Annals of Dunarea de Jos University of Galati

Fascicle I 2010. Economics and Applied Informatics. Years XVI no 2 - ISSN 1584-0409

The Substitution and the Revenue Effects for a

Cobb-Douglas Utility Function

Catalin Angelo IOAN

catalin_angelo_ioan@univ-danubius.ro
Gina IOAN
ginaioan@univ-danubius.ro
Danubius University, Galati

Abstract
In the consumers theory, a crucial problem is to determine the substitution effect and
the revenue effect in the case of one good prices modifing. There exists two theories due
to John Richard Hicks and Eugen Slutsky which allocates differents shares of the total
change of the consumption to these effects. The paper makes an analysis between the
two effects, considering the general case of a Cobb-Douglas utility function and
introduces three indicators which will characterize these shares.
Keywords: Cobb-Douglas, substitution, revenue, utility
JEL Code: D11

1. Introduction
In the consumers theory, a crucial problem is to determine the substitution effect and the revenue
effect in the case of one good prices modifing. The theory due to John Richard Hicks consider after
a modifing of a price, first a new allocation of goods preserving the utility, but modifing the
revenue and after taking into account that the revenue is the initial one the changing in allocation
due to a different utility. The theory of Eugen Slutsky consider a combined displacement of the
relative consuming obtained (in the case of Cobb-Douglas utility function) a share of the
substitution effect or of revenue effect depoending only from the parameters of the utility. The
problem is to determine these shares for both methods and to inquire which effect is uppermost.

In section 2, we determine first, the quantities for the desired equilibrium for two initial prices.
After that, we find the intermediate quantities due to the Hicks effect and after to the Slutsky effect
in the case of one good price change. In both cases, we compute the absolute inceasing of the
quantity for each good and after the share from the total consumption change for the second good
due to the substitution effect, the share from the total consumption change for second good due to
the revenue effect and the ratio between the revenue effect and the substitution effect.

In section 3, after the preceding analysis, we find that if the price of a good decreases, the share
from the total consumption change due to the substitution effect is higher in the case of Slutsky
than in the hicksian case and the share from the total consumption change due to the revenue effect
is smaller in the case of Slutsky than in the hicksian case. Also, we obtain that the ratio between the
revenue effect and the substitution effect is higher in the hicksian case than in the slutskian.

If the price of the good increases, the share from the total consumption change due to the
substitution effect is smaller in the case of Slutsky than in the hicksian case and the share from the
total consumption change for Y due to the revenue effect is higher in the case of Slutsky than in the
hicksian case. Also, the ratio between the revenue effect and the substitution effect is smaller in the
hicksian case than in the slutskian.

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Fascicle I 2010. Economics and Applied Informatics. Years XVI no 2 - ISSN 1584-0409

2. The analysis
Let two goods A and B with the initial prices p A and p B and an utility function of a Cobb-Douglas
type U=TXY, ,>0, where X and Y are the consumed quantities in order to obtain an utility U.
Let also, at a given time, V the consumers revenue.

In order to have the maximum utility for the revenue V it is known that we must have:
U mA p A
=
U mB p B
V = p A X + p B Y
-1 -1
where UmA=TX Y and UmB=TX Y are the marginal utilities corresponding to the two goods
A and B respectively.

After soving the system of equations, we have therefore:

X 1 = ( + )p V
A

Y1 = V
( + )p B
and the corresponding utility is:


U1= TX 1 Y1 = T V V = TV + .
( + )p A ( + )p B ( + ) + p A

pB

Let suppose now that it is a change in the price of one of the goods, let say B, from p B to p'B , but
the revenue V remains constant. We have, from the upper relations:

X 3 = ( + )p V
A

Y3 = V
( + )p'B

and the corresponding utility: U3= TV + .
( + ) + p A

p'B
We shall apply now the Hicks method for our analysis.

