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Derivation of Compensated and Un Compensated Demand Curve

This document discusses the derivation of compensated and uncompensated demand curves. It explains that an uncompensated demand curve shows the effect of a price change when real income changes, while a compensated demand curve shows the effect when money income changes to keep real income constant. It then provides diagrams and equations to derive the demand curves for normal goods, inferior goods, and Giffen goods. For normal goods, the compensated demand curve is less elastic than the uncompensated curve. For inferior goods, the substitution effect outweighs the income effect. For Giffen goods, the income effect is stronger, making the demand curve upward sloping.

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Anita Panthi
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1K views

Derivation of Compensated and Un Compensated Demand Curve

This document discusses the derivation of compensated and uncompensated demand curves. It explains that an uncompensated demand curve shows the effect of a price change when real income changes, while a compensated demand curve shows the effect when money income changes to keep real income constant. It then provides diagrams and equations to derive the demand curves for normal goods, inferior goods, and Giffen goods. For normal goods, the compensated demand curve is less elastic than the uncompensated curve. For inferior goods, the substitution effect outweighs the income effect. For Giffen goods, the income effect is stronger, making the demand curve upward sloping.

Uploaded by

Anita Panthi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Derivation of compensated and uncompensated demand curve

Derivation of demand curve with money income constant and real


income change (ordinary demand or un compensated demand curve)
and money income changed and real income kept constant
( compensated demand curve)

For normal goods:

In figure, consumer is initially in equilibrium at point E1 on IC1 at AB


budget line. At this point, he consumes OX1 of x commodity. As price of
x falls, budget line shifts to AB1 and he reaches new equilibrium at
point E2, where IC2 is tangent to budget line AB1. Here quantity
demanded increases to OX3. Thus derived demand curve DD in lower
fig. is ordinary demand curve (uncompensated).

To find out substitution effect, drawing CD line parallel to AB1, which is


tangent to IC1 at point E3. We see that if real income too is kept
constant, then quantity demanded for x goes only till OX2. The derived
demand curve DlDl is the compensated demand curve.

In figure, X1X3(movement from E1 to E2) is price effect.

X2X3(movement from E2 to E3) is income effect.

X1X2(movement from E1 to E3) is substitution effect.

Here, in the case of normal goods demand curve is downward


slopping. There is inverse relationship between price and demand and
direct relationship between income and demand. Compensated
demand curve is less elastic.

Mathematically,

Marshallian demand function


Max. U = x y-----------(objective function)
Sub. to M = px.x + py.y---------( constraint function)
Using Lagriangian function
Ø = x.y + £(M – px.x –py.y)---------(composit function)
F.O.C. For utility maximization, ∂Ø/∂x = 0, ∂Ø/∂y = 0 and
∂Ø/∂£ = 0
∂Ø/∂x = y - £px = 0-----(1)
∂Ø/∂y = x - £py = 0------(2)
∂Ø/∂£ = M – px.x –py.y = 0------(3)
Taking equ. (1) and (2)
Y = £px----(4)
X = £py ------(5)
Px/py = y/x dividing (4) by (5)
Y = px.x/py , x = py.y/px
Putting in constraint function
M = px + py(px.x/py)
M = 2px.x
Or, x = M/ 2px and y = M/2py, which is uncompensated
demand function.( Marshallian demand function)
Hickian demand function (utility function is constraint function)
Ø = px.x + py.y + £(U – xy)
FOC. ∂Ø/∂x = px - £y = 0 -----(1)
∂Ø/∂y = py - £x = 0-------(2)
∂Ø/∂£ = U – x y = 0 ------(3)
Px = £y
Py = £x
Px/py = x/y
Y = px.x/py, x = py.y/ px
Putting in constraint function
U = x( px.x/ py)
U = px.x2/py
Or, x2 = Upy/ px
X =√ Upy/ px
Y= √ Upx/ py
This is compensated demand function( Hickian demand curve)
For inferior goods:

In the case of inferior goods, income and substitution effect of a price


change work in opposite direction and the substitution effect outweigh
the income effect so that there is net increase in the quantity
demanded of inferior goods when its price falls. It means law of
demand applied to an inferior as to normal goods. It is shown by the
following diagram.
Upper fig. shows initial equilibrium at point E1, where IC1 is tangent to
AB budget line. Here consumer byes OX1 of x commodity. As price of x
falls, budget line shifts to AB1. Thus he can reach new equilibrium at E2.
To find out substitution effect we have to draw CD budget line, which is
tangent to IC1. He is in equilibrium point E3 and he buys OX3 of x
commodity. In lower fig. deriving the demand curve DD is ordinary or
uncompensated demand curve and DlDl is compensated demand curve.

The movement from E1 to E2 is price effect(X1X2)


The movement from E2 to E3 is income effect(X2X3)

The movement from E1 to E3 is substitution effect(X1X3)

We conclude that as income increases quantity demanded decreases,


which shows commodity x is inferior, but as price decreases quantity
demanded increases. Thus demand curve is downward slopping like as
normal goods.

For Giffen goods:

Giffen goods are those goods whose demand is positively related with
price. It means when price falls, demand also falls and vice versa. This
paradox is known as Giffen paradox. It is very strong exceptions to the
law of demand. In the case of Giffen goods income and substitution
effect works in the same direction and income effect is more powerful
than the substitution effect. It can be shown by the following diagram.
Upper fig. shows initial equilibrium is E1 and demand for x is OX2. Now
suppose price of x falls, so that the consumer moves to point E2 on IC2.
As a result of this movement quantity demanded of x decreases to OX1.

Now we separate the income and substitution effect of price effect. To


eliminate the income effect by drawing imaginary budget line CD
parallel to AB1 and tangent to initial IC1 at point E3. Due to this
demand increases to OX3. Here X2X3 is substitution effect. The income
effect(X1X3) is greater than substitution effect(X2X3). The net result is
that the quantity demanded of x falls as its price falls. In lower fig. when
price of x falls, he buys less of x commodity, as his purchasing power
increases, and DD ordinary demand curve is upward sloping which
shows x commodity is Giffen. However by compensating the consumer,
he increases the demand for x, thus the compensated demand curve
DlDl is still downward sloping.

The movement from E1 to E2 is price effect(X2X1)

The movement from E2 to E3 is income effect(X1X3)

The movement from E1 to E3 is substitution effect(X2X3)

All Giffen goods are inferior goods but not all inferior goods are Giffen
goods.

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