Demand
Marshallian and Hicksian Demand
Income and Substitution Effects
Slutsky Decomposition: Slutsky Equation
Hicksian Decomposition
Deriving Marshallian Demand
• Deriving the Marshallian Demand for Good 1, 𝑥1
• Marshallian demand comes from the Utility
Maximization problem.
• Let us see how the optimal demand varies as 𝑝1
changes.
• Assume 𝑝2 𝑎𝑛𝑑 𝑀 𝑡𝑜 𝑏𝑒 𝑓𝑖𝑥𝑒𝑑.
• As 𝑝1 decreases, the budget line expands along
the x-axis
• Generating a relationship between 𝑝1 and
𝑥1 , we get the demand for 𝑥1 .
ഥ
• 𝑥1𝑚 = x(𝑝1 , 𝑝2 , 𝑀).
• Ordinary and uncompensated demand curve for
𝑥1
Deriving Hicksian Demand
• Deriving the Hicksian Demand for Good 1, 𝑥1
• Hicksian demand comes from the
Expenditure minimizing problem.
• Let us see how the optimal demand varies as
𝑝1 changes.
• 𝑝2 𝑎𝑛𝑑 𝑢ത 𝑓𝑖𝑥𝑒𝑑,
• As 𝑝1 decreases, with 𝑢ത 𝑓𝑖𝑥𝑒𝑑, we can trace
out the new optimal point
• Generating a relationship between 𝑝1 and
𝑥1 , we get the demand for 𝑥1 .
• 𝑥1ℎ = x(𝑝1 , 𝑝2 , 𝑢ത ).
• compensated demand curve for 𝑥1
Marshallian and Hicksian Demand Curves
Price decrease
Px
P0 x
P1 x x DM
DH
X0 X1H X1M Qx
Marshallian and Hicksian Demand Curves
• The Hicksian demand is steeper. The Hicksian demand has only
substitution effect.
• The Marshallian demand has both substitution and income effect.
• Marshallian demand is more responsive… suggesting more elastic
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑡𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
(own)Price Elasticity demand =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
𝑑𝑞 𝑝
𝜀𝑝 =
𝑑𝑝 𝑞
Duality of Marshallian and Hicksian Demand Curves
• They intersect at one point.
The Marshallian demand = Hicksian demand curve i.e.
ഥ = 𝑥1ℎ when 𝑀
x(𝑝1 , 𝑝2 , 𝑀) ഥ = e (𝑝1 , 𝑝2 , 𝑢ത )
Marshallian demand for a given level of income will be identical to the quantity
demanded calculated using a Hicksian demand for the utility level that has been
achieved by the choices made using the values obtained by Marshallian demands.
• Symmetrically,
The Hicksian demand = Marshallian demand curve i.e. x(𝑝1 , 𝑝2 , 𝑢ത )= 𝑥1𝑚 when
ഥ
𝑢ത = v (𝑝1 , 𝑝2 , 𝑀)
• Given a set of prices, the quantity demanded calculated using a Hicksian demand for
a fixed utility level will be identical to the quantity demanded calculated using a
Marshallian demand if income is the minimum expenditure needed to remain at that
fixed utility.
