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Hiksian & Marshallian
Hiksian & Marshallian
often separate the impact of a price change into two components: the substitution effect; and the income effect.
Ea I1 xa
X1
*
Ea
I1 xa
X1
X1
X1
Ea
I2
X1
Ea
X1
Ea Ec
Eb I1
I2
Xa
Substitution Effect
Xc
X1
Ea
Xc
X1
Income Effect
Xb
Ea Ec xa xc
Eb I1 xb
I2
X1
AC
P P1 P1*
B
! p1 x1 p2 x2 1
A C B
Hicksian (compensated) demand curves cannot be upward-sloping (i.e. substitution effect cannot be positive)
Slutsky (1880-1948) Russian economist expelled from the University of Kiev for participating in student revolts. In his 1915 paper, On the theory of the Budget of the Consumer he introduced Slutsky Decomposition.
Ea I1 xa
X1
*
Ea I1 xa
X1
X1
claimed that if, at the new prices, less income is needed to buy the original bundle then real income has increased more income is needed to buy the original bundle then real income has decreased Slutsky isolated the change in demand due only to the change in relative prices by asking What is the change in demand when the consumers income is adjusted so that, at the new prices, s/he can just afford to buy the original bundle?
isolate the substitution effect we adjust the consumers money income so that s/he change can just afford the original consumption bundle. In other words we are holding purchasing power constant.
X1
X1
X1
X1
Substitution Effect
xc xb Income Effect
X1
Ea Ec xa
Eb I3
I2
xc xb
X1
both the substitution and income effects increase demand when own-price falls, a normal goods ordinary demand curve slopes downwards. The Law of Downward-Sloping Demand therefore always applies to normal goods.
M 1 ! p1 x 1 p 2 x 2
p1
x1 p2 x2
represent the budget constraint after the Slutsky compensating variation in income has been carried out.
x1 ! x p1, p2 , M
M1 ! p1 x1 p2 x2
Ea xa
M2 !
p1 x1 p2 x2
X1
(M ! M 2 M1 ! (M ! M 2 M1 ! (M ! M 2 M1 ! (M ! M 2 M1 ! (M ! x1(p1 as
p1 x1
p2 x2 - p1 x1 p2 x2
p1 x1 p1 x1
p2 x2 - p1 x1 p2 x2
- p1 x1
1
x1 p1 1
-p
p - p
! (p
1
gives the change in money income needed to consume the original bundle of goods (at EA)
(M=x1(p1
(1)
which is the change in demand for x1 due to the change in its own price, holding M and the price of x2 constant
(2)
(x s ! x
p1 ,
p2 , M 2 x
p1 , p2 , M 1
(3)
(x m
(x s
Claim
! x p , p , M
x p , p , M
! x p , p , M
x p , p , M
d
1
1
1
(x1 ! (x s (x m
(4)
Show this by substituting equations (1), (2) and (3) into equation (4)
(M ! x1(p1
(p1 ! () (M x1
(p1 ! ()(
x1
Eb Ea Ec xa xb xc xa to xc I3
I2
X1
xc to xb
GIFFEN GOODS
rare cases of extreme inferiority, the income effect may be larger in size than the substitution effect, causing quantity demanded to rise as own price falls. Such goods are Giffen goods. Giffen goods are very inferior goods.
In
X1
decomposition of the effect of a price change into a pure substitution effect and an income effect thus explains why the Law of Downward-Sloping Demand is violated for very inferior goods.
No substitution effect
New Budget Constraint
B
Original Budget Constraint
A=C
X1