CEC 6101: •Socrates Majune
Advanced •skmajune@uonbi.ac.ke
Microeconomi •14/October/2024
cs Theory I
Order of presentation
• Recap
• Income and substitution effects
• Slutsky equation
• Examples
Income and substitution
effects
Income and
substitution effects:
Basics
• Income and substitution effects arises from
a change in prices
• Changing a price involves changing not
only the intercepts of the budget constraint
but also its slope
• This entails moving to a new utility-
maximizing choice entails not only moving
to another indifference curve but also
changing the MRS
Income
and
substitutio
n effects
Income and substitution effects:
Basics
• Substitution effect: Even if
the individual were to stay
on the same indifference
curve, consumption patterns
would be allocated to equate
the MRS to the new price
ratio
• Income effect: Arises
because a price change
necessarily changes an
individual’s “real” income.
The individual cannot stay on
the initial indifference curve
and must move to a new one
• Real income: the maximum number of units of
some commodity the consumer could acquire if he
Income and spent his entire money income
• It is intended to reflect the consumer’s total
substitution command over all resources by measuring his
potential command over a single real commodity
effects: Basics
• The substitution effect is sometimes called the
change in compensated demand
Representation of the
substitution and income
effects (Approach 1:
Hicksian decomposition)
Hicksian decomposition compensates
the consumer so that they remain on the
same level of utility/IC as before the
price change
Representation of the substitution and income
effects (Approach 2: Slutsky equation)
Hicksian and Marshallian Demand:
Normal good
Representation of the substitution and income
effects (Approach 2: Slutsky equation)
The slutsky effect keeps the consumer's
real income constant by compensating
them to afford the original bundle
Alternative
approach
17
Key Comparisons: Marshallian,
Hicksian and Slutsky
28
Some examples
Example 1
Example 2: Proving the Slutsky
equation for a Cobb-Douglas
function
Proving the Slutsky equation for a
Cobb-Douglas function
Example 3: quasi-linear utility
function
Example 3: CES utility function
Example 4
Example 5
