Microeconomics Analysis

LESSON # 21
The Slutsky Identity and Demand
Function
Microeconomics Analysis

Module # 81
Microeconomics Analysis

Consumer Behaviour
Consumer Behaviour

Consumer Choices
- The Slutsky Identity
- Considering demand function
X1 = ƒ(P1, P2,m)
How the demand is affected by ?
a) P1 change, holding P2 and m constant
b) m change, holding P2 and m constant
c) P2 change, holding P1 and m constant
 Consumer Behaviour
The Slutsky Identity
• The total change in demand, Δ X1
is the change in demand due to the change in price, holding
income constant:

• It can be broken up into two changes:

• The substitution effect ∆= -

• And the income effect. ∆= -

 Consumer Behaviour
The Slutsky Identity
• What will be the effect on quantity demanded of a good if price
increases?
• In particular, we can use what we know about the signs of the income
and substitution effects to determine the sign of the total effect.
• The substitution effect must always be negative—opposite the change in
the price
• The income effect can be positive (normal good) and negative (inferior
goods)
• Thus the total effect may be positive or negative.
 Consumer Behaviour
The Slutsky Identity for a Normal Good
• For a normal good, the substitution effect and the income effect work in the same
direction.
(a) A decrease in price (P1) results that
Price Demand Real income Reinforced
Demand
decreases increases increases total effect
increases

(b) An increase in price means that

Price Demand Real income Demand Reinforce

increases decreases decreases decreases total effect
 Consumer Behaviour
The Slutsky Identity for an inferior Good
• For an inferior good, the substitution effect and the income effect work in the opposite
direction.
(a) A decrease in price (P1) results that
Price Demand Real income Opposite
Demand
decreases decreases increases total effect
increases

(b) A decrease in price means that

Price Demand Real income Demand Reinforce

increases increases decreases decreases total effect
 Consumer Behaviour
The Slutsky Identity for a Giffen Good
- For a Giffen good, the SE and the IE work in the opposite direction .
- If the the income effect is large enough, outweighs the SE ,the total change in demand
could be positive. This would mean that an increase in price could result in an increase in
demand.
- Thus a Giffen good must be an inferior good. But an inferior good is not necessarily a
Giffen good
(a) A decrease in price (P1) results that
Demand Real income Opposite
Price decreases Demand
increases increases total effect
increases
(b) A decrease in price means that

Price increases Demand Real income Demand Reinforce

increases decreases decreases total effect
 Consumer Behaviour

Small
Large income Income
effect effect
Microeconomics Analysis

Module # 82
Microeconomics Analysis

Consumer Behaviour
Consumer Behaviour

Consumer Choices
- Marshallian demand function
(Concept)
 The function is named after
economist John Marshall who first
described it in 1884.
 A mathematical function that relates
the price of a good to the quantity
demanded of the good.
 “Shows quantities demanded for
different price levels, holding money
income constant”
Consumer Behaviour

Consumer Choices
- Marshallian demand function
(Concept)
 It is also known as the
Uncompensated demand curve
because it not incorporates the
effect of compensation
 The indirect utility in the Marshallian
approach is the amount of
happiness or satisfaction that a
person derives from consuming a
good minus the cost of that good
 Consumer Behaviour
Marshallian demand function (Concept)
 It is possible to solve the necessary conditions of a utility maximum
for the optimal levels of X1,X2,…,Xn can be expressed as functions
of all prices and income
 Mathematically, this can be expressed as n demand functions of the
form:
X1* = d1(P1,P2,…,Pn,I)

X2* = d2(P1,P2,…,Pn,I)
•
•
•
Xn* = dn(P1,P2,…,Pn,I)
 Consumer Behaviour
Marshallian demand function (Concept)
• If there are only two goods, x and y (the case we will usually be
concerned with), this notation can be simplified a bit as

• Once we know the form of these demand functions and

• The values of all prices and income,
• We can ‘‘predict’’ how much of each good this person will choose
to buy.
 Consumer Behaviour
- Marshallian demand function (Concept)
• Assume there are only two goods and that, as before, the demand
function for good x is given by:

• The demand curve derived from this function looks at the relationship
between x and Px while holding Py, I, and preferences constant.
• It shows the relationship

