MICROECONOMICS: DEMAND

FUNCTIONS, ELASTICITIES,
SLUTSKY (HICKSIAN + SLUTSKY
DECOMPOSITIONS)
DEMAND FUNCTIONS
 Marshallian Demand Functions can be derived from the consumer
utility maximisation problem.
 They express the quantity demanded (of good X) as a function of
prices and income:
 X* = x(Px, Py, M)
 The graphical interpretation (the demand curve) holds other prices and income
constant (stemming from it’s derivation):
X *  x( Px, Py, M )
 They are HOMOGENOUS OF DEGREE 0, which means that there
is no money illusion on the part of the consumer.
 Hicksian Demand Functions are a subset of Marshallian Demand
Functions; they only show the substitution effect (discussed later).
 They express the quantity demanded as a function of prices and
UTILITY:
 X* = xh(Px, Py, U)
 The graphical interpretation holds other prices and utility constant:

X *  x( Px, Py, U )
COMPARISON OF HICKSIAN AND
MARSHALLIAN DEMAND CURVES FOR
NORMAL GOODS
 Hicksian demand curves are Px
steeper than Marshallian
X *  x( Px, Py,U )
curves for normal goods.
 This is because, below the
intersection point, the
individual’s income is
reduced under the
Hicksian (compensated) X *  x( Px, Py, M )
curve, so less is demanded
than under the Marshallian
equivalent.
XH XM X
INCOME AND SUBSTITUTION EFFECTS
 Income Effect: The effect Y
on consumption of a good
due to a change in real
income.
 Shown by x’’  x’ U’
 Substitution Effect: The
effect on consumption of a
good due to a change in
relative prices.
 Shown by x  x’’
 The diagram shows a RISE U
in the price of ‘X’ – the
budget line swings inwards
and we fall onto a lower
utility level.
x’ x’’ x X
NORMAL, INFERIOR AND GIFFEN
GOODS
 Normal Good: xi  0
I Downward-sloping demand curves
 Inferior Good: xi
0
I
 Giffen Good: A special case of inferior good, where the
income effect outweighs the substitution effect: As
PRICE FALLS, so does X. Conversely, as PRICE
RISES, so does X  Upward sloping demand curve.
DISTINCTION BETWEEN HICKSIAN DEMAND
CURVES AND CONSTANT PURCHASING
POWER DEMAND CURVES
Y Y

Goes through Tangential to

original bundle original Utility

U U
U’ U’

X X
Constant Purchasing Power: Hicksian:
Budget Line adjusted such that you can Budget Line adjusted such that you are on
afford the ORIGINAL BUNDLE. the ORIGINAL UTILITY LEVEL.
ELASTICITIES
 Elasticity is the responsiveness of some variable to a
change in another variable. The common ones are:
 Own-Price-Elasticity of Demand:

%X X Px
 X , Px   
%Px Px of
 Cross-Price-Elasticity X Demand:

%X X Py
 X , Py   
%Py of
 Income-Elasticity PyDemand:
X

%X X M
 X ,M   
%M M X
HAVING FUN WITH ELASTICITIES
 Homogeneity:
 The sum of the Own-Price Elasticity, Cross-Price
Elasticity and the Income Elasticity of Demand will give
the degree of homogeneity of the good.
 Therefore, for a demand function you would expect the
sum to equal to zero, that is:

 X , Px   X , Py   X , M  0
THE SLUTSKY EQUATION – HICKSIAN
SUBSTITUTION EFFECT
 The Slutsky equation shows the overall change in
consumption arising from a price change:
 dx/dPx = Substitution Effect + Income Effect
 The Substitution effect is simply the change in
consumption at a given utility level: x H  x
Px Px U

 The Income effect is as given: x E x

   x
E Px M
 Therefore, putting it all together:

x x H x
  x
Px Px U M
SLUTSKY EQUATION
 The reason we can make the simplification to the substitution
effect equation, is because of SHEPHARD’S LEMMA.
 dE/dPi = Xhi
 Differentiating the expenditure function wrt the price of the
good will give the Hicksian demand function for that good.
 In the Slutsky equation we can use the Marshallian demand
function due to not holding utility constant (substituting in U
– see final slide).
 Using the Slutsky Equation we can therefore mathematically
decompose a price change into substitution and income
effects.
 Therefore we can see the relative magnitudes (and signs) of
each effect and deduce whether it is a normal, inferior or
Giffen good.
 SLUTSKY SUBSTITUTION EFFECT:
 ΔXs = X(Px’,M’) – X(Px,M)
 The change in demand due to the substitution effect
= demand at NEW prices and altered income so as to
keep purchasing power constant (budget line goes
through original bundle) – original prices and
income.
 SLUTSKY INCOME EFFECT:
 ΔXn = X(Px’,M) – X(Px’,M’)
 The change in demand due to the income effect =
demand at NEW prices and old income (i.e., on
pivoted budget line) – demand at new prices and on
altered income (as above).
 ΔX= ΔXs + ΔXn: The Slutsky identity
 On next slide
 U’
Y

U’’
U

X(Px,M) X(Px’,M’) X(Px’,M) X

Sub. Effect Inc. Effect

SLUTSKY EQUATION TO SHOW CROSS-
PRICE EFFECTS
 The equivalent Slutsky Equation for two goods is:

x x H x
  y
Py Py U M
 The difference between GROSS and NET substitutes/complement
goods can be examined using this.
 GROSS relations focus on the overall change in consumption due to
a change in prices.
 Gross Complements: dx/dPy < 0
 Gross Substitutes: dx/dPy > 0
 Asymmetry problems; due to the income effect, x could be a complement of ‘y’
but y may not necessarily be a complement of x.
 NET relations focus only on the substitution effect, and thus avoid
asymmetry problems.
 Net Complements: dx/dPy | U < 0
 Net Substitutes: dx/dPy | U > 0
SLUTSKY AND ELASTICITY
 Slutsky Equations can also be written in Elasticity form:
 OWN-PRICE SLUTSKY EQUATION:

ex , Px  ex c , P  S x  ex , M
 Where ‘Sx’ is the share of
x total income spent on ‘x’.

 CROSS-PRICE SLUTSKY EQUATION

ex , Py  ex c , P  S y  ex , M
y
 APPENDIX: INTERCONNECTION BETWEEN
HICKSIAN AND MARSHALLIAN DEMAND
FUNCTIONS.

Marshallian : xi*  x( P1 ,..., Pn , M )

Hicksian : xih  x( P1 ,..., Pn ,U )
Expenditure Function : M  E ( P1 ,..., Pn , U )
Indirect Utility Function : U  V ( P1 ,..., Pn , M )
 xi*  x( P1 ,..., Pn , M )  x( P1 ,..., Pn , [ E ( P1 ,..., Pn ,U )])  x( P1 ,..., Pn , U )  xih
 xih  x( P1 ,..., Pn ,U )  x( P1 ,..., Pn , [V ( P1 ,..., Pn , M )])  x( P1 ,..., Pn , M )  xi*

 Hence, Marshallian and Hicksian demand functions are

EQUIVALENT due to DUALITY.