MICROECONOMICS I

Lecture 7: Slutsky Equation (Ch. 8)

May 8, 2023

Effects of a price change

->
What happens when a commodity’s price decreases? a things are
going
to happen

• Substitution effect: the commodity is relatively cheaper, so consumers

-

substitute it for now relatively more expensive other commodities.

-

• Income effect: the consumer’s budget of m can purchase more than before,
as if the consumer’s income rose, with consequent income effects on
quantities demanded. ↳ ↑
purchesing power -> We can consume more

as price of y :
has decrease

dominates ?
Which effect

2
Introduction
Eugen Slutsky (1880-1948)

• A Russian mathematician, statistician and economist.

• In economics he is best known for his formulation of

the Slutsky equation.

• He developed this equation in the “The Theory of the

Budget of the Consumer” (“Sulla teoria del bilancio
del consumatore,” Giornale degli Economisti, 1915).

Effects of a price change

x2 Consumer’s budget is m.

𝑚 Original choice
𝑝2 Now only m’ is needed to buy the
original bundle at the new prices.
𝑚′
𝑝2 It is as if the consumer’s income
increased by m – m’.

Lower price for commodity 1 Optimal bundle when X1 is cheaper ?

pivots the constraint outwards.

pirot

x1
4
Effects of a price change

• Changes to quantities demanded due to this “extra” income are the

income effect of the price change.

• Slutsky discovered that changes to demand from a price change are

always the sum of a pure substitution effect and an income effect.

Real income changes X2

*
*

mi
>-

=
z -
-
⑧- a
-
original
bundle-pirot
as x2

Slutsky asserted that if, at the new prices,

-

-- -
is Cheaper

= all I cen
X1

• less income is needed to buy the original bundle, buy

now

then “real income” is increased ↳ Laffordeble)

me
*Pa
↳ I can consume more

• more income is needed to buy the original bundle,

How much do I need
then “real income” is decreased.
income

C price of y has increased

to
buy my original
Real
bundle ?

!
decreased
· lower income > income

real incomes
has
our
incomed
·

higher income > Real

crucial to determinete both

effects

6
 Real income changes
x2 x2

Original budget constraint and optimal choice Original budget constraint and optimal choice

the
outside
New budget constraint new New budget constraint
↓ budget
=> “real income” has risen constraint => “real income” has fallen
-

C purchesing
power
->
both prices have
chenged in
a ¿ Are we richer or poorer Because I need more
money
original real terms ? to
afford the
original bundle .

bundle
new
inside
constrant
budget
↳↑ Real income

Pe decreased
x1 x1
7

Pure substitution effect

• Slutsky isolated the change in demand that is only due to the change in
relative prices by asking:

• “What is the change in demand when the consumer’s income is adjusted

so that, at the new prices, she can only just afford the original bundle?”

What are the new

optimal choices with this new

budget constraint ?

8
 substitution eff looking
:
at the change in optimal

Pure substitution effect bundle when prices change controlling for real income

x2
At the new prices, consumer has a higher
M =

P1xs
↳ nominal
+

P2Xz
decrease
income
original
no

“real income”.
income
wie the
our
m =

↳ real
pexi +

p2'x :
affordbundle At the new prices, consumer can exactly
M budget
income
d
afford the old bundle.

-same
the ald 2
keeping
bundle
affordeble line Lower p1 makes good 1 relatively cheaper and
x’ 2
↳ causes a substitution from good 2 to good 1.
Whets en ?choice
↳
a
optimal (x1’,x2’) → (x1’’,x2’’) is the pure substitution effect.
tengency real income new
x2’’ Condition
->

shifting orgininel bundle

for original bundle
↳ optimal
choice
bundle
higher utility
.

to the new
original ↳
bundle an the same
funtion
- -

real income

m =

pix 1 +

pix 2

x1’ x1’’ x1
Substitution effect
9

And now… the income effect

x2

-
(x1’’,x2’’) → (x1’’’,x2’’’) is the income effect.
x2’
x2’’’

0
back
a shifting real to the
line
E Optimal choice
budget
x2’’
.

