3

Income and Substitution

Effects
 Topics
• Demand functions and homogeneity.
• Changes in income. Normal and inferior
goods.
• Changes in a good’s price. Ordinary goods
and Giffen goods. Income and substitution
effects.
• Individual’s demand curve. Marshallian and
Hicksian (compensated) demand curves.
Roy’s identity. Shephard’s lemma. Slutsky
equation and decomposition of price effect.
 Reading
 [В, гл 8],
 [ЧФ, гл 2-3; гл 7, 7.3-7.4],
 [К, гл 4, 4.5],
 [ДР, гл 1, 1.5]
Demand Functions and Homogeneity

Marshallian demand functions are

homogeneous of degree zero in prices and
income. That is, for any positive constant t,

𝑑1 𝑡𝑝1 , 𝑡𝑝2 , 𝑡𝑚 = 𝑡 0 𝑑1 𝑝1 , 𝑝2 , 𝑚 = 𝑑1 (𝑝1 , 𝑝2 , 𝑚)

𝑑2 𝑡𝑝1 , 𝑡𝑝2 , 𝑡𝑚 = 𝑡 0 𝑑2 𝑝1 , 𝑝2 , 𝑚 = 𝑑2 (𝑝1 , 𝑝2 , 𝑚)
 Demand Functions
• Prices and income are exogenous
– the individual has no control over these
parameters
• The reason (Marshallian) demands are
homogeneous of degree zero is that
consumption opportunities do not
change if prices and income change by
the same proportion.
 Numeraire Price
• Result of homogeneous of degree zero demand
functions
– can divide all prices and income by one of the prices
• Demand for a commodity depends on
– price ratios (called relative prices)
– ratio of money income to a price (called real income)
• Picking any price, say p1, and multiplying demand
function by 1/p1 gives
– 𝑥1 𝑝1 , 𝑝2 , 𝑚 = 𝑥1 1, 𝑝2 /𝑝1 , 𝑚/𝑝1
– where 𝑡 is 1/𝑝1
• setting 𝑝1 = 1
– which is relative price to which all other prices and income are
compared
» called numeraire price
 Economic Goods

Ordinary goods
Normal goods
Luxuries

Necessities

Inferior goods Giffen goods

Changes in Income
• An increase in income will cause the
budget constraint out in a parallel fashion
• Since 𝑝1/𝑝2 does not change, the MRS will
stay constant as the consumer moves to
higher levels of satisfaction
 Income Changes

• How does the value of 𝑥1∗ (𝑝1 , 𝑝2 , 𝑚) change

as 𝑚 changes, holding both 𝑝1 and 𝑝2
constant?
 Income Changes
Fixed 𝑝1 and 𝑝2
𝑥2

𝑥1
 Income Changes
Fixed 𝑝1 and 𝑝2
𝑥2
𝑚′ < 𝑚′′ < 𝑚′′′

𝑥1
 Income Changes
Fixed 𝑝1 and 𝑝2
𝑥2
𝑚′ < 𝑚′′ < 𝑚′′′

𝑥2′′′
𝑥2′′
𝑥2′

𝑥1′ 𝑥1′′ 𝑥1′′′ 𝑥1

 Income Changes
Fixed 𝑝1 and 𝑝2
𝑥2
𝑚′ < 𝑚′′ < 𝑚′′′

Income оffer curve (income-

consumption curve)
𝑥2′′′
𝑥2′′
𝑥2′

𝑥1′ 𝑥1′′ 𝑥1′′′ 𝑥1

 Income Changes

• A plot of quantity demanded against

income is called an Engel curve.
Income Changes 𝑚
Engel
curve;
Fixed 𝑝1 and 𝑝2 𝑚′′′ good 2
𝑥2 ′′
′ ′′ ′′′ 𝑚
𝑚 <𝑚 <𝑚
𝑚′