Equivalence of Marshallian and Hicksian Demand
• Example for Cobb-Douglas: 𝑈 𝑥1 , 𝑥2 = 𝑥11/2 𝑥21/2 = 𝑥1 𝑥2
Consider the Utility maximization problem
Max 𝑈 𝑥1 , 𝑥2 = 𝑥11/2 𝑥21/2 s.t. 𝑝1 𝑥1 + 𝑝2 𝑥2 =M
Solving this will yield the following Marshallian demands and Indirect utility
functions
𝑚 𝑀 𝑚 𝑀
𝑥1 = and 𝑥2 =
2𝑝1 2𝑝2
𝑀 𝑀 𝑀
v ഥ
(𝑝1 , 𝑝2 , 𝑀) = =
2𝑝1 2𝑝2 2 𝑝1 𝑝2
Equivalence of Marshallian and Hicksian Demand
• Example for Cobb-Douglas: 𝑈 𝑥1 , 𝑥2 = 𝑥11/2 𝑥21/2 = 𝑥1 𝑥2
Now consider the Expenditure minimizing problem
ഥ
Minimize Min 𝑝1 𝑥1 + 𝑝2 𝑥2 s.t 𝑈 𝑥1 , 𝑥2 = 𝑥11/2 𝑥21/2 ≥ 𝑈
1 1
ഥ
L= 𝑝1 𝑥1 + 𝑝2 𝑥2 -𝜆(𝑥1 2 𝑥2 2 − 𝑈)
Solving this will yield the following Hicksian (uncompensated) demands and
expenditure function
𝑝2 𝑝1
𝑥1 ℎ ഥ
=𝑈 𝑎𝑛𝑑 𝑥2 ℎ ഥ
=𝑈
𝑝1 𝑝2
ഥ 1/2 1/2 ഥ 𝑝1 𝑝2
𝐞(𝑝1 , 𝑝2 , 𝑈) = 2 𝑈𝑝1 𝑝2 = 2 𝑈
Equivalence of Marshallian and Hicksian Demand
𝑀
• 𝑥1 = ℎ
𝑥1𝑚 ഥ=
when 𝑈 i. e. ഥ
𝑢ത = v (𝑝1 , 𝑝2 , 𝑀)
2 𝑝1 𝑝2
𝑝2 𝑀 𝑝2 𝑀
• 𝑥1 ℎ ഥ
=𝑈 = =
𝑝1 2 𝑝1 𝑝2 𝑝1 2𝑝1
Symmetrically
ഥ 𝑝1 𝑝2 i. e 𝑀
𝑥1𝑚 = 𝑥1 ℎ when M = 2 𝑈 ഥ = e (𝑝1 , 𝑝2 , 𝑢ത )
𝑀 2 𝑈ഥ 𝑝1 𝑝2
ഥ 𝑝2
𝑥1𝑚 = = =𝑈
2𝑝1 2𝑝1 𝑝1
The same holds true for 𝑥2
Equivalence of Marshallian and Hicksian Demand
• Example 2
• Quasilinear utility , Consider the utility function 𝑢 𝑥, 𝑦 = 2𝑥 + 𝑦.
You will find that
• There is no income effect for good y. y is a neutral commodity.
• After solving the primal and the dual….use duality to arrive at the
Equivalence of Marshallian and Hicksian Demand
Effect of a change in Income
• Suppose there are two goods X and Y. And income of the consumer is I.
• As Income (I), increases demand for X increases
𝜕𝑋
• >0
𝜕𝐼
• As income increases from I1 to I2 to I3, the optimal (utility-maximizing)
choices of x and y are shown by the successively higher points of tangency
• X is a normal good
Effect of a change in Income
• Suppose there are two goods y and z. And income of the consumer is I.
• As Income increases demand for Z decreases
𝜕𝑧
• <0
𝜕𝐼
• Good z is inferior because the quantity
purchased decreases as income increases
• Z is an inferior good
Effect of a change in Price
• Suppose there are two goods x and y. And income of the consumer is I.
• Suppose price of x decreases
𝜕𝑥
• <0
𝜕𝑝𝑥
• Good x is superior because the quantity
purchased increases as price of x decreases
• X is a superior good
Effect of a change in Price
• Suppose price of x decreases
𝜕𝑝𝑥
• >0
𝜕𝑥
• The quantity purchased decrease
as price of x decreases
• Demand for X and price of X are
positively related
• X is a Giffen good
• Violate the basic law of demand
• Often a class of inferior goods
• These products are necessary to
fulfill the need for food, and they
have only a few substitutes
Slutsky Decomposition
Price Change: Income and Substitution
Effects
THE IMPACT OF A PRICE CHANGE
When the price of a good changes there are 2 effects!
1. The substitution effect involves the substitution of good x1
for good x2 or vice-versa due to a change in relative prices
of the two goods.
