ATO CHAPTER 8 ENDIX _ UTION EFFECT SLUTSKY suBSTIT 7 5 ifference Slutsky Substitution Effect and Cost Diffe: ae aubstttion effect. In this version y | s gi ly different vers chasing power incre. So ae ciend say consumer's real income orth change inits purchasi income of the consul he price change His purchasing ra ang which occurs as a result of the p1 ber of units of the good wi ali um! enuf the cha on in Slutsky’s approach, income is rg individual used to buy at the old price. In of + in ich lea e consumer to be just afi eased (as the case may be) by the amount which leaves th ,e just or increaset ea m ir ich he was having at they ee inatic if he so desires, whic! purchase th e combination of gods es Tae t ir is by the dif price. That is, the income is changed tity of X at the new price. I the same quantity co X purchased at the old price and the cost of the Thus, in Slutsky substitution effect, inca is then said to be changed by the cost difference. Thus i reduced or increased not by the compensating variation but by the cost difference. Now, an important question is how to determine the exact magnitude of cost differ by which money income of the consumer has to be adjusted to arrive at Slutsky substitu effect. The reduction in price of a commodity, say X, can be represented as AP, f consumer is buying quantity Q, of the commodity X before the reduction in price off commodity, then AP,. Q, will represent the cost difference by which money income oft consumer is to be adjusted so as to enable him to buy the quantity Q,, of commodity X (and same original quantity of Y) which he was buying before the change in price. Suppose. Wi given money income, a consumer is buying Q, of X and Q, of Y at given prices of Py. and respectively. Now, if the price of X falls from Px, to Px, the money income and priceal remaining the same, the cost difference will thus be equal to 4 Px Q, ~ Pxp Q, = AP, Q. 4 Let us give a numerical example. If at a price of = 10, a consumer is buying 15 unis! the commodity X along with a certain quantity of Y at the gi i he pricet X falls to ® 8, the cost difference will be egiven pelos of Y. I nave 10x 15-8x 15=2x15=30 In this hypothetical case, with the fall in price from % 10 to % 8 per unit, the money income that is required to be reduced is % 30 so as to enable the consumer to buy the 3 original combination of goods (i.e 3 Ox of X and Oy of Y). With thie reduction in money income the sane! line will pass through the original equilibri nati original es ium combination of Fig. 80.1. Slutsky Substit Sood x186 Advanced Economic Theory relatively cheaper than before. In order to find out Slutsky case, consumer's money income must be increased by the ‘cost- difference’ createy (4 price change to compensate him for ‘ the rise in price of X. In other words. his money income must be increased to the extent which is just large enough to permit him to purchase the old combination Q, if he so desires, which he was buying before. For this, a budget line GH has been drawn which passes through point Q. It will be evident from the figure that PG (in terms of Y) or L’H (in terms of X) represents cost-difference’ in this case. With budget line GH he can buy if he so desires the old combination Q, which he was buying at the old price of X. But actually he will not buy the old combination Q, since on budget line y substitution effect in th S Dre S on higher indifference curve IC, replaced out by NW of Y. Movement from point Q to S is the result of Slutsky substitu effect; the effect due to the fall in the purchasing power has been cancelled out by giving hin money equal to PG of Y or L’H of X. In this present case of stipulated rise in price of X Slutsky substitution effect on X is the fall in its quantity bought by MK and Slutsky substitut effect on Y is the increase in its quantity bought by NW. From the above analysis it is clear that, whereas Hicksian substitution effect takes pla ‘on the same indifference curve, Slutsky substitution effect involves the movement from of indifference curve to another curve, a higher one. For the proper understanding of the differet between the two versions of the substitution effect we have shown them below together in om figure 8A.3 and 8.4. 