Using Pricing Subjectively to Estimate Demand Curves

Suppose due to changes in income, population and other factors, the theoretical demand curve shifts from D₁ to D₂, D₂ to D₃ to D₄ in Figure 1. The corresponding supply curve at each of these points occupies positions S₁ to S₄. The price-quantity obser­vation which is recorded in period 1 (say, 1981) is given by the intersection of D₁ to S₁, namely, A. The next one is determined by the intersection of D₂ and S₂ at B (in 1982).

Thus we get a series of observa­tions A to D for four years, viz., 1981, 1982,1983 and 1984. These together trace out a demand curve DD. But this is not the same demand curve discussed in theory. More specifically, it is not reversible. It is improbable that we can move back from C to B and B to A.

It is unlikely that the precise combination of conditions which prevailed at these points will be repeated. In practice, the demand and supply curves may not move consistently in the same direc­tion, as is assumed in this diagram. They may move up or down rather erratically.

In Figure 11.1, points A, B and C are not three points on a single demand curve for, say, product X. Each point is on a different demand curve — one that is shifting over a period of time. So just by con­necting them we cannot trace out the product de­mand curve.

A firm may interpret the line dd (which is a Iocus of points A, B, C and D) as the demand curve by mistake. Thus it might assume that a reduction in price from P₁ to P₂ increases sales from Q₁ to Q₂. An expansion of demand may well justify the price re­duction.

But, in practice, such a price cut will result in a much smaller increase in demand. The true de­mand curve (D₁) is much less elastic than the line dd. Thus, a price cut is much less desirable than it appeared at the first sight.

Simultaneous Relationship

So there is interrelationship between demand and supply curves.

Now, data on prices and quanti­ties purchased can be used to estimate a demand curve only under two sets of conditions:

(1) The de­mand curve has not shifted, but the supply curve has shifted; or

(2) We have almost complete infor­mation to determine just how each curve has shift­ed during the observation period (which covers four years in this case).

Suppose there is a technological change in the production of X. So costs in the industry will fall sharply within a short period but demand condi­tions are likely to be stable. The situation is illus­trated in Figure 2. Here the demand curve, which initially was unknown, in now assumed to be stable. The supply curve shifts from S₁ to S₂, S₂ to S₃ and S₃ to S₄.

It is clear that each price/quantity point represents the intersection of the supply and demand curves. Since all the demand determinants except price are assumed to be stable, points A, B, C and D must be on the same demand curve. So the de­mand curve DD can be estimated by connecting the four points.