The most basic (and practical) theory in economics is the simple supply and demand diagram, which was introduced in economic textbooks by Alfred Marshall at the end of the 19th century. Marshall put price on the vertical axis (or y-axis) and quantity on the horizontal axis (the x-axis). Since both consumers (demanders) and producers (suppliers) are assumed, in this model, to take price as given and choose quantities, this is a little bit upside-down since normally we have the exogenous (or independent) variable on the horizontal axis and the endogenous (or dependent) variable on the vertical axis. However, once a convention like this has been established it is impossible to change it, so we will also put the price on the “wrong” axis.
The quantity demanded given a certain price (and all other factors that influence demand) depends on consumers’ willingness to pay for the good in question. We can also say that it depends on how much they are willing to give up of other goods (expressed in money) for the assumed quantity. Except for the price of the good, consumers’ income, prices of other goods, perceived characteristics of the good, and in general tastes will influence demand for the good. We usually think in economics that consumers are sovereign, i.e., that they are able to exactly judge the quality and desirability of the good for themselves. However, many people are anxious not to stick out and follow fads and fashion, and look at what other people like (or what glitzy magazines tell them is “in”). This may be considered as “irrational” or at least “erratic” factors which shift demand from time to time. Producers also spend a lot of money on advertising to convince us that we “need” a certain good, and that we cannot live without it.
A demand function shows the association between quantities demanded, the price of the good (p), prices of other goods (ps, pc), and the consumers’ income (Y), and other factors (a):
Q = D (p, ps, pc, Y, a)
The prices ps and pc stands for the price of a substitute and complementary good, respectively. A substitute good is a good which is consumed instead of the good and a complementary good (or a complement) is a good which is consumed together with the good in question. We should also be aware that there may be not just one, but several substitute and complement goods, whose prices matter for the demand for our good.
The letter D in front of the parenthesis on the right-hand side of the equality sign stands for a general form of the demand function. However, the most common assumption to make is to assume that it is linear, for example:
QD = a + αo . p + αs . ps + αc . pc + αY . Y
The coefficients in front of the prices and income show the marginal effect on the quantity demanded as the variable increases by a small amount, or:
In each case we change only the variable in question and hold the other variables constant, as well as the intercept (a) which incorporates all other, left-out factors (or unobservable variables). Note that we expect in general that αo < 0, αs > 0, αc < 0 and αY ? 0, i.e., the “own-price effect” is negative, the effect of an increase in the price of a substitute good is positive, and the effect of the price of a complement is negative and the “income-effect” is positive or negative (but mostly positive in practice).
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