QUESTION 2 :

DERIVATION OF THE SLUTSKY EQUATION FOR A CHANGE IN THE CONSUMPTION

OF COMMODITY X2 AS A RESULT OF A CHANGE IN THE PRICE OF COMMODITY X1.

with budget constraint ,

Suppose a consumers utility function is U ( X 1 , X 2 , X 3 ) I = P1 X 1 + P2 X 2 + P3 X 3

then he can maximize his utility as shown below.

L = u ( x1 , x 2 , x3 ) + λ ( I − p1x1 − p 2x 2 − p 3x 3)
∂L ∂u
= − λ p1 = 0
∂x1 dx1
u1 − λ p1 = 0 .....................(1)
∂L ∂u
= − λ p2 = 0
dx2 dx2
u2 − λ p2 = 0 ...................(2)
∂L ∂u
= − λ p3 = 0
∂x3 ∂x3
u3 − λ p3 = 0 .....................(3)
∂L
= I − p1 x1 − p 2 x 2 − p3 x3 = 0
∂λ
I − p1 x1 − p2 x2 − p3 x3 = 0 ...............(4)

Where is the Lagrange function and is the Lagrange multiplier which represents the marginal
L λ
utility of money and >0. Taking the total differentials of (1),(2),(3), and (4), we have;
λ

u11dx1 + u12 dx2 + u13 dx3 − λ dp1 − p1 d λ = 0

u21dx2 + u22 dx2 + u23 dx3 − λ dp2 − p2 d λ = 0
u31dx3 + u32 dx2 + u33 dx3 − λ dp3 − p3 d λ = 0
− p1dx1 − p2 dx2 − p3 dx3 − x1 dp1 − x2 dp2 − x3 dp3 + dI = 0
In matrix form, we have;

 u11 u12 u13 − p1   dx1   λ dp1  λ 0 0 0   dp1 

       
 u21 u22 u 23 − p 2   dx2   λ dp 2  = 0 λ 0 0   dp2 
=
 u31 u32 u 33 − p 3   dx3   λ dp3  0 0 λ 0   dp3 
        
 − p1 − p2 − p3 0   d λ   x1dp1 + x2dp 2 + x3dp 3 − dI   x1 x2 x3 − 1  dI 

let

u11 u12 u13

∆ = u21 u22 u23
u31 u32 u33
Now, the total change in x2 as a result of a change in p1 , we have

u11 λ u13 − p1
u21 0 u23 − p2
u31 0 u3 3 − p3
∂x2 − p1 x1 − p3 0
=
∂p ∆

u21 u23 − p2 u11 u13 − p1

u31 u33 − p3 u21 u23 − p2
∂x2 − p1 − p3 0 u31 u33 − p3
=λ + x1
∂p1 ∆ ∆

u21 u 23 − p2 u 11 u 13 − p1
let ∆12 = u31 u 33 − p3 and ∆ 42 = u 21 u 23 − p2
− p1 − p3 0 u 31 u 33 − p3

therefore,

∂x2 ∆ ∆
= λ 12 + x1 42
∂p1 ∆ ∆
Now, we consider a change in x2 with respect to a change in income,

u11 0 u13 − p1
u21 0 u23 − p2
u31 0 u33 − p3
∂x2 − p1 − 1 − p3 0
=
∂I ∆

u11 u13 − p1
u21 u23 − p2
∂x2 u31 u33 − p3
=
∂I ∆

∂x2 ∆
= − 42 ................(5)
∂I ∆

Also, we try to investig1ate the effect of a change in p1 holding p2, p3 and I (income) constant.
We then have;

3
∴ ∑ pi dxi = 0
i =1
3
The budget line is also given as I= ∑ pi xi
1=1
3 3
dI = ∑ pi dxi + ∑ xi dpi
i =1 i =1

but
3

∑ p dx
i =1
i i =0
3
∴ dI = ∑ xi dpi
i =1

with p2 and p3 constant, then dpi = 0, i = 2, 3

∴ dI = x1 p1
u = u ( x1 , x2 , x3 )
du = u1dx1 + u 2 dx2 + u3dx3 = 0
3
∴ ∑ ui dxi = 0
i =1

but, from (1)

u i = λ pi
3
so, λ ∑ pi dxi = 0
i =1

but λ ≠ 0, (since the marginal utility of money is positive).

Hence;

 u11 u12 u13 − p1  dx1   λ   dp1 

  
 u21 u22 u23 − p2  dx2   0   0 
=
 u31 u32 u33 − p3  dx3   0   0 
     
 − p1 − p2 − p3 0  d λ   0  0 

u11 λ u13 − p1
u21 0 u 23 − p 2
u31 0 u33 − p3
∂x2 − p1 0 − p3 0
− =
∂p1 u ∆

but
u22 u23 − p2
∆12 = λ u 32 u 33 − p3
− p2 − p3 0

∂x2 ∆12
∴ − =λ .......................... (6)
∂p1 u ∆
 ,
Now, from (5) and (6), we have that

∂x2 ∂x2 ∂x 2
= − − x1
∂p1 ∂p1 u ∂I

of a
This represents the Slutsky equation of a change in the quantity of commodity x2 as a result

change in the price of commodity X.