Income оffer curve 𝑥2′ 𝑥2′′ 𝑥2′′′ 𝑥2∗

𝑚

𝑥2′′′ 𝑚′′′ Engel

𝑥2′′ curve;
𝑚′′ good 1
𝑥2′
𝑚′

𝑥1′ 𝑥1′′ 𝑥1′′′ 𝑥1 𝑥1′ 𝑥1′′ 𝑥1′′′ 𝑥1∗

 Income Changes and Cobb-Douglas
Preferences

• An example of computing the equations of

Engel curves; the Cobb-Douglas case
𝛼 𝛽
𝑢 𝑥1 , 𝑥2 = 𝑥1 𝑥2
• The ordinary demand equations are
∗
𝛼 𝑚 ∗
𝛽 𝑚
𝑥1 = ; 𝑥2 =
𝛼 + 𝛽 𝑝1 𝛼 + 𝛽 𝑝2
Income Changes and Cobb-Douglas
Preferences
𝛼 𝑚 𝛽 𝑚
𝑥1∗ = ; 𝑥2∗ =
𝛼 + 𝛽 𝑝1 𝛼 + 𝛽 𝑝2

Rearranged to isolate m, these are:

𝛼+𝛽
𝑚= 𝑝1 𝑥1∗ Engel curve for good 1
𝛼

𝛼+𝛽
𝑚= 𝑝2 𝑥2∗ Engel curve for good 2
𝛽
Income Changes and Cobb-Douglas
Preferences
𝑚
𝛼+𝛽
𝑚= 𝑝1 𝑥1∗ Engel curve
𝛼
for good 1

𝑥1∗
𝑚
𝛼+𝛽 Engel curve
𝑚= 𝑝2 𝑥2∗
𝛽 for good 2

𝑥2∗
 Income Changes and Perfectly
Complementary Preferences
𝑢 𝑥1 , 𝑥2 = min{𝑥1 , 𝑥2 }
• The ordinary demand equations are
∗ ∗
𝑚
𝑥1 = 𝑥2 =
𝑝1 + 𝑝2

𝑚 = (𝑝1 +𝑝2 )𝑥1∗ Engel curve for good 1

𝑚 = (𝑝1 +𝑝2 )𝑥2∗ Engel curve for good 2
 Income Changes and Perfectly
Substitutable Preferences
𝑢 𝑥1 , 𝑥2 = 𝑥1 + 𝑥2
• The ordinary demand equations are
𝑚 𝑚
, if 𝑝1 < 𝑝2 , if 𝑝1 > 𝑝2
𝑥1∗ = 𝑝1 𝑥2∗ = 𝑝2
0, if 𝑝1 > 𝑝2 0, if 𝑝1 < 𝑝2
 Income Changes and Perfectly
Substitutable Preferences

• Suppose 𝑝1 < 𝑝2 .
∗ 𝑚 ∗
• Then 𝑥1 = , 𝑥2 = 0
𝑝1
∗ ∗
• 𝑚= 𝑝1 𝑥1 and 𝑥2 =0
Income Changes and Perfectly Substitutable
Preferences

𝑚 𝑚

𝑚 = 𝑝1 𝑥1∗ 𝑥2∗ = 0

𝑥1∗ 0 𝑥2∗

Engel curve Engel curve

for good 1 for good 2
 Income Changes
• In every example so far the Engel curves
have all been straight lines.
• But, Engel curves are straight lines if the
consumer’s preferences are homothetic.
• Quasilinear preferences are not homothetic.
• For example,
𝑢 𝑥1 , 𝑥2 = 𝑥1 + 𝑥2
 Quasi-linear Preferences

𝑥2
Each curve is a vertically shifted copy of
the others.
Each curve intersects
both axes.

𝑥1
Income Changes and Quasi-linear Preferences
𝑥2

𝑥1 𝑥1
 Income Changes and Quasi-
linear Preferences 𝑚 Engel
𝑥2 curve
for
good 2

𝑥2∗
𝑚 Engel
curve
for
good 1

𝑥1 𝑥1∗
𝑥1 𝑥1
 Income Effects
• A good for which quantity demanded rises
with income is called normal.
• Therefore a normal good’s Engel curve is
positively sloped.
• A good for which quantity demanded falls
as income increases is called income
inferior.
• Therefore an income inferior good’s Engel
curve is negatively sloped.
 Income Changes; Engel
𝑚
Goods 1 & 2 are Normal curve;
good 2
𝑚′′′
𝑥2
𝑚′′
𝑚′
Income
offer curve 𝑥2′ 𝑥2′′ 𝑥2′′′ 𝑥2∗
𝑚