3 ‘A glance at these Figs. 8A.3 (a) and 8A.4 (b) which respectively show the two substitu! effects in the case of both a fall and a rise in the price of good X will reveal that the movemnal from Q to T on the same indifference curve represents Hicksian substitution effect and ! movement from Qn the original indifference curve to a point S on a higher indifference O*® represents Slutsky substitution effect. The difference between the — igher indifferé ee effect solely arises due to the magnitude of money income b eae rai ced increased to compensate for the change in his eal income Tiegeee noe the consumer his initial level of satisfaction, whereas the Shu ie the consumer by putting him on a higher indiffere lutsky approach “over-compen™ the method of adjusting the level of mone nce curve 3 merit that on this interpretation, the substit price, with real income constant, real income. Thus the analysis whic of the price change inte two fundam, fundamental distinction upon ei t i income effect me: rs bsed upon the compensating variation is a reso!" 0 rections anya eeonon tions’, we shall not encounter 2" 4Slutsky Substitution Effect 189 But Slutsky method has a distinct advantage in that it is easier to find out the amount of me equal tthe ‘cost difference by which income of the consumer is to be adjusted. On the ul itis not so easy to know the compensating variation in income, The cost-difference her bi ihhod has the advantage of being dependent on observable market data, while for knowing ve fhe amount of compensating variation in income, knowledge of indifference curves (about jastes and preferences) of the consumer between various combinations of goods is required. prol. J R. Hicks himself recognizes this merit of Slutsky approach (i.¢., adjustment of income ripe cost-iference) and remarks v z - o L FH v oO cor A Lk Good X Good X Fig. 8A.3, (a) Two Types of Substitution Effects Fig. BA.4. (b) Two Types of Substitution Compared (for a Fall in Price of X) Effects Compared (lor a Rise in Price of X) “The difference between two methods is solely a matter of the magnitude of the rise in income, which leads to the income effect; and on this point the method of cost difference has adistinct advantage. For, while the magnitude of the compensating variation is quite a problem. the magnitude of the cost difference raises no problem at all. It can be read off at once from the data of the situation under discussion.” It follows from what has been said above that both the cost-difference and compensating variation methods have their own merits. While the law of demand can be easily and adequately established by the method of cost-difference, method of compensating variation is very useful {or analysis of consumer's surplus and welfare economics. With the help of the cost-difference, the income effect can be easily separated from the substitution effect but the substitution effect so found out involves some gain in real income (since it causes movement from a lower indifference curve to higher indifference curve). It is because of this that in cost-difference ae substitution effect is not theoretically distinct concept. To quote J. R. Hicks again on this point, “The merit of the cost difference method is confined to the property.....that its ‘nome effect is peculiarly easy to handle. The compensating variation method does not share HA this Particular advantage; but it makes up for its clumsiness in relation to income effect by its onvenience with relation to the substitution effect.”* wah Numerical Example. Let us explain the concept of cost-difference and Slutsky itution effect with a numerical example stated below: "2190 Advanced Economic Theory litre, Amit consumes 1,000 litres or litre, vate ery on the price of petrol is ¢ 20.00 per » the cost difference equay eipricelofpelraliriees i ¢ the Government should give him extra money omg after the price rise plus thee rise in price of petrol Will Amit be better or ae ‘nas before ? What he compensation equal to the cost difference than petrol consumption ? i « ill Happen i where AP stands for tho As explained above, the cost difference is equal O See prior to fe in price and Q stands for the quantity of commodity price. Thus, in our example above, AP =% 25-20=%5 Q = 1,000 litres per year Cost-difference = A PQ =%5 x 1,000 = % 5,000. Now. with higher price of petrol of % 25.00 per litre and cash compensation of ®5 equal to the cost difference he can buy, if he so desires, the original quantity of 1,000 litres petrol per year. However, he may not buy this original quantity of petrol in the new pri income situation if his satisfaction is