↳
tengency
condition

x1’ x1’’ x1’’’ x1

Substitution effect O Income effect =>
difference blue
green
10
The 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’
x2’’’
Sub eff= Blue- Red

x2’’ Income
effect :

Green- Blue

Total effect

x1’ x1’’ x1’’’ x1

Substitution effect Income effect
11

Slutsky effects for normal goods

• Most goods are normal (i.e. demand increases with income).

• The substitution and income effects reinforce each other

when a normal good’s own price changes.

12
 X1 Ped

Slutsky effects for normal goods ↳4 xs purchesed

x2 ↑income => ↑ X1

- effect
↳ positive income

Good 1 is normal because

higher income increases demand,
so the substitution and income they
effects reinforce each other. goes
to y
the same

x2’ ↑P1 - -
negetive directions -

x2’’’ income
effect
t
-Sub
eff .

x2’’

Total effect

x1’ x1’’ x1’’’ x1

Substitution effect Income effect
13

Slutsky effects for normal goods

• Most goods are normal (i.e. demand increases with income).
direction
they always goes
to the same
->

• The substitution and income effects reinforce each other

when a normal good’s own price changes.

• Since both the substitution and income effects increase

demand when the good’s own price falls, a normal good’s
ordinary demand curve slopes down.

• The Law of Downward-Sloping Demand therefore always

applies to normal goods.

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Slutsky effects for income-inferior goods
mand eff income

• Some goods are income-inferior

i.e., demand is reduced by higher income.

• The substitution and income effects⑳

oppose each other when
an income-inferior good’s own price changes.

15

Slutsky effects for income-inferior goods

x2

The pure substitution effect is as for

a normal good. But, ….
-
But, the income effect goes in the opposite direction.
x2’’’ Good 1 is income-inferior.
x2’
Because an increase to income causes demand to fall.
However, total effect remains positive!
x2’’
-cont income

x1’ x1’’’ x1’’ more

money- x1We dicide to consume less
ef
Substitution effect - this
good
Income effect =>

opposite direction 16
Giffen goods
• In rare cases of extreme income-inferiority, the income effect may be
larger in size than the substitution effect, causing quantity demanded to
fall as own-price decreases.

• Such goods are Giffen goods.

17

Slutsky effects for Giffen goods

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

x2’’’
h Sub off =>
always positive
Income off =

depends .

x2’ o normel ->

positive
·
inferior
x2’’ =>
negetive
giffen

Total effect

x1’’’ x1’ x1’’ x1

Substitution effect positive sub .

eff .

Income effect so
lerge consuming
less in over all
18
Giffen goods
• In rare cases of extreme income-inferiority, the income effect may be
larger in size than the substitution effect, causing quantity demanded to
fall as own-price decreases.

• Such goods are Giffen goods.

inferior goodis
~

begen
• Slutsky decomposition of the effect of a price change into a pure
substitution effect and an income effect thus explains why the Law of
Downward-Sloping Demand is violated for extremely income-inferior
goods. (Giffen goods) GP1
up
ward
sloping
demand

X2

19

Slutsky equation
Slutsky equation:
A change in the demand or in the consumption of a good due to a price
change is the sum of a substitution effect and an income effect.
Ax Dxch
of
both
effect
+

sum

-
Total effect = new d

&
E up of
①me O

for
-
Controling
income
down
changing
substitution effect income
-
income effect
more/less
How much goods
Axe =
(x2 *
( pe P2 m') (
for
I consume the
change
. ,

in real inome .

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Slutsky decomposition
We want to study the effect of a change in the price of good 1.
• Suppose the new price is lower: p1’ < p1.
• m’ is an income level that allows the consumer to exactly afford the old bundle
at the new price p1’.
Given m’ we can compute the two effects as:

substitution effect

income effect

But how can we compute m’?

