Compensated demand curve
- A compensated demand curve ignores the income effect of a price change.
- It only measures the substitution effect.
- A compensated demand curve is therefore less elastic than an ordinary demand curve.
An ordinary demand curve shows the effect of price on quantity demanded. A change in price causes a substitution effect, but also an income effect.
- Substitution effect – if the price of a good goes up, other goods become relatively cheaper.
- Income effect – an increase in price means your cost of living goes up, so if you buy the good a lot – effectively it reduces your disposable income so you can’t afford to buy as much.
Therefore demand falls. Firstly because the good is more expensive and secondly because income is lower.