Compensated Demand

The compensated demand function shows market demand while stripping out income effects. Typically, the quantity of a good demanded depends on its own price, the prices of other goods, and income levels. Unlike what you’d observe on the demand curve, here a price increase doesn’t automatically mean a drop in quantity demanded, since price changes can trigger income effects.

For instance, a hike in rent can significantly reduce a household’s real income, leading to shifts in market demand.

Demand is driven by two main effects:

• Substitution Effect. This is the impact on the quantity demanded of a good that results directly from price changes.
• Income Effect. This is how changes in income, resulting from price shifts, affect the quantity demanded.

To eliminate the income effect and focus only on the substitution effect, we use the compensated demand curve. On this curve, the consumer is compensated for price hikes with just enough extra income to buy the original bundle of goods, and vice versa.