2. The income effect results from an increase or decrease in
the consumer’s real income or purchasing power as a
result of the price change.
The sum of these two effects is called the price effect/Total
effect.
THE IMPACT OF A PRICE CHANGE
The decomposition of the price effect into the
income and substitution effect can be done in
several ways
There are two main methods:
(i) The Slutsky method; and
(ii) The Hicksian method
THE SLUTSKY METHOD
Eugene Slutsky (1880-1948)
Russian economist expelled from the University of
Kiev for participating in student revolts.
In his 1915 paper, “On the theory of the Budget of
the Consumer” he introduced “Slutsky
Decomposition”.
Well known for the Slutsky Equation
THE SLUTSKY METHOD
X2 A fall in the price of X1
The budget line pivots
P * out from P
Ea
I1
xa X1
THE SLUTSKY METHOD
The new optimum is
X2
Eb on I2.
The Total Price
Effect is xa to xb
Eb
Ea I2
I1
xa xb X1
THE SLUTSKY METHOD
Slutsky claimed that if, at the new prices,
– less income is needed to buy the original bundle then
“real income” has increased
– more income is needed to buy the original bundle then
“real income” has decreased
Slutsky isolated the change in demand due only 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, s/he can just
afford to buy the original bundle?”
THE SLUTSKY METHOD
To isolate the substitution effect we adjust the
consumer’s money income so that s/he change
can just afford the original consumption bundle.
In other words, we are holding purchasing power
constant.
THE SLUTSKY METHOD
• Suppose you want to buy(afford)
X2 initial bundle at the new relative
price.
• Draw a budget line such that it
passes through the old bundle
but is parallel to the new budget
Eb line…reflecting new price ratio
Ea I2
I1
xa xb X1
THE SLUTSKY Method
Demand for x1 is
X2 M2 < M1
𝑥1 = 𝑥 𝑑 𝑝1 , 𝑝2 , 𝑀
𝑀1 = 𝑝1 𝑥1 + 𝑝2 𝑥2
Ea
xa
X1
𝑀2 = 𝑝1∗ 𝑥1 + 𝑝2 𝑥2
THE SLUTSKY METHOD
Draw a line parallel to the
X2
new budget line which
passes through the point Ea.
Eb
Ea I2
I1
xa xb X1
THE SLUTSKY METHOD
• The new optimum on I3 is at Ec
• My purchasing power is the same, but
X2 I prefer a new optimal point. This is
purely because of substitution effect
• The only difference between Ea and
Ec is the price of 𝑿𝟏
• The movement from Ea to Ec is the
Eb substitution effect
Ea I2 • The consumer will substitute 𝑿𝟐 for
Ec 𝑿𝟏 because 𝑿𝟏 is relatively cheaper.
I3
xa xc xb X1
THE SLUTSKY METHOD
The new optimum on I3 is
X2 at Ec. The movement from
Ea to Ec is the substitution
effect
Eb
Ea I2
Ec
I3
xa xc X1
Substitution Effect
THE SLUTSKY METHOD
The remainder of the total price
X2 effect is the Income Effect.
The movement from Ec to Eb.
Eb
Ea I2
Ec
I3
xc xb X1
Income Effect
THE SLUTSKY METHOD for NORMAL
GOODS
Total effect is Substitution plus income effect
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.
THE SLUTSKY METHOD for
NORMAL GOODS
The income and substitution
X2 effects reinforce each other.
Eb
Ea I2
Ec
I3
xa xc xb
X1
THE SLUTSKY METHOD for NORMAL
GOODS
Since both the substitution and income effects
increase demand when own-price falls, a normal
good’s ordinary demand curve slopes downwards.
The “Law” of Downward-Sloping Demand
therefore always applies to normal goods.
THE SLUTSKY METHOD: INFERIOR
GOODS
Some goods are (sometimes) inferior (i.e. demand
is reduced by higher income).
The substitution and income effects “oppose”
each other when an inferior good’s own price
changes.
