scale
LAC long run cost curve

SAC short run cost curves
64
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
Reduction in total purchase cost
Bulk discounts
Per unit purchase cost reduction
Example Two
Large firms who produces in large volumes
Reduce capital costs
Loans at lower interest rates
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.
65
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
66
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
Unit Quantity
Total
Average
price
revenue
revenue
TR/Qty
10
60
600
10
10
40
400
10
10
20
200
10
10
20
30
30
Price /Average revenue
15
Price /Average revenue
Imperfect Market
Quantity
Total
Average
revenue
revenue
TR/Qty
60
600
10
40
800
20
20
600
30
Unit
price
10
20
10
0
10 20 30 40 50 60 70 80 90
Conclusion - AR=Demand curve
10 20 30 40 50 60 70 80 90
AR=Demand curve
You will see that the average revenue curve is the same as the demand curve.
2.3 Marginal Revenue
67
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
15
10
Imperfect Market
Quantity
Total
Marginal
revenue
revenue
TR/Qty
60
600
40
480
6
20
280
10
Unit
price/
AR
10
12
14
Price /Average /Marginal Revenue
Price /Average /Marginal Revenue

Unit Quantity
Total
Marginal
price/
revenue
revenue
AR
TR/Qty
10
60
600
10
10
40
400
10
10
20
200
10
30
20
10
10 20 30 40 50 60 70 80 90
Conclusion - AR=Demand Curve=MR
0
10 20 30 40 50 60 70 80 90
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
of the slope of the AR curve.
68
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
Out put
Price
510
720.00
470
800.50
430
860.20
400
885.70
370
1010.20
340
1200.00
310
1400.00
290
1585.00
260
1678.50
10
230
1981.50
Answer in no of
decimal points
3
TR
1x2
4
AR
3/1
5
MR
3/ 1
6
TC
7
AC
6/1
8
MC
6/ 1
9
Profits
3-6
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
69
.
Activity - Profit Maximizing Output Graphically
Apply Rules 1,2A,3 and draw the below
Apply Rules 1,2B,3 and draw the below

Price/
AR/AC/
MC/MR
Imperfect Market
Price/
AR/AC/
MC/MR
MC
AC
MC
AC
MR=MC
AR=MR=D
MR=MC
AR=D
MR
Q
Profit
Maximum
Output
Output
Profit
Maximum
Output
Output
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)
Minus - Factor Costs
Land rent
Labour wages
Capital interest
Entrepreneurship - Profits
Total Factor Cost
Excess/(Deficit)
Normal Profits = AR=AC
Rs.100,000
Average Revenue (AR) = 100
Rs 20,000
Rs 50,000
Rs 10,000
Rs 20,000
Rs 100,000 Average cost (AC) = 100
AR = AC
0
70
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)
Minus - Factor Costs
Land rent
Labour wages
Capital interest
Entrepreneurship - Profits
Total Factor Cost
Excess/(Deficit)
Supernormal Profits = AR >AC
Rs.150,000 Average Revenue (AR) = 150

Rs 20,000
Rs 50,000
Rs 10,000
Rs 20,000
Rs 100,000 Average cost (AC) = 100
Rs 50,000
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 Apply Rules 1,2B,3 and 4A to draw the
diagram
diagram
Price/
AR/AC/
MC/MR
Imperfect Market
Price/
AR/AC/
MC/MR
Output
71
Output
Activity Supernormal Profits Graphically

Apply Rules 1,2A,3 and 4B to draw the Apply Rules 1,2B,3 and 4B
diagram
diagram
Imperfect Market
Price/
AR/AC/
MC/MR
Price/
AR/AC/
MC/MR
Output
Answer to Activity 3.1

1
2
3
TR
Out put Price
1x2
1
2
3
4
5
6
7
8
to draw the
4
AR
3/1
Output
5
MR
3/ 1
6
TC
7
AC
6/1
8
MC
6/ 1
9
Profits
3-6
510
510
510
510
720.00
720
720
-210.00
470
940
470
430
800.50
400
81
139.50
430
1290
430
350
860.20
287
60
429.80
400
1600
400
310
885.70
221
26
714.30
370
1850
370
250
1010.20
202
125
839.80
340
2040
340
190
1200.00
200
190
840.00
310
2170
310
130
1400.00
200
200
770.00
290
2320
290
150
1585.00
198
185
735.00
72
9
10
260
2340
260
20
1678.50
187
94
661.50
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
73
My Short Notes
74
75
Chapter 05
Market Structures
4. Monopolistic Competitive Market Structure.
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
Number
firms
Perfect
Competition
Monopolistic
competition
Oligopoly
Monopoly
Few
One
of
Extremely Large
Many
Amount
Nature of the Homogeneous
Differentiated
product
(Branded)
Freedom
of No entry
No entry
entry
barriers
barriers
Homogeneous
or differentiated
Entry Barriers
Standardized
Entry barriers
75
Based on the above, the following are typical market structures as identified in economic
theory.
a)
b)
c)
d)
Perfectly competitive market structure

Monopoly market structure
Monopolistic competitive market structure
Oligopoly market structure
Perfect competition is said to be a perfect market situation where the rest is said to be under
imperfect market conditions.

