Question

Suppose the demand for good x is ln Qxd =21−0.8 ln Px −1.6 ln Py +6.2 ln M+0.4 ln Ax.Then what can we say about goods x and y in terms of whether they are substitutes or complements?

Answer 1

Substitute goods are those goods which can be used in place of each other. For example, tea and coffee.

Complementary goods are those goods which are consumed together. For example, toothpaste and toothbrush.

Since the quantity demanded of x is inversely related with price of y, x and y are complements. The negative coefficeint of Py = - 1.6 implies that as price of y increases, the quantity demanded of x falls. This can be explained as follows: as price of y increases, the quantity demanded of y decreases because of law of diminishing marginal utility. The quantity demanded of x will also fall with fall in quantity demanded of y if and only if x and y are complements, that is, they are consumed together.