At the modify of the price of B, for the same utility U1= TV + we shall have:
( + ) + p A

pB

U1= TV' + therefore:
( + ) + p A

p'B

TV + = TV' +
( + ) + p A

pB ( + ) + p A

p'B
from where:
p'B
V' + = V +
pB
or, more simply:

p' +
V' = V B
pB
With the new revenue, we obtain:

X 2 H = ( + )p V'
A

Y2 H = V'
( + )p'B
or, in terms of the prices:

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Fascicle I 2010. Economics and Applied Informatics. Years XVI no 2 - ISSN 1584-0409

p'B +
X 2 H = ( + )p p V
A B


p'B +
Y2 H = V
( + )p B p B
The substitution effect (which preserves the utility) gives us a difference:

p'B +
1HX=X2H-X1=
1 V
( + )pA pB



p'B +

1HY=Y2H-Y1= 1 V
( + )p B
pB

The difference caused by the revenue V instead V is therefore:

p'B +
2HX=X3-X2H= 1 V
( + )pA p B


p'B +
2HY=Y3-Y2H= 1 V
( + )p'B p B

named the revenue effect.

We shall apply now the Slutsky method for our analysis.

At the modify of the price of B, the revenue for the same optimal combination of goods is:
V p'
V' = p A X 1 + p'B Y1 = pA V + p'B V= + B
( + )pA ( + )p B + pB
therefore:

X 2 S = ( + )p V'
A

Y2 S = V'
( + )p'B
or:
p'
X 2 S = + B V

2
( + ) p A p B

Y = p'
+ B V
2S 2
( + ) p'B p B

and the corresponding utility:

p' p'
U2= TX 2 S Y2S = T + B V + B V =
( + ) 2 p pB ( + )2 p' pB
A B
+
p'
T 2( + )
V + + B
( + ) pA p'B pB

The substitution effect after Slusky (which not preserves the utility) gives us a difference:
p'
B 1
p
1SX=X2S-X1= B 2 V
( + ) p A

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Fascicle I 2010. Economics and Applied Informatics. Years XVI no 2 - ISSN 1584-0409

p'
1 B
pB
1SY=Y2S-Y1= 2 V
( + ) p'B
and the revenue effect (after Slutsky):
p'
1 B
pB
2SX=X3-X2S= 2 V
( + ) p A
p'
2 1 B
pB
2SY=Y3-Y2S= 2
V
( + ) p'B
We shall define, in what follows, the ratio:
Y Y1
Y= 2 - the share from the total consumption change for Y due to the substitution effect;
Y3 Y1
Y Y2
Y= 3 - the share from the total consumption change for Y due to the revenue effect;
Y3 Y1
Y Y2
rY= Y = 3 - the ratio between the revenue effect and the substitution effect.
Y Y2 Y1
1 1
We have obviously: Y+Y=1 and rY= 1= .
Y 1
1
Y
In case of Hicks, we have:

p'B + p'B

1H Y p B pB
YH= =
1H Y + 2 H Y p'
1 B
pB

p' +
1 B
YH=
2HY
= pB
1H Y + 2 H Y p'
1 B
pB

p' +
1 B
rYH=
YH
= pB

YH
p'B + p'B

pB pB
In case of Slutsky, we have:
1S Y
YS= =
1S Y + 2 S Y +
2S Y
YS= =
1S Y + 2 S Y +
YS
rYS= =
YS
p'
Let note now x= B - the ratio between the new and the old price of Y and we suppose for non-
pB
triviality that x1.

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 Annals of Dunarea de Jos University of Galati
Fascicle I 2010. Economics and Applied Informatics. Years XVI no 2 - ISSN 1584-0409

x + x 1 x + 1 x +
In hicksian case, we have: YH= , YH= , rYH= .
1x 1x
+
x x

x + x
Let the function f:(0,1)(1,)R, f(x)= .
1x

1 +
We have: f ' ( x ) =
+ xx .
+ +
2 +
(1 x ) x


The function g(x)= + x x + has g' ( x ) = 1 x + therefore for x(0,1) g
+ + +

decreases and for x(1,) g will increases. But g(1)=0 implies that g(x)>0 x(0,1)(1,).

We have therefore that f ' ( x ) >0 which means that f is an increasing function.

Because lim f ( x ) =0, lim f ( x ) = and lim f ( x ) =1 we have that:
x 0 x 1 + x

for x(0,1) we shall have: YH 0 , and for x(1,): YH ,1 .
+ +
Because YH=1-YH we have therefore:

for x(0,1) we shall have: YH ,1 and for x(1,): YH 0 , .
+ +
1 + 1 +
Now, for x(0,1) we shall have: , and for x(1,): 1, .
YH YH

Finally we get: for x(0,1): rYH , and for x(1,): rYH 0 , .