2.1 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.
76
a) Short Run Profitability

Illustration 02 Short run Profitability of the Perfectly Competitive Market Structure
Market
Price
Firm
Market supply
curve
P1
Market
demand
curve
Output
Price/
AR/AC/
MC/MR
MC
AC
AR
AC
AR=MR=D
Supernormal
Profits
Output
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
Price
Firm
Market supply
curve
Price/
AR/AC/
MC/MR
MC
AC
P1
P2
AR=MR=D
AR= AC
Market
demand
curve
Output
Q
Normal Profits
Output
77
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.

3.1 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.
78
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
Price/
AR/AC/
MC/MR
MC
AC
AR
AC
MR
Supernormal
Profits
Q
AR=D
Out put
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.
79
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.
80
4. Monopolistic Competitive Market Structure

Perfect competition
Monopolistic
competition
Monopoly
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
Price/
AR/AC/
MC/MR
MC
AC
AR
AC
MR
Supernormal
Profits
Q
AR=D
Out put
81
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
Price/
AR/AC/
MC/MR
MC
AC
AR= AC
Normal
Profits
MR
Q
AR=D
Output
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)

This is a market structure where a few number of large scale firms operate in the industry.
5.1 Features of this Market
a)
b)
c)
d)
Only a few number of firms in the industry

They produce in large scale
Most of them use modern technology
One firm is aware of what the other is trying to do
82
e)
f)
g)
h)
Firms are interdependent on each other

Firms may either produce homogeneous or differentiated products
There are entry barriers to the market.
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
Price
B = Rs 750
12.00
A = Rs 900
9.00
8.00
C = Rs 880
60
100 110
Demand
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 firms 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.
83
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
Price/
MR/MC/
AR/AC
MC
AR
AC
AC
AR=D
MR
Supernormal
Profits
Demand
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.
84

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
Monopoly
Monopolistic
Oligopoly
Competitive
Market Structure Competitive
Market Structure
Market Structure
Market Structure
Product
Mix
Decisions
Pricing Related
Decisions
Promotional
Mix Design
Distribution
Strategy
People related
issues
Process related
issues
Physical
Evidence
related issues
85
My Short Notes
86
Chapter 06
Utility Theory and Household Equilibrium
1.
2.
3.
4.
5.
6.
Understanding Utility
Concepts of Utility
Household Preferences
Household Budget Line
Household Equilibrium
Household Equilibrium and Marketing Decision Making
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
87
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
0
1
2
3
4
5
6
7
8
9
10
Total utility
( in Utiles)
0
15
27
37
45
51
55
57
57
55
51
Marginal utility
(in Utiles)
15
12
10
8
6
4
2
0
-2
-4
(15-0)/(1-0)
(27-15)/(2-1)
(37-27)/(3-2)
(45-37)/(4-3)
(51-45)/(5-4)
(55-51)/(6-5)
(57-55)/(7-6)
(57-57)/(8-7)
(55-57)/(9-8)
(51-55)/(10-9)
Diminishing
Marginal
utility
Marginal Utility Curve
Total Utility
Marginal Utility
Total Utility Curve
Quantity
Quantity
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
88
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
Utility of
consuming
Y
300
Quadrant II
Quadrant III
- X 100
+ Y 100
A
200
Quadrant I
Quadrant IV
D
100
- Y 100
+ X 100
100
200
300
Utility of
consuming
X
Explanation of the points of the curve based on the different points of the graph;
Quadrant
Point
Original
I
III
II
A
D
G
K
200
100
300
100
200
100
300
300
IV
300
100
Explanation
A is preferred to D (Axiom 01)

G is preferred to A (Axiom 01)
- x = + y (Axiom 02)
Utility dropped in X of 100 = Utility gained in Y
of 100. The consumer is indifferent between A &
K
+ x = - y (Axiom 02)
Utility dropped in Y of 100 = Utility gained in X
of 100. The consumer is indifferent between A & J
89
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
300
Quadrant II
Quadrant III
A
200
Quadrant IV
Quadrant I
D
100
Indifference
Curve
100
200
300
Utility of
consuming
X
90
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

Utility of
consuming
Y
U4
U3
U2
U1
Properties of the Indifference Map;
Utility of
consuming X
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.
91
ii) Calculating the Marginal Rate of Substitution

Y
Marginal Rate of Substitution
X
Change in Y
-12
-5
-3
-2
Change in X
5
5
5
5
MRS
2.4
1
0.6
0.4
Illustration 05 Marginal Rate of Substitution Graphically
Y
Y
X X
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
households 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.
92
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
Py
Y
Px
X
=
=
=
=
=
Consumer income
Price of commodity y
Quantity of Y that could be purchased
Price of commodity x
Quantity of X that could be purchased
b) Graphical Illustration of the Household Budget Line

Illustration 06 Household Budget Line
Household Budget Line - those
combinations that are just
obtainable
Y
M/Py
A
Households not spending the
entire income
Unable to purchase given the

household income and prices
B
X
M/Px
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.
93
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
A
B
C
U3
D
U2
E
U1
Utility of
consuming
X
94
5.2 Household Equilibrium as a Formula.

