Answer to Question #231139 in Economics of Enterprise for Ridzz

Question

A firm’s demand function for good Z is estimated as follows:

Qz = 4500- 1/8 Pz + 1/5 Pa – 1/9 Pb + 2Y

Where:

Pz is the price of good z,

Pa is the price of good a,

Pb is the price of good b, and

Y is income.

(i) Justify whether the law of demand is valid here.

[5 marks]

(ii) According to theories, explain the two main reasons why the law of demand is always valid?

[5 marks]

(iii) Is good Z a normal good?

[5 marks]

(iv) Explain whether goods a and b are related to good z.

Answer 1

Solution:

i.). The law of demand is valid in this demand equation since it shows an inverse relationship between the price of good z with its quantity demanded. That is, the quantity demanded varies inversely with the price. Therefore, at higher prices consumers will demand a lower quantity of good z, thus the law of demand.

 

ii.). The two main reasons why the law of demand is always valid are as follows:

·        Law of diminishing marginal utility – This states that as we consume more units of a good, the utility derived from each successive unit goes on diminishing. Therefore, the demand for a good depends on its utility. If the consumers get more satisfaction from a particular good, they will pay more.

·        Substitution and Income effect – A consumer will always substitute one product in place of another when it becomes relatively cheaper. If one product becomes expensive, a consumer will purchase a substitute product whose price is cheaper. On the other hand, the income effect refers to the effect on demand when the real income of the consumer changes due to a change in the price of that particular product.

 

iii.). Good z is a normal good since it has a direct positive relationship with a consumer’s income and has a positive income elasticity of demand. That is, the demand for normal goods increases with an increase in the consumer’s income and vice versa.

 

iv.). Yes, good a and good b are related to good z.

Good a has a positive coefficient which suggests that an increase in the price of good a will lead to an increase in the quantity demanded for good z, hence the two goods are substitutes.

On the other hand, good b has a negative coefficient which suggests that an increase in the price of good b will lead to a decrease in the quantity demanded for good z, hence these two goods are complements.