Slutsky Equation

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.
 Effects of a Price Change
– Income effect: the consumer’s
budget of $y can purchase more
than before, as if the consumer’s
income rose, with consequent
income effects on quantities
demanded.
 Effects of a Price Change
Consumer’s budget is $y.
x2
y Original choice
p2

x1
 Effects of a Price Change
Consumer’s budget is $y.
x2
Lower price for commodity 1
y pivots the constraint outwards.
p2

x1
 Effects of a Price Change
Consumer’s budget is $y.
x2
Lower price for commodity 1
y pivots the constraint outwards.
p2 Now only $y’ are needed to buy the
y' original bundle at the new prices,
p2 as if the consumer’s income has
increased by $y - $y’.

x1
 Effects of a Price Change
Changes to quantities demanded due
to this ‘extra’ income are the income
effect of the price change.
 Effects of a Price Change
Slutsky discovered that changes to
demand from a price change are
always the sum of a pure
substitution effect and an income
effect.
 Real Income Changes
Slutsky asserted that if, at the new
prices,
– less income is needed to buy the
original bundle then “real income”
is increased
– more income is needed to buy the
original bundle then “real income”
is decreased
 Real Income Changes
x2

Original budget constraint and choice

x1
 Real Income Changes
x2

Original budget constraint and choice

New budget constraint

x1
 Real Income Changes
x2

Original budget constraint and choice

New budget constraint; real
income has risen

x1
 Real Income Changes
x2

Original budget constraint and choice

x1
 Real Income Changes
x2

Original budget constraint and choice

New budget constraint

x1
 Real Income Changes
x2

Original budget constraint and choice

New budget constraint; real
income has fallen

x1
 Pure Substitution Effect
Slutsky isolated the change in
demand due only to the change in
relative prices by asking “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?”
 Pure Substitution Effect Only
x2

x2’

x 1’ x1
 Pure Substitution Effect Only
x2

x2’

x 1’ x1
 Pure Substitution Effect Only
x2

x2’

x 1’ x1
 Pure Substitution Effect Only
x2

x2’

x2’’

x 1’ x1’’ x1
 Pure Substitution Effect Only
x2

x2’

x2’’

x 1’ x1’’ x1
 Pure Substitution Effect Only
x2 Lower p1 makes good 1 relatively
cheaper and causes a substitution
from good 2 to good 1.
x2’

x2’’

x 1’ x1’’ x1
 Pure Substitution Effect Only
x2 Lower p1 makes good 1 relatively
cheaper and causes a substitution
from good 2 to good 1.
(x1’,x2’) → (x1’’,x2’’) is the
x2’
pure substitution effect.
x2’’

x 1’ x1’’ x1
 And Now The Income Effect
x2

x2’ (x1’’’,x2’’’)

x2’’

x 1’ x1’’ x1
 And Now The Income Effect
x2 The income effect is
(x1’’,x2’’) → (x1’’’,x2’’’).

x2’ (x1’’’,x2’’’)

x2’’

x 1’ x1’’ x1
The Overall Change in Demand
x2 The change to demand due to
lower p1 is the sum of the
income and substitution effects,
(x1’,x2’) → (x1’’’,x2’’’).
x2’ (x1’’’,x2’’’)

x2’’

x 1’ x1’’ x1
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.
Slutsky’s Effects for Normal Goods
x2 Good 1 is normal because
higher income increases
demand

x2’ (x1’’’,x2’’’)

x2’’

x 1’ x1’’ x1
Slutsky’s Effects for Normal Goods
x2 Good 1 is normal because
higher income increases
demand, so the income
and substitution
x2’ (x1’’’,x2’’’) effects reinforce
each other.
x2’’

x 1’ x1’’ x1
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 therefore always applies to
normal goods.
Slutsky’s Effects for Income-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.
Slutsky’s Effects for Income-Inferior
Goods
x2

x2’

x 1’ x1
Slutsky’s Effects for Income-Inferior
Goods
x2

x2’

x 1’ x1
Slutsky’s Effects for Income-Inferior
Goods
x2

x2’

x 1’ x1
Slutsky’s Effects for Income-Inferior
Goods
x2

x2’

x2’’

x 1’ x1’’ x1
Slutsky’s Effects for Income-Inferior
Goods
x2
The pure substitution effect is as for
a normal good. But, ….

x2’

x2’’

x 1’ x1’’ x1
Slutsky’s Effects for Income-Inferior
Goods
x2 The pure substitution effect is as for a
normal good. But, the income effect is
in the opposite direction.
(x1’’’,x2’’’)
x2’

x2’’

x 1’ x1’’ x1
Slutsky’s Effects for Income-Inferior
Goods
x2 The pure substitution effect is as for a
normal good. But, the income effect is
in the opposite direction. Good 1 is
(x1’’’,x2’’’) income-inferior
x2’ because an
increase to income
x2’’ causes demand to
fall.

x 1’ x1’’ x1
Slutsky’s Effects for Income-Inferior
Goods
x2
The overall changes to demand are
the sums of the substitution and
(x ’’’,x ’’’) income effects.
1 2
x2’

x2’’

x 1’ x1’’ x1
 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
rise as own-price rises.
Such goods are Giffen goods.
Slutsky’s Effects for Giffen Goods
x2 A decrease in p1 causes
quantity demanded of
good 1 to fall.

x 2’

x 1’ x1
Slutsky’s Effects for Giffen Goods
x2 A decrease in p1 causes
quantity demanded of
good 1 to fall.
x2’’’

x 2’

x1’’’ x1’ x1
Slutsky’s Effects for Giffen Goods
x2 A decrease in p1 causes
quantity demanded of
good 1 to fall.
x2’’’

x 2’

x2’’
x1’’’ x1’ x1’’ x1
Substitution effect
Income effect
 Slutsky’s Effects for Giffen
Goods
Slutsky’s decomposition of the effect
of a price change into a pure
substitution effect and an income
effect thus explains why the Law of
Downward-Sloping Demand is
violated for extremely income-
inferior goods.