Point
A
B
C
D
E
Marginal Rate of
Substitution (MRS)
MRS
MRS
MRS
MRS
MRS
Comment
Relationship Slope of the Budget
Line
>
Px/Py
>
Px/Py
=
Px/Py
<
Px/Py
<
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
U2
U1
Utility of
consuming
X
95
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
Utility of
consuming
Y
`
U2
U1
Utility of
consuming
X
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 learnings of the below
mentioned concepts;
96
Concept
Diminishing
Marginal
Utility Concept.
Implications to Marketing Activities
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
consumers
purchasing
power?
How could the marketer help
the household to reach its
highest equilibrium given the
budget constraints?
97
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
98
Foundation Level
for Marketing
Module Two
Macro Economics
Chapter 07
Inflation
This chapter will cover the following areas
1.
2.
3.
4.
Understanding Inflation
Causes of Inflation
Effects of Inflation
Inflation and Marketing Decision Making
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.
Chapter 07 - Inflation
101
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.
102
Example
Index
of
Building
Step 02
Basket of Goods
an
Step 03
Weight
Bread ( Loaves)
Milk ( Packets)
Rent ( Payments)
Fuel (Liters)
300
50
12
900
Step 01
Base Year
2003
Step 04
Step 05
Base
Base
Prices
Expenditure
15.00
4500.00
80.00
4000.00
5000.00
60,000.00
60.00
54,000.00
Step 06
122,500.00
Step 07
100
Current Year
2004
Step 08
Step 09
Current
Current year
Prices
Expenditure
18.00
5,400.00
100.00
8,000.00
5,500.00
66,000.00
70.00
63,000.00
Step 10
142,400.00
142,400
Step 11
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
Rent
Wages
Interest
Profit
Price
2000
10.00
10.00
10.00
10.00
40.00
2001 (Mild inflation)

10.00
10.00
10.00
12.00
42.00
Remarks
Ceteris Paribus other
factor costs
Increased profits
5% increase in prices
103
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 nations 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.
104
Illustration 01 Demand Pull Inflation
AS
Price
Level
P4
AD4
P3
P2
AD3
P1
AD2
AD1
Y1
Y2
YF
Aggregate Demand and Supply
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.
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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
Wages
Rent
Interest
Profit
Price
10.00
10.00
10.00
10.00
40.00
2001 Cost Push

Inflation)
13.00
12.00
11.00
14.00
50.00
Remarks
Wage Push
Supply Side Cost
Shocks.
Profit Push
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
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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
Wages
Rent
Interest
Profit
Price
10.00
10.00
10.00
10.00
40.00
2001 Cost Push

Inflation)
13.00
12.00
13.00
7.00
45.00
Remarks
Reduction in profits
would lead the supplier to
reduce supply
The following diagram explains this phenomenon.

Illustration 02 Cost Push Inflation
Price
Level
AS2
AS1
P2
P1
AD
Aggregate output
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.
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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, lets 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
Money Income
Pre Inflation
Situation
LKR 10,000
Post Inflation
Situation
LKR 15,000
LKR 3,000
LKR 10,000
LKR 12,000
LKR 10
1000 loaves of
bread
LKR 12
1000 loaves of bread
Tax
(Over
20%)
12,000,
Net Income
Loaf of Bread
Purchasing
Power
Remarks
Wages are increased to
increase money income
Paying taxes due to increased
money income
Inflation
No change in purchasing
power although money
income has increased.
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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
Price
Purchasing
Borrowing
Price of
Purchasing
2000
of
Power
amount
Bread
Power
Bread
in 2000
Rs
in 2000
Amount
10
1000
10,000
10
1000
pounds
pounds
Receiving Price Purchasing Re-payment
2001
amount
of
Power
amount
Rs
Bread
in 2001
Rs
Amount +
12,000
15
800
12,000
Interest 20%
pounds
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.
Lending
amount
Rs
10,000
However in 2001, even though with an interest payment of 20%, the

lenders 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.
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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 firms 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 lets say that a savings account yields 6% interest. That 6% is money earned.
But if inflation is 5%, the true earnings are only 1%.
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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
Export
Situation
Imports
Situation
Home Country
Pre Inflation Post Inflation
Situation
Situation
Rs 1000 or
Rs 1500 or
USD 20
USD 30
Local
Manufacture
price
Rs 1000
Local
Manufacture
price
Rs 2000
Other
Country
Prices
Export price
other countries
is USD 20.
Imported Price
USD 20 or
Rs 1000
Remarks
Due to inflation, the

home country prices
are higher than other
countries
Due to inflation,
importing this product
would be cheaper than
producing in own
country
Impact to
Export revenue will tend to reduce and imports expenditure will tend to
Balance of
increase affecting the balance of payment adversely.
Payment
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.
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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
New Product Development
Efforts
Implications of Inflation
Product Packaging Efforts
Branding Decisions
Pricing
Aspects
and
Costing
Promotional Mix Decisions
Physical
Distribution
Aspects and Working with
Intermediaries
People, Processes and

