Slutsky Equation

ECON201- MICROECONOMICS
Spring 2024
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Demand Functions: Comparative statics analysis
• the study of how ordinary demands x1*(p1, p2, m) and x2*(p1, p2, m) change as prices (p1,
p2) and income (m) change.

LAST LECTURE:
• Question 1: how does x1*(p1, p2, m) change with m (while p1, p2 are fixed)?
• Question 2: how does x1*(p1, p2, m) change with p1 (while m, p2 are fixed)?
• Question 3: how does x1*(p1, p2, m) change with p2 (while m, p1 are fixed)?

TODAY:
• How to decompose the effect of price changes on demand?

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Recall from the last lecture:
• Effect of income changes: Normal vs. Inferior goods
• Effect of own-price changes: Ordinary vs. Giffen goods

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Effects of a Price Change
• What happens when a commodity’s price decreases?

4
Effects of a Price Change
• What happens when a commodity’s price decreases?
• Substitution effect: the commodity is relatively cheaper, so consumers
substitute it for now relatively more-expensive other commodities.

5
Effects of a Price Change
• What happens when a commodity’s price decreases?
• Substitution effect: the commodity is relatively cheaper, so consumers
substitute it for now relatively more-expensive other commodities.
• Income effect: the consumer’s budget of $m can purchase more than
before, as if the consumer’s income rose, with consequent income effects
on quantities demanded.
• Slutsky discovered that changes to demand from a price change are
always the sum of a pure substitution effect and an income effect.

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Effects of a Price Change

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Effects of a Price Change

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Pure Substitution Effect
• “What is the change in demand when the consumer’s income is
adjusted so that, at the new prices, she can only just buy the original
bundle?”

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Pure Substitution Effect Only

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Pure Substitution Effect Only

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Pure Substitution Effect Only

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Pure Substitution Effect Only

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And Now the Income Effect

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And Now the Income Effect

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The Overall Change in Demand

A
B
C

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Income & Substitution Effects: Cobb-Douglas utility function
• Two goods (n=2)
• 𝑝! = 9 , 𝑝" = 1 , 𝑚 = 72
• 𝑢 𝑥! , 𝑥" = 𝑥! 𝑥"
• Find the income and substitution effects when 𝑝! decreases to 4.

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Income & Substitution Effects: Cobb-Douglas utility function
• Two goods (n=2)
• 𝑝! = 9 , 𝑝" = 1 , 𝑚 = 72
• 𝑢 𝑥! , 𝑥" = 𝑥! 𝑥"
• Find the income and substitution effects for 𝑥! when 𝑝! decreases
to 4.
$ $
• We know the optimal bundle is 𝑥!∗ , 𝑥"∗ =( , ). Hence:
"%! "%"

𝑝! 𝑝𝟐 𝑚 𝑥! 𝑥#
A 9 1 72 4 36
B 4 1 72 9 36

18
Income & Substitution Effects: Cobb-Douglas utility function
• Find an income 𝑚& such that the consumer at the new prices can
buy the original bundle.

• In other words, find 𝑚& such that it is equal to the expenditure

𝑝!' 𝑥!( + 𝑝"' 𝑥"( = 4×4 + 1×36 = 52.

𝑝! 𝑝𝟐 𝑚 𝑥! 𝑥#
A 9 1 72 4 36
B 4 1 72 9 36
C 4 1 52

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Income & Substitution Effects: Cobb-Douglas utility function
• Then find Find 𝑥 $ , 𝑦 $ in the usual way

𝑝! 𝑝𝟐 𝑚 𝑥! 𝑥#
A 9 1 72 4 36
B 4 1 72 9 36
C 4 1 52 6.5 28

• The price effect is 𝑥%& − 𝑥%' = 9 − 4 = 5

• The substitution effect is 𝑥%$ − 𝑥%' = 6.5 − 4 = 2.5
• The income effect is 𝑥%& − 𝑥%$ = 9 − 6.5 = 2.5
Note price effect is substitution effect plus income effect since:
𝑥%& − 𝑥%' = 𝑥%$ − 𝑥%' + (𝑥%& − 𝑥%$ )

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Income & Substitution Effects: Perfect complementary preferences
• Two goods (n=2)
• 𝑝! > 0 , 𝑝" > 0 , 𝑚 > 0
• 𝑢 𝑥! , 𝑥" = min{𝑥! , 𝑥" }
• Suppose 𝑝! decreases. Can you compute the substitution effect?