THE SLUTSKY METHOD: INFERIOR
GOODS
The substitution effect is as per
X2 usual. But, the income effect is
in the opposite direction.
Eb
I2
Ea
Ec
I3
xa x b xc
X1
xa to xc
xc to xb
GIFFEN GOODS
In rare cases of extreme inferiority, the income
effect may be larger in size than the substitution
effect, causing quantity demanded to rise as own
price falls.
Such goods are Giffen goods.
Giffen goods are very inferior goods.
THE SLUTSKY METHOD for Giffen
Goods
In rare cases of extreme income-
X2 inferiority, the income effect may be
larger in size than the substitution
effect, causing quantity demanded to
Eb fall as own-price falls.
I2
Ea
Ec
I3
xb xa xc
xa to xc X1
xc to xb
Slutsky Equation
• Consider two goods, x and y
• Important relationship between Marshallian (uncompensated) and Hicksian
(compensated) demand
ഥ be an arbitrary utility level;
• Let 𝑼
𝑚 ഥ such that
ഥ be minimum expenditure required to obtain that 𝑼
𝑚 ഥ ) and 𝑢ത = v (𝒑𝒙 , 𝒑𝒚 , 𝑚)
ഥ = e(𝒑𝒙 , 𝒑𝒚 , 𝒖 ഥ
We already established the following through duality
xh (𝒑𝒙 , 𝒑𝒚 , 𝒖
ഥ )= x (𝒑𝒙 , 𝒑𝒚 , 𝒎
ഥ )= x (𝒑𝒙 , 𝒑𝒚 , e(𝒑𝒙 , 𝒑𝒚 , 𝒖
ഥ ))
ഥ ) is the ordinary or Marshallian demand)
(Note that x (𝒑𝒙 , 𝒑𝒚 , 𝒎
Slutsky Equation
• We want to know how demand changes when price changes
• Differentiate xh (𝑝𝑥 , 𝑝𝑦 , 𝑢ത )= x (𝑝𝑥 , 𝑝𝑦 , e(𝑝𝑥 , 𝑝𝑦 , 𝑢ത )) with respect to 𝑃𝑥
• ℎ 𝜕𝑥 𝜕𝑥 𝜕𝑥 𝜕𝑒
= + ⋅
𝜕𝑝𝑥 𝜕𝑝𝑥 𝜕𝑒 𝜕𝑝𝑥
( By implicit derivation rule. Intuition is when price changes the minimum expenditure to achieve uത will
change. Recall e(𝒑𝒙 , 𝒑𝒚 , 𝒖
ഥ ) = 𝑝𝑥 𝑥+ 𝑝𝑦 𝑦)
𝜕𝑥 𝜕𝑥 ℎ 𝜕𝑥 𝜕𝑒
Rearrange to find = − ⋅
𝜕𝑝𝑥 𝜕𝑝𝑥 𝜕𝑒 𝜕𝑝𝑥
• The substitution effect
• The first term: the slope of the Hicksian (compensated) demand curve. Changes in relative price
• The income effect
• The second term: measures the way in which changes in px affect the demand for x through changes
in purchasing power
The Slutsky equation
𝜕𝑥 ℎ 𝜕𝑥
substitution effect = = ቤ
𝜕𝑝𝑥 𝜕𝑝𝑥 𝑢ഥ=constant
𝜕𝑥 𝜕𝑒 𝜕𝑥 𝜕𝑒 ℎ
𝜕𝑥
income effect = − ⋅ = − ⋅ = −𝑥
𝜕𝑒 𝜕𝑝𝑥 𝜕𝑒 𝜕𝑝𝑥 𝜕𝑚
Why?
