Net Elasticity of Demand: A Thought Beyond ceteris paribus

The price or income elasticity of demand measures the responsiveness of demand to a change in price or income respectively. These elasticities are calculated keeping the effects of other variables constant (ceteris paribus) or we can say that both these elasticities are calculated separately. But in real world examples, we see that a change in demand is response to not only a change in price but also to a change in several other factors such as income, price of substitutes, change in fashion, taste etc. To be precise, the two major factors that have combined effect on demand for any commodity is its price and the income of the consumer. If the demand for a commodity is declining then it could be due to a change in its price as well as a change in income of consumers. Hence, measuring the effect of change in income along with change in price is equally important. The concept of Net Elasticity is an attempt to measure the effect on demand for a commodity with respect to a change in price and income simultaneously. Price of a commodity and its demand are inversely related, i.e., an increase in price leads to a decrease in demand and vice-versa whereas income of consumer and demand for a commodity have a direct relation, i.e., the more is the income; more would be the demand for goods (in case of normal goods) and vice-versa. Thus, calculating net elasticity is like measuring the net effect of change in price and income on demand for a commodity. 3D modeling of Net Elasticity of demand To illustrate the net elasticity of demand graphically, a 3D model is developed that explains the combined effects of both the variables where quantity demanded is on X-axis, price in on the Z-axis, and the income is on the Y-axis [Figure 1]. For such a depiction, a conical structure, with an ellipse as its base can be designed for the operation of the model. Taking two market scenarios as:

FIGURE 1 a) Initial market scenario where D1 = initial quantity demanded, I1 = initial income level and P1 = initial price level and

b) Modified market scenario where D2 = modified quantity demanded, I2 = modified income level and P2 = modified price level In the above figure, any change in the price or income simultaneously leads to a change in demand in the form of expansion or contraction of the circle at the bottom of the conical structure. This expansion or contraction in the circle would depend on the net effect of price and income. If the price elasticity dominates the income elasticity, i.e., if the demand is more price sensitive, than the circle in the figure would expand, else it would lead to a contraction. In mathematical terms, the percentage change in price of any commodity can be described as the sum of x% effect of change in price and (100 x) % effect of change in income. It can be represented as: % Change in demand Net Elasticity = ----------------------------------------------------------------------------------------% Change in price * x + % Change in income * (100 - x)

In the above equation, the introduction of x is an important concept which can be denoted as the definition factor. The combined or the net effect of price and income changes is measured by the denominator of the above equation.

FIGURE 2 The salient feature of the model is that it doesnt explain the price or income elasticity as high, low, zero or unitary. It uses the combination of the price and income. Hence it shows whether the market is price-sensitive or incomesensitive. And this phenomenon can be shown by the denominator of the equation. The range of the definition factor shows the sensitivity of the market towards income or price [Figure 2]. When it is zero the market is income sensitive and the net elasticity equals the income elasticity. If the definition factor increases, the net elasticity increases and at certain point market is said to be highly income sensitive. Beyond that point the market is said to be price sensitive. The price sensitivity reduces with further increase the definition factor. When it reaches 100%, the net elasticity equals the price elasticity of the market. There are two conditions: 1. The market is said to be price sensitive, when factor of percentage change in price is higher than the factor of percentage change in income. The net elasticity will be negative at this condition [from point B in Figure 2]. The market is said to be income sensitive, when factor of percentage change in income is higher than the factor of percentage change in price.

2.

The net elasticity will be positive at this condition [till point A in Figure 2].

If the price elasticity is taken in absolute term, then with the increase in the definition factor, net elasticity gradually approaches towards the absolute price elasticity. Initially it begins from the absolute income elasticity, and then it gradually moves towards the price elasticity [Table 1]. So it can be inferred that the value of net elasticity can be calculated from the absolute figures of the price / income changes. To check the direction of the market sensitivity, the respective signs of the price / income changes can be used. Thus, net elasticity gives us a better measure of combined effect of change in price and income on demand for a commodity. The only limitation of the model is that it fails to incorporate the effects of other important factors that affect the demand for a commodity such as price of substitutes, taste of consumer, change in fashion, etc. However, since price and income are the two most important factors in determining demand for a commodity, the model is able to capture the net effect to a reasonable extent.