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Income & Substitution Effects: Perfect Complements Preferences

• Zero Substitution Effect.

• The change in demand is

entirely due to the income effect.

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Income & Substitution Effects: Perfect Substitutes Preferences

• Zero Income Effect.

• The change in demand is

entirely due to the substitution
effect.

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The Total Change in Demand
• Suppose the optimal bundle given 𝑝! , 𝑝" and 𝑚 is
(𝑥! (𝑝! , 𝑚), 𝑥" (𝑝! , 𝑚)). The notation 𝑝" is suppressed here because
we assumed it is constant to focus on the effect of 𝑝! .
• Suppose 𝑝! changes to 𝑝!) holding 𝑝" and 𝑚 constant.
• The total change in demand Δ𝑥! due to this change is:
Δ𝑥! = 𝑥! (𝑝!) , 𝑚)- 𝑥! (𝑝! , 𝑚)
• We have seen this change can be broken to substitution and income
effect:
Δ𝑥! = Δ𝑥!* + Δ𝑥!+
= [𝑥! (𝑝!) , 𝑚′)- 𝑥! (𝑝! , 𝑚)] + [𝑥! (𝑝!) , 𝑚)− 𝑥! (𝑝!) , 𝑚′)]
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The Total Change in Demand
• This equation is called Slutsky identity. Δ𝑥!* denotes the substation
effect and Δ𝑥!+ denotes the income effect.
• Recall that 𝑚′ is the income that will just make the original optimal
bundle just affordable:
𝑚) = 𝑝!) 𝑥! (𝑝! , 𝑚) + 𝑝" 𝑥" (𝑝! , 𝑚)
• Moreover, 𝑚 = 𝑝! 𝑥! (𝑝! , 𝑚) + 𝑝" 𝑥" (𝑝! , 𝑚).
𝑚) − 𝑚 = 𝑥! (𝑝! , 𝑚) 𝑝!) − 𝑝!
Δ𝑚 = 𝑥! (𝑝! , 𝑚)Δ𝑝!
where Δ𝑝! = (𝑝!) − 𝑝! ).

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The Slutsky Equation
• For convenience define Δ𝑥!$ = −Δ𝑥!+ = [𝑥! (𝑝!) , 𝑚′)− 𝑥! (𝑝!) , 𝑚)]
• Hence,
Δ𝑥! = Δ𝑥!* + Δ𝑥!+
= Δ𝑥!* − Δ𝑥!$
• If we divide each side of the identity by Δ𝑝! we have
,-! ,-!# ,-!$
= −
,%! ,%! ,%!
• Recall Δ𝑚 = 𝑥! (𝑝! , 𝑚)Δ𝑝! . Hence,
,-! ,-!# ,-!$
,%!
= ,% − ,$
𝑥! (𝑝! , 𝑚)
!
• This is called the Slutsky Equation.

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Slutsky’s Effects
• What are the signs of substitution and income effects?

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Slutsky’s Effects
• What are the signs of substitution and income effects?
• Substitution effect: moves always opposite to the price movement
• If the price decreases, it must always be positive: a lower price leads to
higher demand

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Slutsky’s Effects
• What are the signs of substitution and income effects?
• Substitution effect: moves always opposite to the price movement
• If the price decreases, it must always be positive: a lower price leads to
higher demand
• Income effect: ambiguous
• Does demand go up or down with income?
• Inferior good --> negative
• Normal good --> positive
• What about the total effect?

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Slutsky’s Effects for Normal Goods
• 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.

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Slutsky’s Effects for Normal Goods

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Slutsky’s Effects for Normal Goods
• Price decrease for a normal good:
• Substitution effect: a lower price leads to higher demand
• Income effect: higher purchasing power leads to higher demand
()! ()!" ()!#
• Hence, (+ = (+!
− (, 𝑥% 𝑝%, 𝑚 < 0
!

• Price increase for a normal good:

• Substitution effect: a higher price leads to lower demand
• Income effect: lower purchasing power leads to lower demand
()! ()!" ()!#
• Hence, (+ = (+!
− (, 𝑥%(𝑝%, 𝑚) <0
!

