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.


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.


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