𝑥2′′′ 𝑚′′′ Engel

𝑥2′′ curve;
𝑚′′
𝑥2′ good 1
𝑚′

𝑥1′ 𝑥1′′ 𝑥1′′′ 𝑥1 𝑥1′ 𝑥1′′ 𝑥1′′′ 𝑥1∗

 Income Changes; Good 2 is Normal, Good 1
Becomes Income Inferior
𝑚

𝑥2 Engel curve
for good 2

𝑥2∗
𝑚

Engel curve
for good 1

𝑥1 𝑥1∗
 Income Effects for Normal and Inferior
Goods
𝑥2

𝑥2 Good 1 is Normal/
Inferior or Quasilinear

Good 1 is Normal

𝑥2 𝑥1

Good 1 is Inferior

𝑥1

𝑥1
 Changes in a Good’s Price

• How does 𝑥1∗ (𝑝1 , 𝑝2 , 𝑚) change as 𝑝1

changes, holding 𝑝2 and 𝑚 constant?
• Suppose only 𝑝1 increases, from 𝑝1′ to 𝑝1′′
and then to 𝑝1′′′ :𝑝1′ < 𝑝1′′ < 𝑝1′′′
Changes in a Good’s Price 𝑝1 Ordinary
demand curve
Fixed p2 and m 𝑝1′′′ for commodity 1
𝑥2

𝑝1′′
Price offer
curve or price- ′
consumption 𝑝1
curve

𝑥1∗ (𝑝1′′′ ) 𝑥1∗ (𝑝1′ ) 𝑥1∗

𝑥1∗ (𝑝1′′ )

𝑥1∗ (𝑝1′′′ ) 𝑥1∗ (𝑝1′ ) 𝑥1

𝑥1∗ (𝑝1′′ )
 Changes in a Good’s Price

• What does a p1 price-offer curve look like

for Cobb-Douglas preferences?
• Take
𝛼 𝛽
𝑢 𝑥1 , 𝑥2 = 𝑥1 𝑥2

Then the ordinary demand functions for

commodities 1 and 2 are
 Changes in a Good’s Price
𝛼 𝑚
𝑥1∗𝑝1 , 𝑝2 , 𝑚 =
𝛼 + 𝛽 𝑝1
and 𝛽 𝑚
∗
𝑥2 𝑝1 , 𝑝2 , 𝑚 =
𝛼 + 𝛽 𝑝2

Notice that 𝑥2∗ does not vary with p1 so the

p1 price offer curve is flat and the ordinary
demand curve for commodity 1 is a
rectangular hyperbola.
 Changes in a Good’s Price 𝑝1 Ordinary
demand curve
Fixed p2 and m 𝑝1′′′ for commodity 1 is
𝑥2 𝛼 𝑚
𝑥1∗ =
𝛼 + 𝛽 𝑝1
𝑝1′′

𝑝1′

𝛽 𝑚
𝑥2∗ =
𝛼 + 𝛽 𝑝2 𝑥1∗ (𝑝1′′′ ) 𝑥1∗ (𝑝1′′ ) 𝑥1∗ (𝑝1′ ) 𝑥1∗

𝛼 𝑚 𝑥1
𝑥1∗ =
𝛼 + 𝛽 𝑝1
Changes in a Good’s Price 𝑝1 Ordinary
demand curve
Fixed p2 and m 𝑝1′′′ for commodity 1 is
𝑥2 ∗
𝑚
𝑥1 =
𝑝1 + 𝑝2
𝑝1′′
𝑚/𝑝2

𝑝1′

𝑚
𝑥2∗ = 𝑥1∗
𝑝1 + 𝑝2 m
p2

perfect-complements
utility function
𝑥1
∗
𝑚 𝑢 𝑥1 , 𝑥2 = min{𝑥1 , 𝑥2 }
𝑥1 =
𝑝1 + 𝑝2
 𝑝1 Ordinary
Changes in a Good’s Price
demand curve
Fixed p2 and m 𝑝1′′′ for commodity 1 is
x2 ∗
𝑚
𝑥1 =
𝑝1
𝑝2 = 𝑝1′′
p1 price
offer 𝑝1′
𝑚/𝑝2
curve