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Slutsky’s Effects for Normal Goods
• Since both the substitution and income effects increase demand
when own price falls, a normal good’s ordinary demand curve slopes
down.

The law of downward-sloping demand always applies to normal goods

• Law of Demand: If demand for a good increases when income

increases, then the demand for that good must decrease when its
price increases.

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Slutsky’s Effects for Inferior Goods
• Some goods are income-inferior (i.e., demand is reduced by higher
income).
• The substitution and income effects oppose each other when an
income-inferior good’s own price changes.

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Slutsky’s Effects for Inferior Goods

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Slutsky’s Effects for Inferior Goods

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Slutsky’s Effects for Inferior Goods

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Slutsky’s Effects for Inferior Goods

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Giffen Goods
• In rare cases of extreme income-inferiority, the income effect may
be larger in size than the substitution effect, causing quantity
demanded to fall as own price rises.
• Such goods are Giffen goods.

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Slutsky’s Effects for Giffen Goods

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Slutsky’s Effects for Giffen Goods
• Slutsky’s decomposition explains why the law of downward-sloping
demand is not satisfied for extremely income inferior goods.

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Giffen vs. Non-Giffen Goods: Slutsky’s Effects

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Hicks Substitution Effect
• Slutsky substitution effect: adjust the income so that the original
bundle is affordable at the new prices (i.e., keeping the purchasing
power constant)
• Hicks substitution effect: keeps utility constant despite the price
change

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Hicks Substitution Effect

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Income & Substitution Effects: Cobb-Douglas utility function
• Two goods (n=2)
• 𝑝! = 9 , 𝑝" = 1 , 𝑚 = 72
• 𝑢 𝑥! , 𝑥" = 𝑥! 𝑥"
• Find the income and Hicks substitution effects when 𝑝! decreases to
4.

45
Income & Substitution Effects: Cobb-Douglas utility function
• Two goods (n=2)
• 𝑝! = 9 , 𝑝" = 1 , 𝑚 = 72
• 𝑢 𝑥! , 𝑥" = 𝑥! 𝑥"
• Find the income and substitution effects for 𝑥! when 𝑝! decreases
to 4.
$ $
• We know the optimal bundle is 𝑥!∗ , 𝑥"∗ =( , ). Hence:
"%! "%"

𝑝! 𝑝𝟐 𝑚 𝑥! 𝑥# 𝑢
A 9 1 72 4 36 144
B 4 1 72 9 36 324

46
Income & Substitution Effects: Cobb-Douglas utility function
• Find income 𝑚& which generates old utility at new prices
• In other words, find 𝑚/ such that 𝑢 ( is the maximum value of 𝑥! 𝑥"
subject to 𝑝!' 𝑥! + 𝑝"' 𝑥" = 𝑚& .

𝑝! 𝑝𝟐 𝑚 𝑥! 𝑥# 𝑢
A 9 1 72 4 36 144
B 4 1 72 9 36 324
C 4 1 144

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Income & Substitution Effects: Cobb-Douglas utility function
• Find 𝑚& by
𝑚& " (
= 𝑢
4𝑝!' 𝑝"'
which is equivalent to
𝑚& "
= 144 ⇒ 𝑚& = 48
4×4×1
𝑝! 𝑝𝟐 𝑚 𝑥! 𝑥# 𝑢
A 9 1 72 4 36 144
B 4 1 72 9 36 324
C 4 1 48 144

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Income & Substitution Effects: Cobb-Douglas utility function
• Find 𝑥 & , 𝑦 & in usual way
𝑝! 𝑝𝟐 𝑚 𝑥! 𝑥# 𝑢
A 9 1 72 4 36 144
B 4 1 72 9 36 324
C 4 1 48 6 24 144

• The price effect is 𝑥!' − 𝑥!( = 9 − 4 = 5

• The substitution effect is 𝑥!& − 𝑥!( = 6 − 4 = 2
• The income effect is 𝑥!' − 𝑥!& = 9 − 6 = 3
Note price effect is substitution effect plus income effect since:
𝑥!' − 𝑥!( = 𝑥!& − 𝑥!( + (𝑥!' − 𝑥!& )
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