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# Chapter 8

**Review: Slutsky Equation
**

This chapter looks more closely at how a consumer’s choice of a good responds to a change in its price.

8.1

The substitution eﬀect

When the price of a good changes, there are two eﬀects: the rate at which you can exchange one good for another, and the total purchasing power of your income is altered. Say, the price of good 1 falls, then you can buy more of good 1 (because it is cheaper) and the purchasing power of your money goes up (you feel richer). The ﬁrst part - the change in demand due to the change in the rate of exchange between two goods - is called the substitution eﬀect. The second eﬀect - the change in demand due to having more (or less) purchasing power - is called the income eﬀect. 1

The “pivot” locates the change in demand where the slope of the budget line changes (because relative prices changes) while its purchasing power remains the same. REVIEW: SLUTSKY EQUATION The “pivot-shift” operator gives us a convenient way to decompose change in demand into two pieces. That is. p2 .2 CHAPTER 8. with the pivot. p2 . this will be the amount of income associated with the pivoted budget line. x2 ) is aﬀordable at both (p1 . So how much must we adjust money in order to keep the old bundle just aﬀordable? Let m be the amount of money income that will make the old bundle just aﬀordable. m) and (p1 . Since (x1 . the consumer’s purchasing power remains unchanged and the new budget line passes through the original bundle so that it is just aﬀordable. m ). we have m = p1 x1 + p2 x2 m = p1 x1 + p2 x2 Subtracting the second equation from the ﬁrst gives m − m = x1 [p1 − p1 ] .

xs . Note that the change in price and income always move in the same direction. More precisely. It indicates how the consumer “substitutes” one good for another when a price changes while keeping purchasing power constant. x2 ) is aﬀordable. is the hange in the demand for good 1 when prices 1 change from p to p and.8. at the same time. Although the original (x1 .1) This answers how much money should change if prices change to keep the same bundle just aﬀordable. which is is known as the substitution eﬀect. the substitution eﬀect. it is generally not the optimal purchasing point. money income is adjusted to m which keeps the old bundle just aﬀordable: . THE SUBSTITUTION EFFECT which we can more compactly write as m = x1 p1 3 (8. Rather the consumer would move from X to Y (on the diagram above).1.

so that xn ≥ 0. . the price goes down.2 The income eﬀect We know that a parallel shift of the budget line is the movement that occurs when income changes while relative prices remain constant. then we must have x1 (p1 . the income eﬀect. We simply change income from m to m. is the change in demand for 1 good 1 when the income changes from m to m. For example. is the change in demand due to the price change. m) 1 8. if p1 > p1 . keeping prices at (p1 . 8. m). xn .: xn = x1 (p1 . The second stage of he price adjustment is called the income eﬀect. 1 8.4 CHAPTER 8. holding the price of good 1 ﬁxed at p1 . m ) 1 Note that the income eﬀect can be positive or negative. In the ﬁgure above his change is shown as a movement from Y to Z. it always moves in the opposite direction to the price change. m) − x1 (p1 . depending on whether we are talking about a normal or an inferior good. REVIEW: SLUTSKY EQUATION xs = x1 (p1 . m ) − x1 (p1 . More precisely. p2 ).3 Sign of the substitution eﬀect The substitution eﬀect is always negative. Symbolically. x1 .4 The total change in demand The total change in demand. m ) ≥ x1 (p1 . m) We can break this into two changes: the substitution eﬀect and income eﬀect. holding income constant: x1 = x1 (p1 . m) − x1 (p1 .

If a good is a normal good.Also note for a normal good. it might happen that the income eﬀect outweighs the substitution eﬀect. then x1 = xs + 1 xn 1 (−) (−) (−) On the other hand. so that when say price increases. The signs are as follows x1 = xs + 1 xn 1 (+) (?) (−) The Slutsky equation tells us that such perverse eﬀect can only happen with an inferior good. demand could might as well increase. THE TOTAL CHANGE IN DEMAND 5 x1 = xs + 1 xn 1 x1 (p1 . say price of good 1 rises. m) = [x1 (p1 . m )] This equation is the Slutsky identity. m) − x1 (p1 . . then the income and substitution eﬀects move in the same direction reinforcing each other such that demand moves in the “correct” direction to the price change.8. m) − x1 (p1 .4. m)] + [x1 (p1 . m ) − x1 (p1 . if we have an inferior good. This is case of the Giﬀen good (see Figure 8-3 below).

To express it in terms of rates of change it is convenient to deﬁne xm as the negative of 1 the income eﬀect: xm = x1 (p1 .5 The Slutsky in terms of rates of change The Slutsky equation above is stated in absolute terms.2) . REVIEW: SLUTSKY EQUATION 8. the Slutsky identity becomes x1 = and dividing each side by xs − 1 xm 1 p1 . m ) − x1 (p1 .6 CHAPTER 8. m) = − xn 1 1 Given this deﬁnition. we get x1 = p1 xs 1 − p1 xm 1 p1 (8.

THE LAW OF DEMAND 7 The ﬁrst term on the right-hand side is simply the rate of the substitution eﬀect . 8.6. .8.6 The law of demand If the demand for a good increases when income increases. Let’s take a closer look at the second term.7 Hicks substitution eﬀect The Hicks substitution eﬀect keep utility constant rather than keeping purchasing power constant. First recall Hence solving for p1 gives m = x1 p1 .the rate of change of demand when price changes and income is adjusted so as to keep the old bundle aﬀordable.2) gives the Slutsky equation in terms of rates of change: x1 = p1 xs 1 − p1 xm 1 x1 m 8. p1 = m x1 Substituting this into the last term of (8. then the demand for that good must decrease when its price increases.

8 CHAPTER 8. REVIEW: SLUTSKY EQUATION .