A 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.
Compensated demand curve
- A compensated demand curve ignores the income effect of a price change.
- It only measures the substitute effect.
- A compensated demand curve is therefore less elastic than an ordinary demand curve.