• Where the bars over py and I indicate that these determinants of demand
are being held constant.
• The reason Marshalian demand function is also called Partial equilibrium
Analysis Approach
Microeconomics Analysis

Module # 83
Microeconomics Analysis

Consumer Behaviour
Consumer Behaviour

Consumer Choices
- Marshallian demand function
(Derivation)
• A consumer’s ordinary demand function,
also known as the Marshallian demand
function, can be derived from the analysis
of utility-maximisation.
• The graph shows utility-maximizing
choices of x and y as this individual is
presented with successively lower prices
of good x (while holding py and I
constant).
• Except in the unusual case of Giffen’s
paradox, ∆x/∆Px is negative.
 Consumer Behaviour
Marshallian demand function (Derivation)
An individual’s demand for X1 depends on preferences, all
prices, and income:
X1* = d1(P1,P2,…,Pn,I)
It may be convenient to graph the individual’s demand for X1
assuming that income and the prices of other goods are held
constant
Consumer Behaviour
Consumer Behaviour
 Consumer Behaviour

Quantity of Y As the price PX

of X falls...

…quantity of X

demanded rises.
PX1

PX2

PX3

U3
U2 dX
U1

X1 X2 X3 X1 X2 X3
Quantity of X Quantity of X
I = PX1 + PY I = PX2 + PY I = PX3 + PY
 Consumer Behaviour
Derivation of the Demand Curve
(Normal Goods)
• When price of X falls , budget line
pivots outwards
• The optimal consumption
combination is e1 on indifference
Derivation of the Demand Curve: Neutral
curve Goodsthe consumer
U1 at which
now increases consumption of
good X from OX to OX1 units.
• The Price Consumption Curve
(PCC) is rising upwards.
Consumer Behaviour

Derivation of the Demand Curve

(Inferior Good)
• When price of X falls , budget line
pivots outwards
• The optimal consumption
combination is e1 on indifference
curve U1 at which the consumer
now reduces consumption of good
X as good x is inferior.
• The Price Consumption Curve
(PCC) is rising upwards and
bending backwards towards the Y-
axis.
 Consumer Behaviour
Derivation of the Demand Curve
(Neutral Good)
• When price of X falls , budget line
pivots outwards
• The optimal consumption
The optimal consumption combination is e1 on indifference curve U1 at which the consumer buys same OX units of good X as it is
combination is e1 on indifference
a neutral good. The Price Consumption Curve (PCC) is a vertical straight line.
curve U1 at which the consumer
buys same OX units of good X as it
is a neutral good.
• The Price Consumption Curve (PCC)
is a vertical straight line
 Consumer Behaviour
Marshallian demand function (Mathematical Derivation)
The individual’s objective is to maximize

Utility = U(x1,x2,…,xn)

where ; consumer is having goods 1,2,3…n

subject to the budget constraint

I = p1x1 + p2x2 +…+ pnxn

Set up the Lagrangian:

ℒ = U(x1,x2,…,xn) + λ(I - p1x1 - p2x2 -…- pnxn)

 Consumer Behaviour
Marshallian demand function (Derivation)
We derive (n+1) first-order conditions for an interior maximum

∂ℒ/∂x1 = ∂U/∂x1 - λp1 = 0

∂ℒ /∂x2 = ∂U/∂x2 - λp2 = 0

…
∂ℒ /∂xn = ∂U/∂xn - λpn = 0

∂ℒ /∂λ= I - p1x1 - p2x2 - … - pnxn = 0

 Consumer Behaviour
Marshallian demand function (Derivation)
U / xi pi
  MRS (xi for x j )
U / x j pj

U / x1 U / x2 U / xn

   ... 
p1 p2 pn
U / xi
pi  , for every i


• This shows the economic valuation of the commodity ,

• How much the consumer is willing to pay for the additional unit of
this commodity
• Substituting into the budget constraint, we can solve for the
demand functions
Microeconomics Analysis

Module # 84
Microeconomics Analysis

Consumer Behaviour
Consumer Behaviour

Consumer Choices
- Marshallian demand function
(Properties)
(a) Adding up
• Despit the MONOTONICITY, Demands
must lie within the budget set:
• X1 = ƒ(P1, P2,m) ≤ M
• If consumer spending exhausts the
total budget then this holds as an
equality, X1 = ