THE SLUTSKY EQUATION

LECTURE TWO.

LECTURE OBJECTIVES

At the end of the lecture, the learner should be able to:

Derive and demonstrate slutsky equation.

Determine the Substitution effect, the income effect and the total change.
Derive and demonstrate Hicks Substitution effect.

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economic environment. So far, the prices of the goods and the income are the common variables
in the consumer economic environment.

The EET 100 an exposure is done on how the optimal choice by a consumer changes due to
changes in both prices and income. In this case, we consider a detailed analysis of how a
anges in its price.

When the price of a good changes, there are two types of effects, the rate at which one can
exchange one good for another changes, and the total purchasing power of income changes.
These two changes in the consumer demand for the goods.

The change in demand due to the change in the rate of exchange between the goods is called the
substitution effect. While the change in demand due to changes in the purchasing power is
called income effect. To give a more precise definition, let us consider the two effects separately
and in details.

The substitution effect

To capture the SE, we let the relative prices to change due to a price change and adjust money
income so as to hold pursing power constant.

Using the following diagram:

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Good 2

Shift

Suppose the price of good 1 falls, this means that the budget line rotates around the vertical

intercept and becomes flatter. This movement of the budget line can be broken into two
2

steps:

1. Pivot the budget line around the original demanded bundle and then,
2. Shift the pivoted line out to the new demanded bundle.

The pivot is a movement where the slope of the budget line changes while its purchasing power
remains constant, while a shift is a movement where the slope of the BL remains constant while
the purchasing power changes.

These two movements give a convenient way to decompose the change in demand into two
places. This decomposition is only hypothetical and the consumer simply observes a change in

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price and chooses a new bundle of goods in response. In analysing how the choice
changes it is useful to think of the budget line changing in two stages (i) pivot and (ii) shift.

Considering the pivot, the pivoted budget line has the same slope and thus the same relative
prices as the final budget line. However, the money income associated with this budget line is
different since the vertical intercept are different.

Since the original consumption bundle lies on the pivoted BL, that consumption is just
affordable. In this sense, the purchasing power of the consumer has remained constant in the
sense that the original bundle of goods is just affordable at the new pivoted line. That is after the
price of good 1 falls, income must have been adjusted so as to make the original bundle just
affordable at a change in relative prices.

Suppose the original prices for goods 1 and 2 are P1 and P2 respectively and M is the original
income. Let M1 be the amount of money income that will just make the original consumption
bundle affordable this will be the amount of money income associated with the pivoted budget
line.

Since is affordable at both and

Where 1 is the new fallen price of good 1, then we have

M ' P1' X 1 P2 X 2
M P1 X 1 P2 X 2

Subtracting the two equations

'
1 1 1

That is, the change in money income necessary to make the old bundle affordable at the new
price is just the original amount of consumption of good 1 times the change in prices.

Let P1 P1' P1 . Represent the change in price.

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 . Represent the change in income necessary to make the old bundle just
affordable.

Then:

NOTE: The change in income and the changes in price will always move in the same direction:
if the price goes up, then we have to raise income to keep the same bundle affordable.

Although is still affordable, it is not generally the optimal purchase at the pivoted
budget line. The optimal purchase on the pivoted budget line is

Bundle Y is the optimal one, when we change the price and adjust income so as to keep the old
bundle of goods just affordable. The movement from X and Y is known as SE. It indicates how

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the consumer substitutes one good for the other, when the price changes while adjusting income

More precisely, the SE X 1 is the change in the demand for good 1, when the price of good 1
changes to P1 ' from and at the same time, money income changes from M to

X 1S X 1 P1' M ' X 1 P1 M

The SE is sometimes called the change in compensated demand. The idea is that the consumer is
being compensated for a price change by having his/her income adjusted accordingly, if the price

amount of a good affordable at a higher price and vice versa.

For example:

Mathematically

Suppose that the consumer has a demand function for good x of the form.

Let his original income be Kshs.120 per day and let the price of good X be Ksh.3 per unit. Thus
the demand for good X per day is:

Suppose the price of good X falls to Ksh.2 per unit. His new demand at his new price would be

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The total change in demand is increased by 2 units of good X per day. In order to calculate the
SE, we must first calculate by now much income would have to change in order to make the
original demand of 14 units just affordable when the price is Ksh.2 per unit.

Recall that:

M X 1 P1
14 2 3
14

The level of income necessary to keep purchasing power constant is:

The consumer demand at the new price of Kshs.2 and the new income level of Ksh. 106 is.

'
1

Thus the SE is

X 1S X P1' M ' X P1 M

The Income Effect

We have so far considered the pivot of the budget line, the second stage of the price adjustment
is the shift movement.

A parallel shift of the budget line is the movement that occurs when income changes while
relative prices remain constant. Thus the second stage of the price adjustment is called the
income effect. It is a change of the consumers income from M1 back to M1 keeping the prices
constant at 1 2 . In the last diagram this change moves from the point Y to Z. It is natural to

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call this last movement the income effect since all we are doing is changing income while
keeping the prices fixed at the new prices.

Precisely, the income effect is the change in the demand for good 1 when the income

changes from to M holding the price of good 1 fixed at

X 1n X 1 P1' M X 1 P1' M '

Recall from EET 100, that income effect of a price change can operate either way. It will tend to
increase or decrease the demand for good 1 depending on whether good 1 is Normal or Inferior.

