Mashael Fahad Alkhurayji

Microeconomic

Assignment 2

You have given the following utility function:

𝒖 = (𝒙𝟏 , 𝒙𝟐 ) = 𝒙𝟏 𝒙𝟐 𝑴 = ⅈ𝒏𝒄𝒐𝒎𝒆
- Calculate the income effect and the substitution effect.

We could see that income function is:

𝑀 = 𝑃𝑥1 𝑥1 + 𝑃𝑥2 𝑥2

And to Calculate the income effect and the substitution effect. We need to apply
Slutsky Equation:
𝜕𝑥1 𝜕𝑥 𝑐 𝜕𝑥
𝜕𝑃𝑥1
= 𝜕𝑃 1 − 𝑥 𝜕𝑀1
𝑥1
And to do this we need to drive:
1. The ordinary demand functions for both goods.
2. The compensated demand for good x1.
3. indirect utility function.

First, we must drive the demand of good x by using the utility function above.

𝜕𝑢
𝑀𝑢𝑥1 = 𝜕𝑥1 = 𝑥2

𝜕𝑢
𝑀𝑢𝑥2 = 𝜕𝑥 = 𝑥1
2
𝑃𝑥1
𝑀𝑅𝑠 = 𝑝
𝑥2
𝑀𝑢𝑥1 𝑃𝑥
𝑀𝑢𝑥2
=𝑃1
𝑥2
𝑥1 𝑃𝑥1
𝑥2
=𝑃
𝑥2
𝑃𝑥
𝑥2 = 1 𝑥1 plug in to budget constraint:
𝑝 𝑥2

𝑃𝑥
𝑀 = 𝑃𝑥1 𝑥1 + 𝑃𝑥2 𝑝 1 𝑥1
𝑥2

𝑀 = 2𝑃𝑥1 𝑥1
𝑀
𝑥1 = 2𝑝 Ordinary demand for good x1
𝑥1
𝑀 𝑃𝑥
𝑥1 = plug in to 𝑥2 = 1 𝑥1
2𝑝𝑥1 𝑝𝑥2
𝑃𝑥1 𝑀
𝑥2 = .
𝑝𝑥2 2𝑝𝑥1
𝑀
𝑥2 = Ordinary demand for good x2
2𝑝𝑥2

Second: we need to use the Ordinary demand for good x2

 𝑃𝑥
𝑥2 = 𝑝 1 𝑥1 plug in to 𝒖 = 𝒙𝟏 𝒙𝟐 to find compensated demand for good x1
𝑥2
𝑃𝑥
𝒖 = 𝒙𝟏 𝑝 1 𝑥1
𝑥2

𝑃
̅ = 𝟐𝒙𝟏 𝑥1
𝒖 𝑝 𝑥2

𝑃
𝒙𝒄𝟏 = 𝟐 𝑝 1 𝒖
𝑥
̅
𝑥2

Third: we need to solve for indirect utility function by substituting the demand for good x1
and x2 in to utility function:

𝒖 = 𝒙𝟏 𝒙𝟐
𝑀 𝑀 𝑀
̅=
𝒖 . 2𝑝 =
2𝑝 𝑥1 𝑥2 2.𝑝𝑥1 .𝑝𝑥2

Now after we get what we need, now we could apply Slutsky Equation:
𝝏𝒙𝟏 𝝏𝒙𝒄 𝝏𝒙
𝝏𝑷𝒙𝟏
= 𝝏𝑷 𝟏 − 𝒙 𝝏𝑴𝟏
𝒙𝟏

𝑴 𝑷𝒙𝟏
𝒙𝟏 = 𝒙𝒄𝟏 = 𝟐 ̅
𝒖
𝟐𝒑𝒙𝟏 𝒑𝒙𝟐

𝑀
̅=
𝒖 2.𝑝 𝑥1 .𝑝𝑥2

𝝏𝒙𝟏
Total effect of price change:𝝏
𝑷𝒙
𝟏

𝜕𝑥1 0−2(2𝑃𝑥1 )𝑀 2𝑀 𝑀
𝜕𝑃𝑥1
= (2𝑃𝑥1 )2
= − 2𝑃 =− 𝑃
𝑥1 𝑥1

𝝏𝒙𝒄𝟏
Substitution effect of price change:
𝝏𝑷𝒙𝟏

𝜕𝑥1𝑐 2 𝑢̅ 𝑃𝑥2 −0 2 𝑢̅
𝜕𝑃𝑥1
= 2
𝑃𝑥2
= 𝑃𝑥2
Plug indirect utility function for 𝑢̅

𝑀
𝟐
𝝏𝒙𝒄𝟏 2.𝑝𝑥1 .𝑝𝑥2 𝑴
= =
𝝏𝑷𝒙𝟏 𝑷𝒙𝟐 𝑷𝒙𝟏

𝝏𝒙
Income Effect = −𝒙 𝝏𝑴𝟏

𝝏𝒙 𝟏( 𝟐𝑷𝒙𝟐 )−𝟎 𝒙
−𝒙 𝝏𝑴𝟏 = −𝒙 𝟐𝑷𝟐𝒙𝟐
= − 𝟐𝑷
𝒙𝟐

𝑴 𝟏 𝑴
= − 𝟐𝒑 . 𝟐𝑷 = − 𝟐.𝒑
𝒙𝟏 𝒙𝟐 𝒙𝟏 .𝒑𝒙𝟐

Then Slutsky Equation will be:

𝑀 𝑴 𝑴
−𝑃 = 𝑷𝒙𝟏
− 𝟐.𝒑
𝑥1 𝒙𝟏 .𝒑𝒙𝟐