𝝏𝑒(𝑝,𝑢)
Because of Shephard’s Lemma = 𝒙𝒉𝒊 𝑝, 𝑢 … … . which will equal the Marshallian demand 𝑥 , if
𝝏𝒑𝒊
ഥ = e(𝒑𝒙 , 𝒑𝒚 , 𝒖
𝑚 ഥ ) and 𝑢
ത = v (𝒑𝒙 , 𝒑𝒚 , 𝑚)
ഥ
Slutsky equation: substitution effect + income effect
𝜕𝑥 𝜕𝑥 ℎ 𝜕𝑥
= −𝑥
𝜕𝑝𝑥 𝜕𝑝𝑥 𝜕𝑚
The Slutsky equation
• Example for Cobb-Douglas: 𝑈 𝑥1 , 𝑥2 = 𝑥11/2 𝑥21/2 = 𝑥1 𝑥2
• Solving the dual and primal we get,
𝑚 𝑀 𝑚 𝑀
𝑥1 = and 𝑥2 =
2𝑝1 2𝑝2
v ഥ = 𝑀
(𝑝1 , 𝑝2 , 𝑀)
𝑀
=
𝑀
2𝑝1 2𝑝2 2 𝑝1 𝑝2
𝑝2
𝑥1 ℎ ഥ
=𝑈
𝑝1
𝑝1
𝑥2 ℎ ഥ
=𝑈
𝑝2
ഥ 11/2 𝑝21/2 = 2 𝑈
𝐞(𝑝1 , 𝑝2 , 𝑈) = 2 𝑈𝑝 ഥ 𝑝1 𝑝2
The Slutsky equation
𝜕𝑥1
• The total effect of price change is 𝜕𝑝1
𝑀
• 𝑥1 = This is the ordinary or Marshallian demand
2𝑝1
𝜕𝑥1 −𝑀
=
𝜕𝑝1 2𝑝1 2
This is the price effect(Total effect)
𝜕𝑥 𝜕𝑥 ℎ 𝜕𝑥
The Slustky equation is: = − 𝑥
𝜕𝑝𝑥 𝜕𝑝𝑥 𝜕𝑚
𝜕𝑥1 ℎ
Substitution effect is given by
𝜕𝑝1
𝑝2 𝑝2 1/2
ഥ
𝑥1 ℎ = 𝑈 = ഥ 1/2
𝑈 This is the compensated demand function
𝑝1 𝑝1
The Slutsky equation
𝜕𝑥1 ℎ 𝑝2 1/2
=- ഥ
𝑈
𝜕𝑝1 2𝑝1 1.5
Because of duality, 𝑢ത = v (𝒑𝒙 , 𝒑𝒚 , 𝑚)
ഥ . Hence, we can plug the indirect
ഥ
utility instead of 𝑈
𝑀
ഥ =
v (𝑝1 , 𝑝2 , 𝑀)
2 𝑝1 𝑝2
𝜕𝑥1 ℎ 𝑝2 1/2 𝑀 𝑀
=- =- This is the substitution effect
𝜕𝑝1 2𝑝1 1.5 2 𝑝1 𝑝2 4𝑝1 2
What about income effect?