maximum at some other point. Consider Figure 8 where we measure petrol on the X-axis and money income representing other goods on Y-axis. Suppose, BL, is the initial budget line when the price of petrol is ¥ 20.00 per litt consumer is in equilibrium at point Q on indifference curve IC, where he is consuming 1,0 litres of petrol per year. Now, with the rise in price of petrol to ¥ 25.00 per litre, suppose the budget line shifts Gq to BL». Now, if to compensate the As. 5000 rise in price, his money income is B raised by % 5,000, that is, equal to the cost difference, the budget line shifts parallel to BL, so that it reaches the position GH which passes through the original point of consumption Q. Aglance at Fig. 8A.5 will reveal that the consumer with higher price of Petrol and having received monetary compensation equal to the cost difference of % 5,000 will not be in equilibrium at the original point Q and instead he will be maximizing his satisfaction in the new situation at cha ange ‘Wat ordi fron Money bist ay “hi ° N 1000 lo oH Ly 4 Quantity of Petrol Fig. 80.5, Cash Compensation for a ise” Price of Petrol d 4 fle pine: with the rise in price and simultaneous no eY MIN is the Slutsky sulsltlion has enabled him to attain higher indifferenc T2282 i his i aa rise in price ice foroducts and the factor d cardinal utility app r Introduction In the earli determine it Intl er two chapters we he last chapter we ex to consumer's demand. In the present CI inderlying consumer's deman' ¢ t es, income: consumer choice u! ‘changes in to predict consumer jonses to changes in pnd me, Soo eel o predict cons agers expenditure. With this understanding managerq firm is better able to know the changes in firm’s revenue consequent id that the firm can control such as price of its product, advertising expenditure to promot sales as well as consumer's responses to changes in variables such as consumer's inca prices of products of other rival firms and their promotional strategies. The indifference analysis is a popular theory of consumer's, demand which forms the sub jatter off present chapter. ‘The technique of indifference curves was first of all invented byad economist Edgeworth but he used it only to show the possibilities of exchange between persons oe to expain consume! demand, Two English economists, J.R. Hicks and R.G ein their now well-known paper ‘A Reconsiderati ory t ” s0 criticized Marshalls cardinal utility analysis based oa eee Ke af ty a df forward the indifference curve approach based on the notion of o' anal hs 0 e vansue's behaves In 1939 Hicks reproduced the indifferenc re EST af and in his book ‘Value and Capital ' modifying so 2 curve er mewhat the version of the 7% paper. _CONSUMER PREFERENCES bth The analysis of - —— goods or bundles of jour is concerned with = - ren hi the choi oes gen thelr prices, that consu paudget , akes a goods for satisfaction i of their wants. T. nts. To ex nsurgers have a set of pref ae c si ol mrelerencse oa nsumer bel unplon The preferences-of diff which guide the whoosinttenn ¢ hoosing/amang goods (Fm ‘duals di ers may prefer alter substantially. For exampl?, fer coloured shirts. Likewise, oT? 4 diage consumers have to make 6 ms compel us to limit 4 10 eo lity which repre ne s e n ae is composite 9° other goods, it is take goods, How two di a However economists use the aS dimensional other goods andthe choice isbetwen two goods i) y S general purchasing pe goods while ower Whi ich ca it— | _ Indifference Curve Analysts 01 We site commodity. Thus with the help of the composite commodity, we can consider com, choice involving May {goods and still use two dimensional diagrams Let us explain how we explain consumer preferences. Let x, denote the quantity of good pet quantity of good 2 Sees a bundle of two goods containing x, of good Land x, of good rt erally denoted by (x1, x) and is called X bundle. Similarly, the other bundle may ts of Yi amount of good 1 and yy ‘amount of the good 2 and therefore is denoted by ’ lied Y bundle. In the theory of consumer preferences it is assumed that, given co d yand is ca Wy ve) andes ‘of goods, (, »Xq)and (v), ¥2) the consumer ‘table to rank them in order of wrefet nce. In other words, the consumer can determine whether he strict!y prefers one ish « he is indifferent between the two bundles. strictly prefers dle of joods to the other one o1 aurleo! Som Gefinitely kes the one over the other. This preference relation