Physical
Evidence
Activities.
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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
Pricing Decisions
Promotional Decisions
Distribution Decisions
Offer second quality products (lower quality)
Offer discounts
Offer easy payment schemes, leasing, hire purchase
Carry out more consumer and trade promotions
Offer banded, value offers
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
113
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 familys 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
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Chapter 08
International Trade
1.
2.
3.
4.
5.
6.
7.
Introduction to International Trade

The Concept of Absolute Advantage
The Concept of Comparative Advantage
International Trade and Protectionism
Balance of Payments
Devaluation
Exchange Rates
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.
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Input - Using one resource unit

Output as follows
Country
Cars (units)
A
B
30
10
or
Wheat (bushels)
or
or
300
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)
A
B
30
10
or
or
or
Wheat (bushels)
300
250
Opportunity cost of producing each unit
Opportunity cost of producing

one unit of cars
10 bushels of wheat
Opportunity cost of producing one

bushel of wheat
1/10 of a car
25 bushels of wheat
1/25 of a car
Country
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.
116
If the opportunity costs are the same for both countries then there wont 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.
117
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 countrys government. Foreign
countries would impose protectionism measures to avoid such dumping by imposing antidumping 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 countrys 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
Visible Trade
(goods)
Capital account
Invisible Trade
(services)
Visible balance/
Balance of trade
Invisible
balance
Capital A/C
balance
118
5.1 Balance of Payment Statement

1. Current Account
1.1 Visible Account
Export of Goods
Less Import of goods
Visible Balance/Balance of Trade
1.2 Invisible Account
1.2.1 Services
Receipts
Payments
Net services
1.2.2 Property income(interest/profits/dividends)
Receipts
Payments
Net property Income
1.2.3 Net Transfers
Receipts
Payments
Net Transfers
Balance of the Invisible Account
Current Account Balance
2. Capital Account
Capital inflows
Capital outflows
Capital Account Balance
Balance of Payments
xxxx
(xxxx)
xxx/(xxx)
xxxx
(xxxx)
xxx/(xxx)
xxx/(xxx)
xxxx
(xxxx)
xxx/(xxx)
xxx/(xxx)
xxxx
(xxxx)
xxx/(xxx)
xxx/(xxx)
xxx/(xxx
xxxx
(xxxx)
xxx/(xxx)
xxx/(xxx)
xxx/(xxx)
xxx/(xxx
xxx/(xxx)
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.
119
Activity
Comment on Sri Lankas 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 Lankas Capital Account balance based on the latest Central Bank report
c) Sri Lankas Balance of Payment Situation

Activity
Comment on Sri Lankas 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 countrys 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
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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 worlds
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.
121
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
Marshalls 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.
Before 1USD = Rs. 50

After 1USD = Rs 75
Export Price in Rs
Rs 750
Rs 750
Export Price in USD

USD 15
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.
122
Let us look at the following two scenarios.

OVERSEAS ELASTIC DEMAND
Export
Export
Export
Price
Demand
Revenue
$15
1000
$15,000
$10
2000
$20,000
PED Coefficient = 3
OVERSEAS INELASTIC DEMAND

Export
Export
Export
Price
Demand
Revenue
$15
1000
$ 15,000
$10
1200
$ 12,000
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
Before 1USD = Rs. 50

After 1USD = Rs 75
Imported Price in USD

USD 10
USD 10
Imported Price in Rs
Rs 500
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
Imports
Imports
Imports
Price
Demand
Expenditure
500
10,000
Rs. 5,000,000
750
4,000
Rs 3,000,000
LOCAL INELASTIC DEMAND

Imports
Imports
Imports
Price
Demand
Expenditure
500
10,000
Rs. 5,000,000
750
9,000
Rs.6,750,000
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)
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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 CONDITIONs
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
Industrial sector (Mainly textiles and
garments)
Agriculture (tea, rubber, coconuts)
Mineral (gems
Others
% of Exports
77.5%
Type of Elasticity
Elastic Demand
20.5%
1.6%
0.4%
Inelastic Demand
Elastic Demand
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.
124
Import Goods Composition of Sri Lanka 2003

Category
Consumer goods (mainly food and drink, rice,
sugar, wheat)
Intermediate goods (Petroleum, fertilizer,
chemicals, textiles and clothing)
Investment Goods(machinery and equipment,
transport equipment and building materials)
Unclassified imports
% of Imports
22%
Type of Elasticity
Inelastic Demand
57%
Inelastic Demand
20%
Elastic Demand
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 countrys 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 countrys
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.
125
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 countrys currency is traded in exchange for
another countrys 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.
126
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
Exchange Rate
USD=RS
Supply of USD
From Exports
1US=75Rs
1US=50Rs
Increased demand
for USD
Increase in
Imports
Demand for USD
For Imports
USD Quantity
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.
127
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.
128
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
Marshalls 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
Exchange Rate
USD=RS
Supply of USD
From Exports
1US=75Rs
1US=50Rs
Increased demand
for USD Increase
in Imports
Demand for USD
For Imports
USD Quantity
Summary of the Process Explained Above
Corrects the
Balance of
Payment Deficit
Currency
Depreciates
BOP Deficit
Free Floating
Exchange Rate
Marshalls Learner
Condition
129
My Short Notes
130
Chapter 09
National Income Accounting
1.
2.
3.
4.
5.
Understanding National Income

The Circular Flow of Income
Calculating National Income
The Circular Flow and Economic Sectors
Per Capita Income
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.
131
Illustration 01 Circular Flow of Income

Factor Inputs
Land, Labour, Capital
and Entrepreneurship
(Real Flow)
Firms
C
D
Factor Payments
Rent, Wages
Interest and profit
(Money Flow)
Expenditure
on goods and B
B
services
(Money Flow)
Households
A
B
Goods
and
Services (Real
Flow)
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
132
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.
Process (10, 000
Input Value
Value Addition
Final Value/Transfer
units of bread)
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
Rs 170,000 ?
Rs 150,000 ?
Rs 320,000 ?
National out put
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.
133
iii) Sri Lankas National Out Put
Sri Lankas Situation ( In Rs Mn) ( 2001)

f* - Current
g* - Constant % contribution
factor costs
factor
costs
(1996)
Agricultural Sector
242,532
170,073
20.10%
Agriculture (Tea, Rubber, Coconut
193,891
131,121
, Paddy , Other )
Forestry
17,116
16,342
Fishing
31,525
22,610
Industry
Manufacturing
Mining and quarrying
Construction
Electricity , gas and water
332,616
Services
Transport , Storage and
Communication
Wholesale and Retail
Banking , Insurance and Real
Estate
Ownership of dwelling
Public administration/defence
Other services ( N.E.S)
a* - Gross Domestic Product at
factor costs
b*- Net property factor income
c* - Gross National Product at
factor costs
d* - ( Less) Depreciation
e* - Net National product
677,654
231,594
198,073
23,869
94,547
16,127
27.40%
143,153
15,019
61,292
12,130
442,944
52.50 %
154,587
105,927
274,805
105,552
177,086
68,076
22,190
69,409
51,111
15,228
41,857
34,770
1,252,801
844,611
-25,048
1,227,754
-15492
829,120
100%
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.
134
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 Lankas Situation
( In Rs Mn) 2001)
Consumption Expenditure
Private
Government
Gross Domestic Capital Formation (Investment)
Private Sector and Public Corporations
Government
1,185,482
1,043,937
141,545
308,473
266,449
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

Gross Domestic Expenditure at Factor Costs
+/- Net Property Factor Income
+ Statistical Discrepancy
Gross National Expenditure at Factor Costs
149,361
1,250,819
-25,048
1,983
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.
135
Wages (Income from employment and self employment)
Rent Income
Interest Income
Profits (Gross Trading Profits of Companies and
Sri Lanka does not

calculate NI based on
Income
XXXX
XXXX
XXXX
XXXX
Corporations)
Gross Domestic Income at Factor Costs
+/- Net Property Factor Income
Gross National Income at Factor Costs
( Less) Depreciation
Net National Income
XXXXXXXXXXXX
XXXX
XXXXXXXXXXXX
XXXX
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 Lankas 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
firms output is provided at market prices (including profits). A country with a very large
government sector may understate its national income
136
Valuation of unpaid services (housewives) and DoItYourself 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 countrys GDP and its relative
importance over the years
Its 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
Households + Firms
Three Sector Economy

Four Sector Economy
Households + Firms + Households + Firms +
Government
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.
137
Withdrawals
(W)
Two Sector
Three Sector
Four Sector Economy
Economy
Economy
Households + Households + Firms + Households + Firms +
Firms
Government
world.
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.
Injections
J
Two Sector
Three Sector Economy
Four Sector Economy
Economy
Households + Households + Firms + Households + Firms +
Firms
Government
world.
Investments ( I) Government
Exports ( X)
expenditure(G)
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.
138
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
Households
Firms
Injections
I
Withdrawals S
Equilibrium I=S
Three sector economy
Four sector economy
+ Households + Firms + Households + Firms +

Government
world.
I+G
I+G+X
S+T
S+T+M
I+G=S+T
I+G+X=S+T+M
Illustration 02 Circular Flow of Income with Injections, Withdrawals & Equilibrium
Injections
2 Sector
3 Sector
4 Sector
I+G
I+G+X
Firms
C
1000
Factor Payments Expenditure

Rent, Wages
on goods and
Interest and profit
services
(Money Flow) (Money Flow)
200
100
200
B
500
Bank
200
Government
100
Overseas
200
Households
Leakages
Equilibrium
S=T
S+T
S+T+M
S+T=I+G S+T+M=I+G+X
139
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 persons
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.
140
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 nations 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
% cumulative
income
Line of perfect
equality
75%
Lorenz
Curve for
Sri Lanka
50%
Lorenz
Curve for
Fuji
25%
25%
50%
75%
% of Population
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.
141
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
Sri Lanka
Fuji
Per Capita Income (USD)