1 x + x 1
Also, rYH=1 is equivalent with: YH= therefore: = or:
2 1x 2

+
2x x1=0

+
Let now the function h:(0,1)(1,)R, h(x)= 2 x x 1.
+

2
+ 2
We have: h ' ( x ) = x 1 therefore the root of the derivative is xd= . But
+ +

lim h' ( x ) =, lim h' ( x ) = and lim h' ( x ) =-1 implies the following cases:
x 0 x 1 + x

if < we have that: xd>1 and h ' ( x ) >0 for x(0,1), x(1,xd) h ' ( x ) >0 and x(xd,) h ' ( x ) <0;
if > we have that: xd<1 and h ' ( x ) >0 for x(0,xd), x(xd,1) h ' ( x ) <0 and x(1,) h ' ( x ) <0.
Because lim h( x ) =-1, lim h( x ) =0, lim h( x ) =- we obtain that:
x 0 x 1 x
if <: the only root of h is in the interval: (xd,);
if >: the only root of h is in the interval: (0,xd)
2 +
2
+
We have now that h" ( x) = 2
x <0 therefore h is concave.
( + )
For the determination now of the real root x of h, we shall apply the Newton method of
approximation for functions of one variable. Because the starting point x0 for a function h:[a,b]R,
who maintains the monotony and the concavity is those for which h(x0) h" ( x 0 ) >0 and at us
h" ( x 0 ) <0 for any x0, we must choose x0 such that h(x0)<0.

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Fascicle I 2010. Economics and Applied Informatics. Years XVI no 2 - ISSN 1584-0409

We have now, from the Newtons method:

2 +
1 xn
h( x n ) 2 x n +
xn 1 +
(1) xn+1=xn- = xn
=
, n0
h' ( x n ) 2 + 2 +
xn 1 xn 1
+ +
where for <: x0 is sufficiently large and for >: x0 is sufficienlty small.

Like a conclusion, because rYH is a decreasing function, we have that:

for <: if x(0,1)(1, x ) rYH>1 and if x( x ,) then rYH<1;
for >: if x(0, x ) rYH>1 and if x( x ,1)(1,) rYH<1.

In the figure 1, we have on the horizontal axis the values of and on vertical axis the value of x for
which rYH=1 in the case of a Cobb-Douglas function with constant return to scale (+=1)

Figure 1. The chart of the roots x for which rYH=1 in the case of a Cobb-Douglas function with
constant return to scale (+=1)

Figure 2. The evolution of YH for =0,4 in the case of a Cobb-Douglas function with constant
return to scale (+=1)

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 Annals of Dunarea de Jos University of Galati
Fascicle I 2010. Economics and Applied Informatics. Years XVI no 2 - ISSN 1584-0409

Figure 3. The evolution of YH for =0,4 in the case of a Cobb-Douglas function with constant
return to scale (+=1)

Figure 4. The evolution of rYH for =0,4 in the case of a Cobb-Douglas function with constant return
to scale (+=1)
3. Conclusion
For x<1 we have that YH<YS that is the share from the total consumption change for Y due to the
substitution effect is higher in the case of Slutsky than in the hicksian case and, of course YH>YS
that is the share from the total consumption change for Y due to the revenue effect is smaller in the
case of Slutsky than in the hicksian case. Because rYH>rYS we have that the ratio between the
revenue effect and the substitution effect is higher in the hicksian case than in the slutskian.

For x>1 we have that YH>YS that is the share from the total consumption change for Y due to the
substitution effect is smaller in the case of Slutsky than in the hicksian case. In this case we have
YH<YS that is the share from the total consumption change for Y due to the revenue effect is
higher in the case of Slutsky than in the hicksian case. Because rYH<rYS we have that the ratio
between the revenue effect and the substitution effect is smaller in the hicksian case than in the
slutskian.

Also:
for <: if x> x >1 then the revenue effect is less than the substitution effect and for the other
cases we have the opposite conclusion;
for >: if x< x <1 then the substitution effect is less than the revenue effect and for the other
cases we have the opposite conclusion.

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Fascicle I 2010. Economics and Applied Informatics. Years XVI no 2 - ISSN 1584-0409

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