has an operational a we Wa person strictly prefers one bundle over the other, he will choose that one over ia other if there is opportunity for him to have any of them. Thus, the consumer's choice and demand for goods will depend on whether he strictly prefers one bundle over another. Thus, if a consumer always chooses a bundle (x1, X2) when bundle (y;, ¥2) is available, it shows he prefers be, X2) 10. Vay v2) Further, if the consumer shows hi means he derives the some satisfaction from consuming ivy vg ot the goods. There isa third case which occurs if the consumer either pre the two bundles of goods, it is then said that the consumer weakly to the other available basket (y,, Y2) of the two goods. This weak preference has been used by J.R. Hicks in onlogical ordering. In his analysis of weak-ordering preference hypothesis Hicks assumes that when a person chooses one bundle of two goods from among the several bundles of two goods available to him, it means he either prefers the chosen combination over all others available or he will be indifferent between the chosen one ‘and some others available. Thus, Hicks in his revised demand theory does not rule out the indifference of the chosen bundle with any other bundle of the two goods available to the consumer but not chosen. Thus weakly preference ae that choice of a bundle of goods among several available to the consumer means that i a nat shi prefer the bundle he chooses among the various alternative bundles available twee : fe likely, according to weakly preference hypothesis, that he may be indifferent .e chosen bundle and some other alternative bundles available to him. Assi ‘Cumptigns about Consumer Preferences. fie manaling consumer behaviour economists usually make some crucial assumptions about are 50 fundamen mite preferences. Some of these assumptions about consumer preferences following thre t they are referred to as ‘axioms’ of consumer theory. There are such assumptions made about consumer preferences. Compl ; aterm, ve ben According to this assumption, the consumer is capable of ranking Seeds a consumer nS goods for his consumption. This implies that between two bundles of Steen ther, This pak teen ea eee! he either prefers one bundle to another or is indifferent emer cannot Seren about consumer preferences rules out the possibility that the wee between an apple whieh bundle is preferable. For example, if a person is offered a cite a5 no preference, orange and he chooses the apple, it means he prefers the apple of them will leave Te would not care which fruit, apple or orange, is given to him since e him equally satisfied (that is, he will be indifferent between the two). s indifference between any two bundles of goods, it bundle (x1, x2) as the other bundle fers or is indifferent between prefers one basket (x, Xp) his revision of demand theory basedEconomic Theory about preferences of consumers js nsistent According to this, if a congy Band prefers the bundle B to another bung Similarly, if @ consumer is indifferent » preler then he will also Pt between bunt C, then he will also belinditerent ba tities 4 and Band Bele of transitivity oF ‘proerences implies that he cong bundles A and C. Thus. TT bundles of goods n & consistent ma act, trangil ible t ave i al. wei pis thatthe consumer behaviour is a mer retest i tion abou a is Better. The third assump! M r eer C smavingthe sre, ‘more of a commodity i5 beter than ess of it thats, mo fhe conm «pre less of it. This implies that the perso! ot a ci Pret ready consumed so much of the doc Te he is fully satiated, then the g ive hi satisfaction. Prrount of it would not give hima more / It may however he noted that there are some things for which less of them is pref to more They are called bads in economics. For example, pollution, smog, germs are and less of them is preferred to more. However, the standard economic neory does notd ah bade and explains consumer choice with regard to desirable combinations of good FE] N URVE APPROACH _ Indifference curve method has been evolved to supersede the cardinal utility ana demand which was discussed in the last chapter. The indifference curve method seeks to! all rules and laws abouLconsumer s demand that are derivable from the cardinal utility a At the same time the inventors and supporters of new method contend that their ana based on fewer and more reasonable assumptions. The indifference curve analysis has, retained some of