820
800
Gini Index
34.4
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
142
Chapter 10
Consumption, Savings & Investment
1.
2.
3.
4.
5.
6.
7.
8.
Consumption
Savings
Relationship between Consumption and Savings.
Investment
The Concept of the Multiplier
The Concept of the Accelerator
Equilibrium National Income.
The Concept of Full Employment
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.
Chapter 10 Consumption, Savings & Investment
143
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, peoples 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.
APC
Total Consumer Expenditure
(C)
Total Income
(Y)
Example
Consumer Expenditure (Rs)
Consumer Income (Rs)
Average Propensity to Consume
800
1000
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.
144
MPC
Total Consumer Expenditure
( C)
Total Income
( Y)
Example
Marginal Propensity to Consume
Year 01
800
1000
Year 02
900
1200
Change
100 (900 - 800)
200 (1200 1000)
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.
145
a) Average Propensity to Save (APS)

This refers to savings as a proportion of total income during a particular time period.
APS
Total Savings
(S)
Total Income
(Y)
Example
Consumer Savings (Rs)
Average Propensity to Save
800
200
1000
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.
MPS
Total Savings
( S)
Total Income
( Y)
Example
Consumer Savings (Rs)
Marginal Propensity to Consume
Year 01
800
200
1000
Year 02
900
300
1200
Change
100 (300 - 200)
200 (1200 1000)
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
Second Observation.
APC + APS = 1
APC = 0.8, APS = 0.2, Therefore APC (0.8) + APS (0.2) = 1
146
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)
Increase in
National
Income
Factor
incomes to
households
increase
Increase in
income leads
to an increase
in savings
Increase in
savings
would
increase
investments
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
Expenditure
Increase
expenditure on
Gross Domestic
Capital Formation
Increase
spend
on
investment expenditure
would mean increase in
investments
in
the
country
147
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
I2
148
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
149
5.2 The relationship between the Multiplier and the Marginal Propensity to Consume.
Marginal Propensity
to Consume ( MPC)
0.2
0.4
0.6
0.8
Marginal Propensity
to Save ( MPS)
0.8
0.6
0.4
0.2
Multiplier Formula
( based on MPC)
1
1- MPC
Value of Multiplier
1.25
1.66
2.50
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
01
02
03
National
Income
Constant
10% increase
20% from Y2
Consumer
Demand
1000 pairs
1100 pairs
1320 pairs
Required Available
Machines Machines
10
10
11
10
13.2
11
Additional Investment
Machines
None
None
1
Yes
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
Increase
Increase in
in
purchasing
Purchasing power of people increases
national
power of
income
people
Increase
demand for
consumer
products
Increase demand for

capital
goods
to
manufacturer
consumer goods
Increase in
Investment
150
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.
Increase in
investments
Multiplier
Accelerator
National income
Induced investments
in capital goods
Multiplier
National income
Accelerator
Induced investments
in capital goods
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.
151
National
Income
Consumption
(household)
Savings
Investments
Y=C+S
0
C
300
S
-300
I
300
Planned Expenditure
( National
Expenditure)
E= C+I
600
400
600
-200
300
900
800
900
-100
300
1200
1200
1200
300
1500
1600
1500
100
300
1800
2000
1800
200
300
2100
2400
2100
300
300
2400
2800
2400
400
300
2700
3200
2700
500
300
3000
Point
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

Y = C+S
Planned expenditure
E=C+I
E<Y
Y=E
E=C+I
E>Y
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.
152
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)
Y = C+S
E=Y (4)
E=Y (3)
E=C+I +G + (X-M)
4 sector economy
E=C+I +G
3 sector economy
E=C+I
2 sector economy
E=Y (2)
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
2 sector
3 sector
4 sector
Y=C+S
Y=C+S
Y=C+S
Planned
expenditure
E=C+I
E=C+I+G
E=C+I+G+(X-M)
Equilibrium
condition
Y=E , S=I

Formulae
Y=C+I
Y=C+I+G
Y = C + I + G + ( X-M)
The above table will indicate how the National Income Equilibrium Formulae are derived for
the different sector economies
153
Practice Example
The following details are given for a hypothetical economy.
Investments
MPS
Exports
Imports
LKR. 3,500 million

LKR 1,250 million
0.2
LKR 1,600 million
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
154
Part b to d
Section
b
c
d
Change
item
Investment
+ 25%
Gvt exp
- 10%
MPS
+ to 0.3
Old
value
3500
New
value
4375
1250
1125
0.20
0.30
Calculation
Formula
C=4375/0.2*0.8
C= 17500
Y=17500+4375+1250
+(1600-1900)
Y=14000+3500+1125
+(1600-1900)
Y=8166.66+3500
+1250+(1600-1900)
C=3500/0.3*0.7
C= 8166.66
National
income
22,825.00
18,325.00
12,616.66
Part e
Calculating the Multiplier
Answer based on original figures (part a)
Multiplier =
1
MPS
1
0.2
= 5
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
Y=C+S
E=Y
(3)
Planned expenditure
Inflationary gap
E=Y
(2)
E=C+I +G
Deflationary gap
E=C+I
E=Y
(1)
E=C+I +G 1
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.
155
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
156
Chapter 11
Fiscal Policy and Monetary Policy
1. Fiscal Policy
2. Monetary Policy
1. Fiscal Policy
Fiscal policy refers to a governments 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
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
Y = C+S
E=C+I +G 1
E=Y
(2)
E=C+I +G 0
E=Y
(1)
Deflationary gap
Y
YF
National income
157
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.
Lets 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
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
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.
158
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
Expansionary
Fiscal Policy
<
Government Revenue
Reduction in government revenue
through reduction in taxes
Increase in government
expenditure
The following table will indicate an example to highlight the above.
Pre Expansionary
Fiscal Policy
Post Expansionary
Fiscal Policy
Government Income
( Taxation)
1000 Million
Government
Expenditure
1000 Million
Government Budget
500 Million
(Reduction in taxes)
1500 Million
(Increase in Gvt
Expenditure)
(1000 Million)
Budget Deficit
0 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.
159
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
Y
Planned expenditure
E=C+I+G
E=C+I +G 0
E=Y
(1)
E=Y
(2)
E=C+I +G 1
Deflationary gap
YF
National income
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.
160
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
Y
Planned expenditure
E=C+I+G
E=C+I +G 0
E=C+I +G 1
E=Y
(1)
E=Y
(2)
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
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
161
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
Contractionary
Fiscal Policy
= Government Revenue
>
Increase in government revenue

