ICFAI UNIVERSITY DEHRADUN

Name: GOPAL KRISHAN IUD No: 0901202792 IBS No: 09BS0002792 Course Code: SLEC501 Course Name: Managerial Economics Faculty Name: Dr. Anirvinna Date: 21st August 2009 Topic of the Assignment: Hicks model is theoretically and empirically better than Slutsky model

Hicksian model is adjusted so that the consumer is able to be on the same indifference curve at the new set of prices whereas the Slutsky model is derived when the income adjusted is such that the consumer is able to buy the old bundle at the new set of prices. the increase in quantity consumption of the good X will be purely because of the substitution effect. Theory: When a consumer is consuming OXq of the good X at the indifference curve Uo with the income line KL. Thus this gives us the pure substitution effect which is Xq Xr. Thus price effect (XqXs) = Income effect (XrXs) + Substitution effect (Xq Xr). Fig: 1. Thus. With the fall in price of the good X. Prove that Hicks handling of substitution and income effect is theoretically and empirically sounder than that of Slutsky. Because the real income rises for the consumer with fall in price. This total effect is the price effect. Thus with fall in prices we increase the consumption of X from OXq to OXs. his equilibrium is at the point Q. i. the income reduced is when given back to the consumer he can consume more of both the goods X and Y because his income has increased. This gives us the income effect.Income and Substitution Effect by Hicks and Slutsky Q. This was done because with fall in prices of X the real income of the consumer increases and he shifts to the upper indifference curve with a new income line.1 (Hicks Income and Substitution Effect) Now. Because the consumer will take back the resources from good Y and use it to consume X because it is cheaper. the new equilibrium falls at point S where the quantity consumed of good X is Xs. When the income effect has been taken away. Hicks: (Fig 1. Hicks and Slutsky divided this complete price effect into two parts. the income effect and the substitution effect. the quantity of X that can be consumed increases and thus we get a new income line KL¶ which is tangent to a higher indifference curve U1 resulting in more satisfaction to the consumer because higher the indifference curve more will be the satisfaction. because of that income effect the quantity increase in consumption of X is XrXs.e.1) In order to find out the income effect and the substitution effect. . Hicks reduced the income of the consumer to take back the income effect and thus brought the income line downwards parallel to the line KL¶ which was tangent to the same indifference curve at point R. Thus quantity consumed of X further increases by XrXs.

Therefore. income and substitution Fig: 1. he actually passed the point E1 and brought it lower than it at point E2. i. Thus the income line that was made by him passed through the point E1. Comparative study of Hicks and Slutsky: (Fig: 1.e. Now with this there is increase in the quantity consumption of good X which has increased from OS to OS1. This was not appropriate because the income should be at the level where it previously was and thus the new income line should at least pass through E1 to make sure that income is still at the same level where it previously was.2) To break the price effect into two parts. But rather than bringing the consumer on the previous indifference curve. S1N is purely because of income effect.3.Slutsky: (Fig 1. the income effect and the substitution effect. effect. So rather than bringing the consumer on the same indifference curve IC1. Slutsky also used the same method what Hicks used but he was more concerned about the amount of income to be reduced in order to get the exact substitution effect. the quantity consumed of X further increases and reaches the level of ON. Slutsky also divided the total price effect into two parts. This is purely because of substitution effect. when the income line is again raised to YX¶.3 Comparative Studies So. He argued that money income has to be reduced equal to the cost difference to get a fair picture of the income and substitution effect.2 (Slutsky Income and Substitution effect) Now. As we can see in the Fig: 1. Fig: 1. while bringing the income line below. where he was consuming the goods previously. to ensure the fair reduction in income. he brought him to another indifference curve which is above the previous indifference curve. . Slutsky tried to bring the income down equal to the cost difference.3) Now the question is what was the need to make two different approaches towards the derivation of income and substitution effect? It was because of the reason the income reduction by Hicks was not appropriate. he brought the income line down to MN which passes through the previous equilibrium E and this income line is tangent to the new indifference curve IC2 at point Q. Thus.

e. Thus we see that we have to use Slutsky theorem rather the Hicksian model because Slutsky model gives us a fair picture. MN is the line made by Slutsky and M¶N¶ is the line made by Hicks. the sales tax is implemented on the good X. enjoys his satisfaction at the point E¶ with income line of YX¶. Let us take the example of the indirect tax first that is. the income effect of Hicks is S2S3 whereas that of Slutsky is S1S3. Let¶s say that people have income level of YX and on that they are consuming OS level of X goods at the equilibrium E. the consumer initially when there is no tax. Also. The consumer will shift to a lower indifference curve because his income line will Fig: 2. So the consumer will consume OR of good X. the cash benefit is better than the subsidy because increase in income creates opportunities in the market. i.In the Fig: 1. If govt.2) Government imposes direct and indirect taxes to increase its revenue. is based on the Slutsky model of income and substitution effect. Hicks¶ substitution effect is equal to SS2 whereas substitution effect of that of Slutsky is SS1 which is more appropriate because income reduced is fairer. A consumer can buy goods that he is willing to buy with increase in the income as we can see that with increase in income due to cash benefit the consumer starts more consumption of both Y and X which is good for the market.3. But the OR level of goods can also be used at the previous level of income at point G consuming RG of Y. gives subsidies on food people will be able to purchase more of that food item and thus moving the income level to YY¶ which is tangent to another indifference curve higher than the previous one giving the consumer more satisfaction. Direct versus Indirect Tax: (Fig: 2. Government offers many kinds of subsidies to poor people. In practical application Slutsky proves to be better. In Fig: 2. At this level a consumer can consume more of both goods Y and X. if govt. Here one thing to be noticed is that we have to pass the new line from the equilibrium E¶ because it has to have the same level of income for both the cases. Thus the new equilibrium is at Ex. about whether to increase sales tax or to implement income tax. This can further be proved by one more example. gives cash to the people equal to GE¶ their income level will increase from OY to OZ and thus income line will be ZJ. Empirically proving Slutsky better than Hicks approach (Fig: 2. Now the decision made by the govt. Similarly. direct or indirect tax.1 Cash versus Kind Subsidy .1) is Now rather than giving them subsidy.2. Thus we can say that GE¶ is the subsidy provided by the govt.

n the above example. Thus govt.   . will lie on the same indifference curve making it difficult to decide for govt. Thus the consumer moves to equilibrium Q where he consumes lesser units of both X and Y. generates an income of ZE. Slutsky model gives us a better picture as compared to Hicksian model.2 Direct and Indirect Taxes Instead of implementing sales tax if govt. should go for the direct tax that is the income tax. will lie on the same indifference curve whereas in Slutsky model they will lie on different indifference curves that is point E and point Q giving us a fair picture and allowing us to make a good decision. if the Hicksian model is used. But in case of indirect tax he will be in the worse condition. Because the consumer in case of direct tax will be on a higher indifference curve he will have better satisfaction level. And he will be consuming less of X commodity.also shift to YX. it will be a problem because then both the equilibrium in different cases of direct and indirect tax or the cash and kind subsidy. Thus govt. if Hicksian model is used the equilibriums in both the cases. Now to decide which one of the two options is better? The answer is same as was in the case of cash and kind subsidy. Fig: 2. Here. which plan to go for. whether it be the direct tax or indirect tax. implements direct tax equal to ZE on the income the income of the consumer will decrease and the income line will shift to MN. But this line will pass through the point of equilibrium E because the income level has to be the same as it would have been if there is equal sales tax. Here the income generated by the govt. is equal to EZ because the consumer is now able to purchase only SE units of the good Y rather ZE.

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