Understanding the Differences Between Compensated and Normal Demand Curves
One of the fundamental concepts in microeconomics is the demand curve, which illustrating how the quantity demanded of a good changes with its price. However, there are two key types of demand curves: the normal demand curve and the compensated demand curve.
Normal Demand Curve
The normal demand curve, often referred to as the Marshallian demand curve, is a well-known economic concept. It shows the relationship between price and quantity demanded, encompassing both the substitution effect and the income effect (Choi, 2012). Here, changes in price influence quantity demanded due to two factors:
Substitution effect: When the price of a good increases, consumers tend to buy less of that good and more of a substitute good. Income effect: When the price of a good increases, it effectively reduces the consumer's purchasing power, leading to a reduction in the quantity demanded of the good.The slope of the normal demand curve captures the combined effect of these two factors.
Compensated Demand Curve
The compensated demand curve or the Hicksian demand curve, on the other hand, isolates the substitution effect by adjusting consumers' income to maintain utility (Hicks, 1939). This curve shows how demand changes with price when a consumer's purchasing power is kept the same. This adjustment ensures that any change in demand due to price changes is purely based on the substitution effect (Choi, 2012).
Derivation of the Compensated Demand Curve
The concept of the compensated demand curve is rooted in the work of John Hicks, who sought to re-establish the consumers' surplus (CS) (Hicks, 1939). CS is a measure of the net benefit derived from a public project. When a project benefits some and hurts others, Hicks used the principle of compensation to balance the gains and losses. This involves shifting the gainers' budget line back to the original indifference curve, effectively compensating the losers and still leaving the gainers better off (Hicks, 1939).
The Role in Economic Analysis
The compensated demand curve offers a more refined view of consumer behavior by eliminating the income effect. This allows economists to study the pure substitution effect, which can provide deeper insights into the preferences of consumers.
Comparing Normal and Compensated Demand Curves
While the normal demand curve integrates both substitution and income effects, the compensated demand curve only captures the substitution effect. This distinction is crucial because the income effect can distort the understanding of how consumers actually respond to price changes (Choi, 2012).
Conclusion
Understanding the differences between normal and compensated demand curves is essential for economists and students of microeconomics. The normal demand curve provides a comprehensive view of consumer behavior, while the compensated demand curve isolates the substitution effect, offering a clearer perspective on how consumers respond to price changes. Both curves play vital roles in economic analysis and policy-making.