through increase in taxes
Decrease in government
expenditure
The following table will indicate an example to highlight the above.
Pre Expansionary
Fiscal Policy
Post Expansionary
Fiscal Policy
Government Income
( Taxation)
1000 Million
Government
Expenditure
1000 Million
Government Budget
1,500 Million
(Increase in taxes)
500 Million
(Decrease in Gvt
Expenditure)
1000 Million
Budget Surplus
0 Deficit
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.
162
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.
163
Illustration 08 Expansionary Monetary Policy at Work

Y
Planned expenditure
E=C+I+G
E=Y
(2)
E=C+I +G1
E=C+I +G0
E=Y
(1)
Deflationary gap
YF
National income
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.
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

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.
164
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
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
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
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
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.
165
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
Y
Planned expenditure
E=C+I+G
E=Y
(1)
E=C+I +G0
E=C+I1 +G1
E=Y
(2)
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.
166
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.
Central Bank
Securities
Commercial Banks & the Economy

Selling securities to banks/public
Reduce money supply from the
banking system
Money
Less money available in the banking

system for investments
Decrease investments
Decrease in aggregate demand
Contractionary effect on national income
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
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
167
c) Central Bank Increasing the Statutory Cash Reserve Ratio

Illustration 15 Contrationary Monetary Policy and Cash Reserve Ratio
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
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
Fiscal
Policy
Monetary
Policy
Tools
Expansionary
Effect
Contractionary
Effect
Increase
Decrease
Taxation
Decrease
Increase
Buy securities
Sell securities
Bank Lending Rate
Decrease
Increase
Cash Reserve Ration
Decrease
Increase
Open Market Operations
168
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
169
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 familys 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
170
for Marketing
Module Three
Legal Aspects
Foundation Level
Chapter 12
Introduction to the Law of Contract
1.
2.
3.
4.
5.
Definition
Formation
Invalidation
Discharge
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.
173
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 partys 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 offerors 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.
174
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 doctors 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 wifes 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.
175
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
176
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.
177
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).
178
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
Plaintiffs bid which had been properly submitted was not considered.
Held: that the Defendants were contractually bound to consider the Plaintiffs 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
179
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 Carlills case above.
d) Auction Sales
In an auction, the auctioneers 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.
180
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
181
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 plaintiffs 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 Bs communication is acted on by A, e.g. by delivery of
goods, a contract may come into being on Bs 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]
182
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 countrys law shall apply and which countrys
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 companys 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.
183
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 plaintiffs 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 Carlills 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.
184
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 nephews 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 nephews conduct that he mentally accepted
his uncles 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
186
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 subjectmatter 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
childs contracts, unless the child was acting as the parents agent; (ii) a minors 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 minors 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 minors 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 companys 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.
189
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 persons option.
Where, however, the other (sane) party is unaware of the others disability, the contract will
be judged by the same standards as if the contract were between tow persons of sound minds;
See Hart v OConnor. [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.
190
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 widows 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)
(ii)
There must be a concluded antecedent agreement upon which the written

document was based.
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.
191
(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.
192
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 others 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 defendants clerk, the plaintiff accepted by letter, believing that the
pounds 63 rental was the only payment under the contract. The defendant had intended that
193
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
194
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
Blenkarns 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 plaintiffs 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 customers 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, Kings 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
195
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
companys 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 plaintiffs 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.
196
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 defendants silence
in the face of this development was a misrepresentation.
197
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 vendors 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.
198
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 sons 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]
201
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 defendants 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 plaintiffs 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.
203
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.
204
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
205
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 fathers death, broke off the engagement during the fathers 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 defendants 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.
206
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 plaintiffs 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]
207
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.
208
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.
Activity Mini Case

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). Harrys 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.
209
Activity Mini Case

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 XYZs 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
210
Chapter 13
Sale of Goods
1.
2.
3.
4.
5.
Understanding the Elements, Formalities of Sale of Goods