21

Slutsky decomposition
How can we compute m’?
Recall that m’ is the level of income that:
• makes the original bundle (𝑥1 , 𝑥2 ) exactly affordable at the new price p1’,
• is the cost of original bundle (x1,x2) at the new price p1’.
𝑚′ = 𝑝1′ 𝑥1 + 𝑝2 𝑥2
Am =
m' -
m =
APeXe
*

(P1 , P2 ,
m)

The budget before the price change: m = 𝑝1′ 𝑥1 + 𝑝2 𝑥2

The necessary change in income to keep “real income” constant can be
computed as:
0
∆𝑚 = 𝑚′ − 𝑚 = 𝑝1′ 𝑥1 + 𝑝2 𝑥2 − 𝑝1 𝑥1 + 𝑝2 𝑥2 = 𝑝1′ − 𝑝1 𝑥1 = ∆𝑝1 𝑥1 -

/real , mome
that makes old M Pe' x2
*
(P1 P2 m) P2 x
, (P1 m)
=

P2
+
,
,

22
,

budle
affordable at new prices)
Slutsky decomposition
Then we can write:

Total effect substitution effect income effect

-
0
consume now
consume before
mith new price

p's convex => vell-heneved

goods
-
Note: The substitution effect is always negative if 𝑝1′ > 𝑝1 and always
positive if 𝑝1′ < 𝑝1 .&
Why? any good tengent ->

The income effect can be both positive or negative.

type of good
↳ the
depends dealing
on we are
.

23

if had par act like a

Slutsky decomposition: Example

we =>

* constant both effects

->
affect in

a constant
way .

Demend funtion interms of xe and pe

How can we compute the substitution effect?
• Suppose the consumer has the following demand for milk (good 1):
17 -
inicial
demand
-

-
-

• Her demand for good 1 is: & =x ! (1 , 120)

S
X1 X1 3
effect
-

↓ Total
=

consume D+ =
3
↳ descompose I

• If the price drops to 80 cents: then: =

X2
*
(018
-
, 120)
new price -
Demend for this new price
• The income change needed to keep “real income” fixed: new p old p1
original amount
of m d
M consuming
- - -

• The new level of income is: change

in
price

income
Real
-
!
chenge in income

• Substituting this into the demand function: Esubstitute

demand
into
funtion
-

new price
• Hence, the substitution effect is:
-

change in change in income

P1 meking
ald bundle
afforceble
24
Slutsky decomposition: Example
->
realize total effect
How can we compute the income effect?
positive

>
∆𝑥1𝑆 = 𝑥1 0.8, 120 − 𝑥1 0.8, 115.6 = 25 − 24.45 = 0.55 > 0 → normal good!
-

total -
subeff +
income
off
effect
.

How can we compute the total effect?

Slutsky equation: ∆𝑥1𝐼 + ∆𝑥1𝑆 = 2.45 + 0.55 = 3

In particular, we deduce that, for this consumer, milk is a normal good (since the income
effect is positive) and that it is also an ordinary good (since the total effect is positive).

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Perfect complements / perfect substitutes

no sub .

eff no income
effect .

+
A =

26
Example
A consumer has an income of m = 400, to spend on food (x1) and clothing (x2), that have prices
p1 = 4 and p2 = 2. Her preferences between the two goods are defined by the following utility
function:

The functions that reflect the consumers optimal demand are given by:

The government decides to subsidize food products such that the new price is p1’ = 2.

Compute the Slutsky decompositions.

What are the substitution and income effect due to the change in the price of food?