 𝑥1∗
0 ≤ 𝑥1∗ ≤ 𝑚/𝑝2

perfect-substitutes
utility function
x1 𝑢 𝑥1 , 𝑥2 = 𝑥1 + 𝑥2
 Inverse Demand Curves
• Demand functions depicted in figures above are
sometimes called inverse demand functions
– Dependent variable is on vertical axis and independent
variable is on horizontal axis
• Price as dependent variable states what level of
quantity demanded for a commodity would have
to be for household to be willing to pay this price
per unit
• Inverse demand functions represent price as a
function of quantity demanded
– As opposed to quantity demanded as a function of price
 Changes in a Good’s Price
• A change in the price of a good alters the
slope of the budget constraint
– it also changes the MRS at the consumer’s
utility-maximizing choices
• When the price changes, two effects come
into play
– substitution effect
– income effect
 Changes in a Good’s Price
• Even if the individual remained on the same
indifference curve when the price changes,
his optimal choice will change because the
MRS must equal the new price ratio
– the substitution effect
• The price change alters the individual’s “real”
income and therefore he must move to a new
indifference curve
– the income effect
 Effects of a Price Change
• What happens when a commodity’s
price decreases?
– Substitution effect:
• the commodity is relatively cheaper, so
consumers substitute it for now relatively
more expensive other commodities
• consumer tends to buy more of the good that
has become cheaper and less of those goods
that are now relatively more expensive.
 Effects of a Price Change
• What happens when a commodity’s price
decreases?
– Income effect:
• the reduction in the price of good allows the
consumer to increase his level of satisfaction—
his purchasing power has increased
• because one of the goods is now cheaper,
consumer enjoy an increase in real purchasing
power. He is better off because they can buy the
same amount of the good for less money, and
thus have money left over for additional
purchases.
 Substitution Effect
• Substitution effect is
– change in consumption of a good
associated with a change in its price,
with the level of utility held constant
 Income Effect
• Income effect is
– change in consumption of a good
resulting from an increase in
purchasing power, with relative prices
held constant
 Substitution Effect Only
x2 Lower p1 (𝑝1′  𝑝1′′ ) makes good 1
relatively cheaper and causes a
substitution from good 2 to good 1.

𝑥2′
(𝑥1′ , 𝑥2′ )  (𝑥1′′ , 𝑥2′′ ) is the
substitution effect

𝑥2′′

𝑥1′ 𝑥1′′ x1
 Income Effect
x2 The income effect is
(𝑥1′′ , 𝑥2′′ )  (𝑥1′′′ , 𝑥2′′′ )

(𝑥1′′′ , 𝑥2′′′ )
𝑥2′′′

𝑥2′′

𝑥1′′ 𝑥1′′′ x1
Substitution and Income Effects for Normal Goods

x2 The change to demand due to

lower p1 is the sum of the
income and substitution effects,
(𝑥1′ , 𝑥2′ )  (𝑥1′′′ , 𝑥2′′′ )
𝑥2′
(𝑥1′′′ , 𝑥2′′′ )
𝑥2′′′

𝑥2′′

𝑥1′ 𝑥1′′ 𝑥1′′′ x1

Good 1 is normal because higher income
increases demand, so the income and
substitution effects reinforce each other.
Substitution and Income Effects for Inferior Goods

x2 The substitution effect is as for a normal

good. But, the income effect is in the
opposite direction. Good 1 is income-
inferior because an increase to income
causes demand to fall.
𝑥2′′′
𝑥2′

𝑥2′′

𝑥1′ 𝑥1′′′ 𝑥1′′ x1

Substitution and Income Effects for Giffen Goods

x2 A decrease in p1 causes
quantity demanded of
good 1 to fall.
𝑥2′′′

𝑥2′

𝑥2′′

𝑥1′′′ 𝑥1′ 𝑥1′′ x1

“Hicks” versus “Slutsky” Substitution

• We have now defined the substitution

effect as the change in consumption of a
good associated with a change in its price,
with the level of utility held constant, i.e.,
without a change in “real income” or
without a change in the indifference
curve.
• This is sometimes called Hicksian
substitution.
“Hicks” versus “Slutsky” Substitution

• A slightly different concept of a

substitution effect arises when we ask
“What is the change in demand when the
consumer’s income is adjusted so that, at
the new prices, he can only just buy the
original bundle?”
• Slutsky isolated the change in demand
due only to the change in relative prices.
• This is called Slutsky substitution.
 Substitution Effect: Slutsky
x2 Lower p1 (𝑝1′  𝑝1′′ ) makes good 1
relatively cheaper and causes a
substitution from good 2 to good 1.