the assumptions of Marshall's cardinal utility analysis. Thus, the indiffe curve approach, like the old cardinal utility approach, assumes that the consumer po 8 ‘complete information’ about all the relevant aspects of economic environment in finds himself. For example, the prices of goods, the markets in which they are available, satisfaction to be obtained from them efc. are all known to the consumer. Further, al ae cod ise ra eal nthe ante that, given the prices of goods and the gives him maximum satisfaction More rom amona the serious possible come a ‘over, the assumption of ‘continuity’ has also retained by Hicks-Allen indifference curve method. Continuity assumption means nsumers are capable of ordering or ranking all conceivable combinations of goods indamental approach of indifference curve analysis is that it has abandot cardinal utility and instead has adopted iietconccotte| ee finally. or he indference curves theory, uty i ey and tt a nce itative cardinal terms. In other words, utility being a a eS dhe. ‘The concept of cardinal utility, according eine i one wenry is perlote untenable. On the other hand, the aeeumption them, is quite reasonable and realistic. The ordinal utilit¥ in i le we simply ‘comparing the different 1 b era cer ing to the ordinal utility hypothesis, while the , J ene arnt of tities that he derives from comm i ind Ic Fae! le of judging whether the satisfaction obtaint js equal to, lower than, or higher than another. advanced ity. The secone ; bundles of goc ive bundle d assumption ads is CO} 136 (2) Transitl ference oveT alterna consumers’ pre! prefers bundle A 0 0 and ank allpreference and Indifference » theory of consumer's behaviour, itis sufficient to assume that the Jelerences consistently. Thus, the basis of indifference curve a hha preference-indifference hypothesis. This means that if the consumer is presented er of various combinations of goods, he can order or rank them according to his nai ces the various combinations are marked A,B C.D, E, etc. the consumer rere prefers Ato B, oF B10 A, oF is indifferent between them, Similarly, he can wh eference oF inference between any other pair of combinations. The concept inal utility implies that the consumer cannot go beyond stating his nce or indifference. In other words, if a consumer happens to prefer A to B, he ereitby how much he prefers A to B. Thus, under ordinal utility hypothesis, the consumer ome ell the ‘quantitative differences’ between various levels of satisfaction: he can simply cone em ‘qualitatively’, that is, he can merely judge whether one level of satisfaction is | 3 >| ~ & 2) a x Good X 87. inditerence Curves of Perfect Fig. 8.8. Indifference Curves of Substitutes Perfect Complements As will be seen in Fig. 8.8, the left-hand portion of an indifference curve of the perfect complementary goods is a vertical straight line which indicates that an infinite amount of Y is recessary to substitute one unit of X, and the right-hand portion of the indifference curve is a tonzontal straight line which means that an infinite amount of X is necessary to substitute one unt of Y. All this means that the two perfect complements are used in a certain fixed ratio and cznnot be substituted for each other. In Fig. 8.8 two perfect complements are consumed in the ”3¥ : 2Y. Complements are thus those goods which are used jointly in a fixed ratio in consumption so that their consumption increases or decreases simultaneously. Pen and ink, right shoe and left shoe, automobile and petrol, sauce and hamburger. type writer and typists are some examples of perfect complements. Utility Functions of Perfect Substitutes and Perfect Complements Perfect Substitutes. In general utility function of perfect substitutes can be written as Ulx, y) = ax + by ‘ where x and y are the quantities of two goods X and Y and a and b are some positive currbers that mezcure the values of goods to the consumer. The slope of indifference curve a Behe b een sooune! fs wilung 1 subside good X and Y at the rate of one-to-one, the utility n of the perfect substitute goods can be written as Uk, y)=xey a rence cures of sch sibsite goods uh one-one relationship in consumption ‘ng ae is uilling to accept two units of good Y to compensate him for the Good X, then utility function of these two perfect substitutes can be written as Ulx. y= 2x ty "resenting the above utility function of perfect substitutes is equal to -mi Foonontie Theory