Estimating Demand Curves: Estimating Linear and Power Demand Curves
Demand curve estimation refers to the exercise of estimating the demand curve, typically the market demand curve (as opposed to the individual demand curve) for a good. Demand curve estimation is typically done for the following purposes:
- It may be done by sellers (and in some cases buyers) with significant market power, so that they can decide the appropriate price to set. Note that buyers or sellers who do not have market power simply set the price as the market price and know that whatever quantity they produce will get sold. In contrast, in the extreme case of a monopoly, the seller chooses both the price and quantity but is not guaranteed to sell everything. In order to be so guaranteed, the seller needs to have a plot of the market demand curve so that the (price, quantity) pair can be chosen as a point on the demand curve.
- It may be done by buyers or sellers in order to better estimate prices and quantities to buy or sell for the future. Note that this is advantageous even in a perfectly competitive market: with knowledge of the future demand and supply curves, sellers can estimate future prices, and therefore optimize their long-run choices (i.e., make appropriate fixed cost investments).
Linear Demand Curve
Understanding linear demand curves is critical to learning the basics of how a market works and running a successful business. Being able to use a demand is almost like telling the future, because it predicts consumer behavior. However, in the real world, most curves are nonlinear, so you constantly need to analyze demand for your products.
Identification of Linear Demand Curve
A linear demand curve is the graphical representation of the relationship between the price of a good and the quantity of that good consumers are willing to pay at a certain price at a point in time. The slope, or rate that the line rises or falls, is equal to the difference between two quantities of a product — usually represented on the horizontal axis on the graph — divided by the difference price of two points of the graph — usually on the vertical axis.
Features of Linear Demand Curve
Linear curves rarely exist in the real world because demand depends in large part on elasticity of demand, or how consumers react to a change in price. Also, the relationship between demand and price is not always constant. Some products are in demand regardless of price. For instance, customers probably use about the same amount of electricity regardless of price because it is essential to living. On the other hand, televisions are a luxury, so consumers usually become exponentially more willing to buy a unit as the price drops.
Tip for Linear Demand Curve
Look at data from your past sales to graph a demand curve. You may want to hire a market research firm to help you set the price on your goods or calculate production level if you do not have sales data. You may also need to use your own estimation skills and to factor in the economic environment. For instance, Christmas decorations and new toys usually spike in price right before the holidays but fall during the beginning of the year because demand plummets. In the world of supply and demand, price increases as demand increases, and vice versa.