The Terms of Contract of Sale of Goods
The General Rule on Transfer of Title
Duties of the Seller
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.
211
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.
212
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.
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 sellers 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.
213
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
buyers right to possession and enjoyment of the goods is in anyway disturbed as a
consequence of the sellers 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.
214
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.
215
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 Ts 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.
Activity Mini Case

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 sellers 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 buyers 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 Fs 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.
216
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 Gs 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.
Activity Mini Case
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 dont 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 partys 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 sellers 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: Bs 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.
Activity Mini Case

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.
Activity Mini Case

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)
(ii)
(iii)
(iv)
whether the property in the necklace had passed to Julian, and if so, at what
point of time;
whether Julian is bound in law to pay Modern Jewels the balance sum of
Rs. 45,000/-;
whether Julian can recover the necklace from Dave; and
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?
Activity Mini Case

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)
(ii)
(iii)
What implied conditions and warranties contained in Section 13 of the Sale

of Goods Ordinance have been breached by E in this transaction?
Can R succeed in an action for breach of the implied condition contained in
Section 14 of the Sale of Goods Ordinance?
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.
Buyers 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
buyers 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
224
Chapter 14
Law Related to Consumer Protection
1. Introduction
2. Regulations on Internal Trade
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
225
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]
226
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
227
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
228
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.
229

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 Commissions 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.
230
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 anticompetitive 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
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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.
2.
3.
4.
Introduction
Patent Rights
Marks and Trade Names
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].
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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 Ys 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.
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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 sublicenses. [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, reliefs, 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.
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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 nondescriptive 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 accusers mark forged the complainants 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, applicants 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 encyclopedias 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 authors 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
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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.
Activity Mini Case
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
Activity Mini Case
Examine the protection available to the undisclosed information under the provisions of
the Intellectual Property Act No.36 of 2003.
246
Chapter 16
Introduction to Other Legal Aspects relevant to
Marketing
1. Law of Agency
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 Agents 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
Chapter 16 Other Legal Aspects Relevant to Marketing
247
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 Companys
affairs.
248
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 partys position resulting from such
reliance.
Case
Lloyd v Grace Smith & Co. [1912] AC 716
249
A solicitors managing clerk dealt with a clients 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 owners 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
250
bought from a seller at above the price and did not disclose that he was acting on Ys
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 principals 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 principals 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
251
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 sons
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]
252
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.
Activity Mini Case
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

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
253
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 companys 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 Lees 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.
254
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.
255
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 companys 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 Companys 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
256
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]
257
Types of companies
a) a company limited by shares
In which case the liability of a member to contribute to he companys 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 peoples company. Further, members are not personally liable
for the companys 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 nonadjudicative 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.
258
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 arbitrators award.
259
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
260

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Foundation Level

Recommended Study Text

Economic & Legal Concepts for

M & N Solutions (Private) Limited

Copy Rights Reserved.

Chapter 02 Price Theory

Chapter 03 Theory of Elasticity

Chapter 04 Cost, Revenue and Profit Maximisation Rules

Chapter 05 Market Structures

Chapter 06 Utility Theory and Household Equilibrium

Chapter 08 International Trade

Chapter 09 National Income Accounting

Chapter 10 Consumption, Savings & Investment/National Income Equilibrium

Chapter 11 Fiscal Policy and Monetary Policy

Chapter 13 Sale of Goods

Chapter 14 Law Related to Consumer Protection

Chapter 15 Law Related to Intellectual Property

Chapter 16 Introduction to Other Legal Aspects Relevant to Marketing

2. What is Economics? A Few Definitions

3. Fundamental Concepts of Economics

4. Production Possibility Curve (PPC)

Chapter 02 Price Theory

4. Establishment of Market Price

6. Importance of the Price Theory for Marketing Decision Making

Chapter 03 Theory of Elasticity

4. Elasticity and Taxation

5. Elasticity and Marketing Decision Making

Chapter 04 Cost, Revenue and Profit Maximisation Rules

Chapter 05 Market Structures

2. Perfectly Competitive Market Structure

3. Monopoly Market Structure

4. Monopolistic Competitive Market Structure.

5. Oligopoly Market Structure

6. Marketing Implications of Market Structures

Chapter 06 Utility Theory and Household Equilibrium

4. Household Budget Line

6. Household Equilibrium and Marketing Decision Making

4. Inflation and Marketing Decision Making

2. The Concept of Absolute Advantage

3. The Concept of Comparative Advantage

4. International Trade and Protectionism

Chapter 09 National Income Accounting

2. The Circular Flow of Income

3. Calculating National Income

4. The Circular Flow and Economic Sectors

5. Per Capita Income

Chapter 10 - Consumption, Savings and Investment

3. Relationship between Consumption and Savings.

5. The Concept of the Multiplier

6. The Concept of the Accelerator

7. Equilibrium National Income

8. The Concept of Full Employment

Chapter 11 Fiscal Policy and Monetary Policy

Chapter 13 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

Chapter 14 Law Related to Consumer Protection

2. Regulations on Internal Trade

3. Establishment of a Consumer Affairs Authority

Chapter 15 Law Related to Intellectual Property

3. Marks and Trade Names

Chapter 16 Introduction to Other Legal Aspects Relevant to Marketing