27

Example
𝑚 400
• 𝑥1∗ 𝑝1 , 𝑝2 , 𝑚 = = = 50
2𝑝1 2×4

𝑚 400
• 𝑥2∗ 𝑝1 , 𝑝2 , 𝑚 = = = 100
2𝑝2 2×2

𝑚
• 𝑥1∗ 𝑝1′ , 𝑝2 , 𝑚 = = 100
2𝑝1′

• Total effect: 𝑥1∗ 𝑝1′ , 𝑝2 , 𝑚 − 𝑥1∗ 𝑝1 , 𝑝2 , 𝑚 = 50

• Slutsky decomposition: 𝑚𝑆′ = 𝑥1 𝑝1′ + 𝑥2 𝑝2 = 50 × 2 + 100 × 2 = 300

𝑚𝑆′ 300
• 𝑥1∗ 𝑝1′ , 𝑝2 , 𝑚𝑆′ = = = 75
2𝑝1′ 2×2

• Substitution effect: 𝑥1∗ 𝑝1′ , 𝑝2 , 𝑚𝑆′ − 𝑥1∗ 𝑝1 , 𝑝2 , 𝑚 = 75 − 50 = 25

• Income effect: 𝑥1∗ 𝑝1′ , 𝑝2 , 𝑚 − 𝑥1∗ 𝑝1′ , 𝑝2 , 𝑚𝑆′ = 100 − 75 = 25

28
Hicks decomposition: An alternative decomposition
• Sir John Richard Hicks (1904-1989)

• A British economist and Nobel laureate in

economics (1972).

• Famous for his contributions in the field of

economics, particularly consumer demand
theory, general equilibrium theory, and the
IS/LM model, which summarized a
Keynesian view of macroeconomics.

29

Hicks decomposition: An alternative decomposition

Substitution and income effects with Hicks decomposition.

The Hicks decomposition adjusts income to keep

utility constant at the new prices.

The Slutsky decomposition adjusts income so that the

individual can afford the original consumption bundle
-Mantein Es
at the new prices.
Llaves of
utility
The Hicks decomposition adjusts income so that the substitution
effect
individual maintains the same indifference curve of the
original consumption bundle.

30
Hicks decomposition
x2

The change to demand due to lower p1 is the

arace impe sum of the substitution and income effects:
x2’
original (x1’,x2’) → (x1’’’,x2’’’).

x2’’’
bundle
income effect
Here: At utility level is maintained constant!
↳
x2’’ ami originale en

Total effect

x1’ x1’’ x1’’’ x1

Substitution effect Income effect
31

Slutsky decomposition
x2

The change to demand due to lower p1 is the

sum of the income and substitution effects:
(x1’,x2’) → (x1’’’,x2’’’).
x2’
x2’’’ Here: At old bundle is just affordable!

x2’’
making
the
original
bundle just
affordable
Total effect

x1’ x1’’ x1’’’ x1

Substitution effect Income effect
32
Thanks. See you tomorrow!

Appendix: Example of Hicks composition

𝑚 400
• 𝑥1∗ 𝑝1 , 𝑝2 , 𝑚 = = 2×4 = 50
2𝑝1

𝑚 400
• 𝑥2∗ 𝑝1 , 𝑝2 , 𝑚 = = 2×2 = 100
2𝑝2

𝑚
• 𝑥1∗ 𝑝1′ , 𝑝2 , 𝑚 = = 100
2𝑝1′

• Total effect: 𝑥1∗ 𝑝1′ , 𝑝2 , 𝑚 − 𝑥1∗ 𝑝1 , 𝑝2 , 𝑚 = 50

• Hicks decomposition: 𝑢(𝑥1∗ 𝑝1 , 𝑝2 , 𝑚 , 𝑥2∗ 𝑝1 , 𝑝2 , 𝑚 ) = 50 × 100 = 5000

′
𝑚𝐻 𝑚′
• 𝑢(𝑥1∗ 𝑝1′ , 𝑝2 , 𝑚𝐻
′
, 𝑥2∗ 𝑝1′ , 𝑝2 , 𝑚𝐻
′
)= × 2𝑝𝐻 = 5000
2𝑝1′ 2

′
𝑚𝐻 = 5000 × 2𝑝1′ × 2𝑝2 = 200 2 (< 300)
𝑚𝑆′ 200 2
• 𝑥1∗ 𝑝1′ , 𝑝2 , 𝑚𝐻
′
= = ≈ 71
2𝑝1′ 2×2

• Substitution effect: 𝑥1∗ 𝑝1′ , 𝑝2 , 𝑚𝐻

′
− 𝑥1∗ 𝑝1 , 𝑝2 , 𝑚 ≈ 71 − 50 = 21

• Income effect: 𝑥1∗ 𝑝1′ , 𝑝2 , 𝑚 − 𝑥1∗ 𝑝1′ , 𝑝2 , 𝑚𝐻

′
≈ 100 − 71 = 29
34