(𝑥1′ , 𝑥2′ )  (𝑥1′′ , 𝑥2′′ ) is the

𝑥2′
substitution effect
𝑥2′′

𝑥1′ 𝑥1′′ x1
 Income Effect
x2 The income effect is
(𝑥1′′ , 𝑥2′′ )  (𝑥1′′′ , 𝑥2′′′ )

(𝑥1′′′ , 𝑥2′′′ )
𝑥2′′′

𝑥2′′

𝑥1′′ 𝑥1′′′ x1
 Overall Change in Demand
x2 The change to demand due to
lower p1 is the sum of the
income and substitution effects,
(𝑥1′ , 𝑥2′ )  (𝑥1′′′ , 𝑥2′′′ )
𝑥2′ (𝑥1′′′ , 𝑥2′′′ )

𝑥2′′

𝑥1′ 𝑥1′′ x1
 “Hicks” vs “Slutsky” Substitution
• In the limit, as price change tends to zero, Hicks and
Slutsky compensations are identical
– Will usually not matter which type of compensation is used
• Provided price change is small
• Hicks compensation has desirable property for policy
analysis
– Compensating a household to point where level of
satisfaction is unaffected by a price change
– Such compensation is not directly revealed in market
• Slutsky compensation is revealed
– Can provide an approximation for Hicks compensation
 Substitution and Income Effects
• Price decrease in p1 results in increased
quantity demanded of 𝑥1
– Increase in quantity demanded is total
effect of price decline
• Total effect = 𝑥1/𝑝1 < 0
– Can be decomposed into substitution and income effects
 Substitution Effect
To determine substitution effect
• Hold level of utility constant at initial utility level, U
– Consider price change for 𝑥1
• If a household were to stay on same indifference curve
– Consumption patterns would be allocated to equate MRS to new
price ratio
• If p1 decreases, implying p1/p2 decreasing
– MRS also decreases
• Only way for MRS to decrease is for 𝑥1 to increase and 𝑥2 to decrease
• Thus, decreasing 𝑥1’s own price holding utility constant results in
– Consumption of 𝑥1 increasing
• Own substitution effect is always negative
• Implying 𝑥1/𝑝1 |𝑑𝑈 = 0 < 0
– Where price and quantity always move in opposite directions for a constant level of
utility
 Income Effect
• Change in income from a change in p1, holding
consumption of commodities 𝑥1 and 𝑥2 constant, is
– 𝑚/𝑝1 = 𝑥1
• Substitution effect will equal total effect if, given a decline
in p1, income also falls by 𝑥1
– If income is not reduced, then this decline in p1
represents an increase in real income
• Specifically, a decline in p1 results in an increase of 𝑥1
– 𝑚/𝑝1 = −𝑥1
• Minus sign results from condition that a change in price and a
change in real income move in opposite directions
 Slutsky Equation
• Combining equations for substitution and
income effects yields
𝜕𝑥1 𝜕𝑥1 𝜕𝑥1
= − ∙ 𝑥1
𝜕𝑝1 𝜕𝑝1 𝑈=𝑐𝑜𝑛𝑠𝑡
𝜕𝑚
• Called Slutsky equation
𝜕𝑥1 𝜕𝑥1𝑐 𝜕𝑥1𝑚
= − ∙ 𝑥1
𝜕𝑝1 𝜕𝑝1 𝜕𝑚
 The Individual’s Demand Curve
• An individual’s demand for good 1
depends on preferences, all prices, and
income:
𝑥1∗ 𝑝1 , 𝑝2 , 𝑚

• It may be convenient to graph the

individual’s demand for good 1 assuming
that income and the price of good 2 (p2)
are held constant
 The Individual’s Demand
𝑝1 Individual’s
Curve
demand curve
Fixed p2 and m. for good 1 is
𝑥2 𝛼 𝑚
𝑥1∗ =
𝛼 + 𝛽 𝑝1

