Demand function is a mathematical equation that links the demand for goods and their determinants. Besides its own-price, several factors affect demand, including buyer’s income, taste, and preferences, price of substitutes, price of complements, interest rate, and availability of credit.
Assume we have three determinants of a product, namely its own price, buyer’s income, and the price of the related product. For example, we get the following function:
QDA = a – bPA + cI – dPb
Where:
- QDA = quantity demanded of product A
- PA = price of product A
- I = buyer’s income
- Pb = price of product B
- a = constant
- b,c,d = variable coefficient
From the equation above, we can draw some following conclusions.
A negative sign on the price coefficient of product X indicates it inversely related to the quantity demanded. When the price goes up, the quantity demanded goes down and vice versa, when the price goes down, the quantity demanded goes up. In this case, the price coefficient (b) represents the magnitude of the price effect on the quantity demanded of product X.
The coefficient of the buyer’s income is positive, indicating that demand is increasing as the income of the buyer rises. In other words, product X is a normal good.
Furthermore, product Z is a related product. A negative sign indicates the two are inversely related. An increase in the price of product Z will reduce demand for product X. Conversely, a decrease in the price of product Z will increase the demand for product X.
A negative sign indicates that the two items are complementary, as in the case of a car and gasoline. When car prices go down, people buy cars so that demand for gasoline rises. The reverse effect applies when car prices rise.
If the related product price sign is positive, it indicates the two goods are substitutes. Examples are Coca-Cola and Pepsi. When the price of Coca-Cola rises, consumers will switch to consuming Pepsi, and hence, its demand increases.
