Chapter Eight

Slutsky’s Equation
 Effects of a Price Change
 What happens when the price of a
commodity decreases?
 First, the commodity becomes
relatively cheaper, so consumers
substitute towards it and away from
now relatively more expensive other
commodities. This is the
substitution effect of the price
change.
 Effects of a Price Change
 Second, the consumer’s budget of $y
can purchase larger bundles than
before. It is as if the consumer
received an increase in income.
 The consequent changes in
quantities demanded are the income
effects of the price change.
 Effects of a Price Change
Consumer’s budget is $y.
x2
y Original choice
p2

x1
 Effects of a Price Change
Consumer’s budget is $y.
x2
Lowered price for commodity 1
y pivots outwards the budget constraint.
p2

x1
 Effects of a Price Change
Consumer’s budget is $y.
x2
Lowered price for commodity 1
y pivots outwards the budget constraint.
p2 Now only $y’ are needed to buy the
y' original bundle at the new prices. It is
p2 as if the consumer’s income has
increased by $y - $y’.

x1
 Effects of a Price Change
 The change to quantities demanded
due to this ‘extra’ income is the
income effect of the price change.
 Effects of a Price Change
 Slutsky’s insight was that the effects on
quantities demanded of any price change
can always be decomposed into a pure
substitution effect and an income effect.
 The overall change in quantities
demanded due to a price change is the
sum of the substitution and income
effects.
 Pure Substitution Effect
 Slutsky isolated the change in
quantities demanded due only to the
change in relative prices by asking
“What is the change in quantities
demanded when the consumer’s
income is adjusted so that, at the
new prices, she can only just buy the
original bundle?”
 Pure Substitution Effect Only
x2

x2 ’

x1’ x1
 Pure Substitution Effect Only
x2

x2 ’

x1’ x1
 Pure Substitution Effect Only
x2

x2 ’

x1’ x1
 Pure Substitution Effect Only
x2 Lowering p1 makes good 1 relatively
cheaper and causes a substitution
from good 2 to good 1. The change
x2 ’ from (x1’,x2’) to (x1’’,x2’’) is the
pure substitution effect.
x2’’

x1’ x1’’ x1
 And Now The Income Effect
x2 The income effect is the change
from (x1’’,x2’’) to (x1’’’,x2’’’).

x2 ’ (x1’’’,x2’’’)

x2’’

x1’ x1’’ x1
The Overall Change in Demand
x2 The overall effect on demands
of the change in p1 is the sum
of the income and substitution
x2 ’ (x1’’’,x2’’’) effects. This is the
change from
x2’’ (x1’,x2’) to (x1’’’,x2’’’).

x1’ x1’’ x1
Slutsky’s Effects for Normal Goods
x2 Good 1 is normal because an
increase to income causes
demand to rise.

x2 ’ (x1’’’,x2’’’)

x2’’

x1’ x1’’ x1
Slutsky’s Effects for Normal Goods
x2 Good 1 is normal because an
increase to income causes
demand to rise. So the income
and substitution
x2 ’ (x1’’’,x2’’’) effects reinforce
each other.
x2’’

x1’ x1’’ x1
Slutsky’s Effects for Normal Goods

 Since both the substitution and

income effects increase demand
when own-price decreases, the
ordinary demand curve for a normal
good must slope downwards.
 The Law of Downward-Sloping
Demand therefore always applies to
normal goods.
Slutsky’s Effects for Income-Inferior
Goods
 Some goods are income-inferior; that
is, demand is reduced by an increase
in income.
 Slutsky showed that, for income-
inferior goods, the substitution and
income effects oppose each other
when a good’s own price changes.
Slutsky’s Effects for Income-Inferior
Goods
x2
The pure substitution effect is as for
a normal good. But, ….

x2 ’

x2’’

x1’ x1’’ x1
Slutsky’s Effects for Income-Inferior
Goods
x2 The pure substitution effect is as for a
normal good. But, the income effect is
in the opposite direction.
(x1’’’,x2’’’)
x2 ’

x2’’

x1’ x1’’ x1
Slutsky’s Effects for Income-Inferior
Goods
x2 The pure substitution effect is as for a
normal good. But, the income effect is
in the opposite direction. Good 1 is
(x1’’’,x2’’’) income-inferior
x2 ’ because an
increase to income
x2’’ causes demand to
fall.

x1’ x1’’ x1
Slutsky’s Effects for Income-Inferior
Goods
x2
The overall changes to demand are
the sums of the substitution and
(x ’’’,x ’’’) income effects.
1 2
x2 ’

x2’’

x1’ x1’’ x1
 Giffen Goods
 In the rare case of extreme income-
inferiority, the income effect may be
larger in size than the substitution
effect, causing quantity demanded to
decrease as own-price decreases.
 Such goods are called Giffen goods.
Slutsky’s Effects for Giffen Goods
x2 A decrease in p1 causes a
decrease in the quantity
demanded of good 1.

x2’

x 1’ x1
Slutsky’s Effects for Giffen Goods
x2 A decrease in p1 causes a
decrease in the quantity
demanded of good 1.
x2’’’

x2’

x1’’’ x1’ x1
Slutsky’s Effects for Giffen Goods
x2 A decrease in p1 causes a
decrease in the quantity
demanded of good 1.
x2’’’

x2’

x2’’
x1’’’ x1’ x1’’ x1
Substitution effect
Income effect
 Slutsky’s Effects for Giffen
Goods
 Slutsky’s 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.