cae Oe \ ws vutluable to ti eens Uae ood hy 4 Is flee as De oe Diet ier teutility fanetion will have a stoyi Ser tlingy Sti ! ities OF Qo qoods in the afilily hanetion [Os res of the quantities of tue Yds Iso give us the following utilily tanetion of the pertect alsey give us the substity Uls, vd (vt vy lements. Now, how can we describe the utility function 6 two nisauches fl chon {right shoe. In case of lwo perlect complements, the cong s Ei iles tonto ing them. Therefore, in order (0 pow son ele Ba s \ person must have the minimum number of righ 2 10es, ° ther 8 the case of shoes, one right shoe and one left shoe cons ilule a a or wey *to-one relation between right shoe and left shoe. The utility funetig Plements with one-to-one relationship can be written as | u(x, v) = min (x, y) ple. if @ person has a bundle n can be written as of goods of 5 right shoes and 5 left sh ulx, v) = min (5, 5) I the person is provided with one More unit of right shoe, then his utility will not C @ left shoe is not available to him to make up the Pair for wearing. Therefore, shoe. keeping the number of left shoes remaining the same, will not cai the utility of the Person. Thus in this case utility function can be written as Ulx, ¥) = min (5, 5) = min (6, 5) nis relate to whe; cas s of compleme: complements, 'n general, the utiity 6 which are ‘goo! re Of it jig referre, less of Il undestrat, °S Which | Preferred to k “UPVES bey PX I the o ble object 112i. How, J “ ss war Are “goods” slope down" ele : : 18 ie aa Table to more p faction yy. COMModity ts aay in 2 case of 3 nu : his example Pollution) AS. init, ene S Work. ape yf @ Commodity which is Yoaxis, (pe tepreser Une. 5. ther,46 Adv - Theory Genera . lndicah " iva e ne ‘onomics have been derived in two ways: (1) Deductive Mey ve Metho le shall expla deductive method ol deriving «,.,. generalisations. The all first_explain the deductive method of derivir ‘© Principal steps in the process of deriving economic generalisations Through do, logic are: (a) perception of the problem to be enquired into; (b) defining precisely the ju,, terms and making appropriate assumptions, often called postulates or premises; (c) der, hypotheses, that is, deriving conclusions from the premises through the process of |, reasoning; i sis deduced. % perception of the problem is by no means an easy task (3 Defintion of Technical Terms and Making of Assumptions. The nx! sep process of deriving generalisations sS@elineipreeiselvand unambiguously the various tec terms to be used in the analysis as well as a makes As mentioned above, assumptions may be_behavio., AOUF of the e: ables or they may be tec rear pertaining to the bel are made on conomic vari the state of technolagy and the jactoPondouments. The SSNS : crucial assumption that has been made in econor, is that consumers try to maximise their satisfaction and producers try to maximise their proj: is assumed that investors try to minimise their risk and maximize the expected quiterealistic. The'actial economic world is quite complex and full of details in which num: factors play a part and act and interact on each other. The introduction of simplifying assumpt: is quite necessary in order to bring out the importance of really significant factors ha bearing on the problem under investigation. Aééording tol Prof. Bouldingy économie teal! and not a perfect picture of it. To q= him, “Just as we do not expecf a map to show every tree, every blade of grass in a landscen so we should not expect economic analysis to take into account every detail and quirk of economic behaviour.” ! It, therefore, follows that each and every assumption made by a theory may nc realistic. The crucial factor in building up a valid theory is whether its predictions are corrobo® by the facts in the world. A correct scientific theory or generalisation must be expressed it” form of a hypothesis that is conceivably refutable. As mentioned above, Professor Friedm his now well-known article, “The Methodology of Positive Economics” has expressed the that undue importance should not be given to the ‘realism’ of assumptions. What matiers™ bed ite viewpoint of scientific theory, according to him, is whether it enables us to pr accurately {ec 2adutina Huvotheves through Logial Deduction, The next ste in deriv generalisation Through deductive logic i mn ' phenomenon (mmi@@! This logical reasoning fay Né carried out Verbally or it may be conducted in sy"