7/13/11

What is the difference between endogenous and exogenous variables, considering the determinates of demand.




One of the things to do when analyzing a supply and demand graph is to shift the demand curve.  When we consider what factors will shift a demand curve, we need to make a distinction between the endogenous factors (those contained in the model) and exogenous factors (those outside of the model).  The easiest way to tell the difference between endogenous and exogenous factors is to look at the graph.  You can see from the graph to the right that both quantity and price are on the axis, which means they are controlled for within the model, or they are endogenous.  Every other factor that is not controlled for would therefore be exogenous, (determined outside of the model and held constant).  

If the exogenous factors change, such as income or preferences, then we would need to shift the demand curve.  In this example, demand shifted right, so we would need to see a rise in income (assuming a normal good/not an inferior good), or a change in preferences towards more positive feelings.

Let’s look at another example using math. 
Consider the following demand function, which shows quantity demanded as a function of exogenous variables and price.

Q=a-bP

Where Q is quantity, a is the intercept, b is the slope coefficient for P price.  So when we consider the endogenous factors in this model we only have one variable on the right hand side which has its own coefficient, which is price.  Quantity is on the left hand side so it is considered the dependent variable (but also endogenous).  The exogenous are all considered within the a variable, which gives us the intercept.  Let’s consider another example:

Q=a+bI.

Here everything is the same except for the I variable which represents income.  Because income is on the right hand side with a coefficient (which determines the slope) it is now the endogenous variable in this model.  Now the price variable is exogenous and is considered in the a variable which determines the intercept.  Here is what the graph would look like below for a normal good (as income goes up, quantity demand goes up).

 
So this post went over an easy way to remember the difference between exogenous and endogenous variables.  If you have access to the graph, or equations, look at the variables controlled for on the axis, or controlled for on the right hand side with a slope coefficient.


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2 comments:

Anonymous said...

What is explain in the text and video on endogenous does not match.
Q = a + bP
Text say both are endogenous but in the video he mention that only Q is endogenous.
So which is true?

freeeconhelp said...

haha, it depends how you look at it I suppose. If all you are given is Q = a +bP then Q is endogenous because P is determined outside of the system.

The trick here is to determine which variable is determined OUTSIDE of the system (thus exogenous). If you have P = Q/b - a/b then Q is now endogenous because it is determined outside of the equation.

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