𝛽 𝑚
𝑥2∗ =
𝛼 + 𝛽 𝑝2 𝑥1∗

Here utility function is

𝛽
𝑥1∗ =
𝛼 𝑚 𝑥1 𝑢 𝑥1 , 𝑥2 = 𝑥1𝛼 𝑥2
𝛼 + 𝛽 𝑝1
 The Individual’s Demand Curve
• An individual demand curve shows the
relationship between the price of a good
and the quantity of that good purchased by
an individual assuming that all other
determinants of demand are held constant
 Shifts in the Demand Curve
• Three factors are held constant when a
demand curve is derived
– income
– prices of other goods (p2)
– the individual’s preferences
• If any of these factors change, the demand
curve will shift to a new position
 Shifts in the Demand Curve
• A movement along a given demand curve is
caused by a change in the price of the good
– a change in quantity demanded
• A shift in the demand curve is caused by
changes in income, prices of other goods,
or preferences
– a change in demand
– so, any change in income will shift these
demand curves
 Compensated Demand Curves
• The actual level of utility varies along the
demand curve
• As the price of good 1 falls, the individual
moves to higher indifference curves
– it is assumed that nominal income is held
constant as the demand curve is derived
– this means that “real” income rises as the
price of good 1 falls
 Compensated Demand Curves
• An alternative approach holds real income
(or utility) constant while examining
reactions to changes in p1
– the effects of the price change are
“compensated” so as to constrain the individual
to remain on the same indifference curve
– reactions to price changes include only
substitution effects
 Compensated Demand Curves
• A compensated (Hicksian) demand curve
shows the relationship between the price of
a good and the quantity purchased
assuming that other prices and utility are
held constant
• The compensated demand curve is a two-
dimensional representation of the
compensated demand function
𝑥1∗ = 𝑥1𝑐 (𝑝1 , 𝑝2 , 𝑢) or 𝑥1∗ = ℎ1 (𝑝1 , 𝑝2 , 𝑢)
 Compensated and Uncompensated Demand
𝑥2

𝑢′′

𝑢′

𝑥1
𝑝1
𝑝′

𝑝′′
ℎ1 𝑑1

𝑥′ 𝑥 ′′ 𝑥1
 Compensated and Uncompensated
Demand
• For a normal good, the compensated
demand curve is less responsive to price
changes than is the uncompensated
demand curve
– the uncompensated demand curve reflects
both income and substitution effects
– the compensated demand curve reflects only
substitution effects
 Slutsky Equation
• In Slutsky equation
𝜕𝑥1 𝜕𝑥1𝑐 𝜕𝑥1𝑚
= − ∙ 𝑥1
𝜕𝑝1 𝜕𝑝1 𝜕𝑚

𝜕𝑥1𝑐 𝜕𝑝1 is derivative of compensated

demand function with respect to 𝑝1 . So:
𝜕𝑥1 𝜕ℎ1 𝜕𝑥1
= − ∙ 𝑥1
𝜕𝑝1 𝜕𝑝1 𝜕𝑚
 Slutsky Equation
• Now we will try to get Slutsky equation by
more formal way.
• We need envelop theorem, Shephard’s
lemma, and probably Roy’s identity.
 Shephard’s Lemma
• Let 𝑥1 = ℎ1 (𝑝1 , 𝑝2 , 𝑢) is compensated demand
function for good 1. If consumer’s
expenditure function 𝐸(𝑝1 , 𝑝2 , 𝑢) is
differentiable and 𝑝1 > 0, then
𝜕𝐸(𝑝1 , 𝑝2 , 𝑢)
= 𝑥1 = ℎ1 (𝑝1 , 𝑝2 , 𝑢)
𝜕𝑝1
• So the partial derivatives of the expenditure
function with respect to the prices of goods
equal the Hicksian demand functions for the
relevant goods
 Roy’s Identity
• This says that the consumer’s Marshallian
demand for good i is simply the ratio of the
partial derivatives of indirect utility with
respect to 𝑝𝑖 and 𝑚 after a sign change.
𝜕𝑉 𝜕𝑉
𝑑1 𝑝1 , 𝑝2 , 𝑚 = −
𝜕𝑝1 𝜕𝑚
𝜕𝑉 𝜕𝑉
𝑑2 𝑝1 , 𝑝2 , 𝑚 = −
𝜕𝑝2 𝜕𝑚
 Relations Between Indirect Utility and
Expenditure Functions

