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.
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.