When the price of a good decreases the income also decreases in order to keep purchasing power
constant. If the good is normal, then this decrease in income will lead to a decrease in demand.
If the good is inferior, then the decrease in income will lead to an increase in demand.

For example

X P1' M X 2,120 16
X P1' M ' X 2,106 15.3

Thus

Since the demand for good X here increases when income increases, then good X is normal.

The Sign of the Substitution Effect

Consider (last diagram ) where the amount of good 1 consumed is less that at the bundle X and Y
were both affordable at the old prices 1 2 but they were not purchased. Instead, the bundle x
was purchased. If the consumer is always choosing the best bundle he/she can afford, then X

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must be preferred to all of the bundles on the part of the pivoted budgetline that lies inside the
original budget set.

That is, the optimal choice on the pivoted budgetline must not be one of the bundles that has
underneath the original budgetline. The optimal choice on the pivoted line would have to be
either X or some point to the right of X. But this means that the new optimal choice must
involve consuming at least as much as good 1 as originally just as we wanted to show. In the
(diag.) the optimal choice at the pivoted budgetline is the bundle Y, which certainly involves
consuming more of good 1 than at the original consumption point X.

The substitution effect always moves opposite to the price movement. It is said to be always
negative, since the change in demand due to the SE is opposite to the change in price. If the
price increases, the demand for the good due to the SE decreases.

The Total Change

The total change in demand is X 1 , is the change in demand due to the change in price, holding
income constant:

X1 X 1 P1' M X 1 P1 M

We have already seen that, this total change can be split into two effects, the substitution effect
and and the income effect

That is

X1 X 1S X 1N

Hence

X 1 P1' M X 1 P1 M X 1 P1' M X 1 P1 M X 1 P1' M X 1 P1' M '

These equations say that the total change in demand equals the substitution effect plus the
for all values of ,M

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and . The first and the fourth terms on the RHS cancel out, so the RHS is identically equal to
the LHS.

y. The content comes in the interpretation

of the two terms on the RHS, the substitution effect and the income effect. In particular, the
signs of the income and substitution effect can be used to determine the sign of the total effect,
which in turn reveals the type of a good in question. That is, the total effect reveals whether a
good is normal, inferior or giffen.

When the SE must always be negative (opposite to the change in price) the income effect can go
either way thus, the total effect maybe positive or negative.

i) Normal Good

If a good is normal, the substitution effect and the income effect work in the same direction. An
increase in the price will mean that demand will go down due to the SE. If the price goes up, i.e.
a decrease in income, which for a normal good means a decrease demand. Both effects reinforce
each other. In terms of our notations, the change in demand due to a price increase means that

ii) Inferior good

On the other hand, if we have an inferior good, the income effect is positive. A fall in price for
example is like an increase in income. an increase in income would reduce the demand for an
inferior good.

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However, the second term on the RHS the income effect the first term of the right hand side.
The total change is therefore negative. This would mean that a fall in price results to an increase
in demand.

iii) Giffen good,

For a giffen good, the second term on the RHS income effect is positive but large enough that
the total change could be positive. This would mean that a fall in price would result to a fall in
demand.

S n
1 1 1

A fall in price and increased the consumer purchasing power such that, the consumer has reduced
his/her consumption of the inferior good.
effect can only occur for inferior goods. If the good is normal, then the income and substtituion

Thus a giffen good must be inferior. But an inferior good is not necessarily a giffen good. The

to outweigh the right sign of the substitution effect. This is why giffen goods are so rarely
observed in real life; they would not only have to be inferior goods, but they would have to be
too inferior.

Income and Substitution Effects for Other Preferences.

A similar analysis could be done for other preferences. A similar analysis could be done for
particular kinds of preferences and decompose the demand changes.

a) perfect compliments:- The slutsky decomposition is shown below:

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When the budgetline pivots around the chosen bundles the optimal choice at the new budgetline
is the same as at the original one this means that the substitution effect is zero. The change in
demand is entirel due to the income effect.

b) Perfect substitutes

In this case, when the budgetline tilts, the demand bundle moves from the vertical axis to the
horizontal axis. There is no shifting and the entire change in demand is due to the substitution
effect. This is show as:

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THE HICKS SUBSTITUTION EFFECT

The substitution effect is the name that economists give to the change in demand when prices

Suppose that instead of pivoting the budgetline around the original consumption bundle, the
budgetline is rolled around the indifference curve through the original consumption bundle as
shown.

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The budgetline is pivoted around the indifference curve rather than around the original choice
i.e., the consumers purchasing power will no longer be sufficient to purchase his/her original
bundle of goods, but will be sufficient to purchase a bund that is just indifferent to his/her
original bundle.

Thus the substitution effect keeps the utility level constant rather than keeping the purchasing
power constant. This SE is called the Hicks SE.

The Slutsky substitution effect gives the consumer just enough money to get back his/her
original level of consumption while the Hicks SE gives the consumer just enough money to get
back to his/her original difference curve.

Despite the difference in definition, it turns out that the Hicks SE must be negative in the sense
that it is a direction opposite that of the price change just like the Slutsky SE.

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