𝑑𝑖 𝑝1 , 𝑝2 , 𝑚 ≡ ℎ𝑖 𝑝1 , 𝑝2 , 𝑉 𝑝1 , 𝑝2 , 𝑚
ℎ𝑖 𝑝1 , 𝑝2 , 𝑢 ≡ 𝑑𝑖 𝑝1 , 𝑝2 , 𝐸 𝑝1 , 𝑝2 , 𝑢
𝐸 𝑝1 , 𝑝2 , 𝑉 𝑝1 , 𝑝2 , 𝑚 ≡𝑚
𝑉 𝑝1 , 𝑝2 , 𝐸 𝑝1 , 𝑝2 , 𝑢 ≡𝑢
 Relationships among Demand Concepts
Primal Dual
max 𝑢(𝐱) min 𝐩𝐱
𝐩𝐱 = 𝑚 𝑢(𝐱) = 𝑢
𝐱≥0 𝐱∗ 𝐱≥0

solution solution

Uncompensated demand Compensated demand

functions functions
Slutsky
𝐱 ∗ = 𝑑(𝐩, 𝑚) 𝐱 ∗ = ℎ(𝐩, 𝑢)
equation

Substitution in Roy’s identity Substitution in Shephard’s

𝑢(𝐱) 𝑝𝑖 𝑥𝑖 lemma

Indirect utility function Expenditure function

𝑉(𝐩, 𝑚) Inverses 𝐸(𝐩, 𝑢)
 Slutsky Equation
• We can differentiate
ℎ1 𝑝1 , 𝑝2 , 𝑢 ≡ 𝑥1 𝑝1 , 𝑝2 , 𝐸 𝑝1 , 𝑝2 , 𝑢
with subject to 𝑝1
𝜕ℎ1 𝑝1 , 𝑝2 , 𝑢 𝜕𝑥1 𝑝1 , 𝑝2 , 𝐸 𝑝1 , 𝑝2 , 𝑢
= +
𝜕𝑝1 𝜕𝑝1
𝜕𝑥1 𝑝1 , 𝑝2 , 𝐸 𝑝1 , 𝑝2 , 𝑢 𝜕𝐸 𝑝1 , 𝑝2 , 𝑢
+ ∙
𝜕𝐸 𝜕𝑝1
 Slutsky Equation
• Using identity 𝐸 𝑝1 , 𝑝2 , 𝑉 𝑝1 , 𝑝2 , 𝑚 ≡ 𝑚
we can rewrite equation
𝜕ℎ1 𝑝1 , 𝑝2 , 𝑢 𝜕𝑥1 𝑝1 , 𝑝2 , 𝑚
= +
𝜕𝑝1 𝜕𝑝1
𝜕𝑥1 𝑝1 , 𝑝2 , 𝑚 𝜕𝐸 𝑝1 , 𝑝2 , 𝑢
+ ∙
𝜕𝑚 𝜕𝑝1
 Slutsky Equation
𝜕ℎ1 𝑝1 , 𝑝2 , 𝑢 𝜕𝑥1 𝑝1 , 𝑝2 , 𝑚 𝜕𝑥1 𝑝1 , 𝑝2 , 𝑚 𝜕𝐸 𝑝1 , 𝑝2 , 𝑢
= + ∙
𝜕𝑝1 𝜕𝑝1 𝜕𝑚 𝜕𝑝1
Then using Shephard’s lemma
𝜕𝐸(𝑝1 , 𝑝2 , 𝑢)
= 𝑥1 = ℎ1 (𝑝1 , 𝑝2 , 𝑢)
𝜕𝑝1
and changing terms we get the Slutsky equation
𝜕𝑥1 𝑝1 , 𝑝2 , 𝑚 𝜕ℎ1 𝑝1 , 𝑝2 , 𝑢 𝜕𝑥1 𝑝1 , 𝑝2 , 𝑚
= − ∙ 𝑥1
𝜕𝑝1 𝜕𝑝1 𝜕𝑚
or in short
𝜕𝑥1 𝜕ℎ1 𝜕𝑥1
= − ∙ 𝑥1
𝜕𝑝1 𝜕𝑝1 𝜕𝑚