The Slutsky equation
𝜕𝑥1
What about income effecet , -𝑥1
𝜕𝑚
𝑀
𝑥1 =
2𝑝1
𝜕𝑥1 1
=
𝜕𝑚 2𝑝1
𝜕𝑥1 𝑀 1 𝑀
−𝑥1 =- ∗ =- ……..This is the income effect
𝜕𝑚 2𝑝1 2𝑝1 4𝑝1 2
Substitution effect + income effect
𝑀 𝑀 𝑀 𝜕𝑥1
- - =- =
4𝑝1 2 4𝑝1 2 2𝑝1 2 𝜕𝑝1
The Slutsky equation
• Numerical example: Suppose the utility function is 𝑢 𝑥, 𝑦 = 𝑥𝑦
𝑝𝑥 = $10 𝑎𝑛𝑑 𝑝𝑦 = $10 and M =$500
Find∗ the substitution and income effects if the price of x, 𝑝𝑥 decreases to $5
(𝑝𝑥 )
• Find initial optimal demand at 𝑝𝑥 = $10 𝑎𝑛𝑑 𝑝𝑦 = $10 and M =$500
• Find final optimal demand at 𝑝𝑥 ∗ = $5 𝑎𝑛𝑑 𝑝𝑦 = $10 and M =$500
• This is the total /price effect. To decompose
• Find optimal demand at new prices if consumer is to purchase old bundle at
new∗
price. Hence find income at new prices but affording old bundle, 𝑀2 =
𝑝𝑥 𝑥 + 𝑝2 𝑥2 =5𝑥+10y). Find optimal demand 𝑀2 . This will give you the
substitution effect
• Now determine SE and IE
• Check if Slutsky equation holds
• Question : Solve the same question when the utility function is 𝑢 𝑥, 𝑦 =
min(𝑥, 𝑦)
DECOMPOSITION of TOTAL PRICE EFFECT:
PERFECT COMPLEMENTS
X2 A fall in the price of X1
I1 I2 No substitution
effect
B New
Budget
Original Constraint
Budget A=C
Constraint
X1
Hicksian Method
THE HICKSIAN METHOD
Sir John R.Hicks (1904-1989)
Awarded the Nobel Laureate in Economics (with
Kenneth J. Arrrow) in 1972 for work on general
equilibrium theory and welfare economics.
THE HICKSIAN METHOD
X2 Optimal bundle is Ea, on
indifference curve I1.
Ea
I1
xa X1
THE HICKSIAN METHOD
X2 A fall in the price of X1
The budget line pivots
P * out from P
Ea
I1
xa X1
THE HICKSIAN METHOD
The new optimum is Eb on
X2
I 2.
The Total Price Effect is xa
to xb
Eb
Ea I2
I1
xa xb X1
THE HICKSIAN METHOD
To isolate the substitution effect we ask….
“what would the consumer’s optimal bundle be if s/he
faced the new lower price for X1 but experienced no
change in real income?”
This amounts to returning the consumer to the original
indifference curve (I1)
THE HICKSIAN METHOD
The new optimum is
X2
Eb on I2.
The Total Price
Effect is xa to xb
Eb
Ea I2
I1
xa xb X1
THE HICKSIAN METHOD
Ensure that the person gets the same level
X2 of utility 𝑰𝟏 but under the new price regime.
Draw a new budget line(dashed green) such
that it reflects the new relative price but is
tangent to 𝑰𝟏
Eb
Ea I2
I1
xa xb X1
THE HICKSIAN METHOD
Draw a line parallel to the new
X2 budget line and tangent to the old
indifference curve
Eb
Ea I2
I1
xa xb X1
THE HICKSIAN METHOD
The new optimum on I1 is at Ec. The
X2 movement from Ea to Ec (the increase
in quantity demanded from Xa to Xc) is
solely in response to a change in
relative prices
Eb
Ea I2
Ec I1
xa xc xb X1
THE HICKSIAN METHOD
This is the substitution effect.
X2
Eb
Ea I2
Ec
I1
X1
Xa Substitution Xc
Effect
THE HICKSIAN METHOD
To isolate the income effect …
Look at the remainder of the total price effect
This is due to a change in real income.
THE HICKSIAN METHOD
The remainder of the total effect
X2 is due to a change in real
income. The increase in real
income is evidenced by the
movement from I1 to I2
Eb
Ea I2
Ec
I1
X1
Xc Income Effect Xb
THE HICKSIAN METHOD
X2
Eb
Ea I2
Ec
I1
xa xc xb X1
Sub Income
Effect Effect
HICKSIAN ANALYSIS and DEMAND CURVES
P
A fall in price
M1 = p1 x1 + p2 x2
from p1 to p1*
B
AC
• Hicksian (compensated)
demand curves cannot be
M1 = p1 x1 + p2 x2
upward-sloping (i.e.
substitution effect cannot be
positive. P X1
• Inverse relationship. Price A Marshallian Demand
increase implies substitution P1
effect: Reduce x1)
Curve (A & B)
• Price decrease implies
substitution effect: increase B Hicksian Demand
P1* C
x1) Curve (A & C)
X1
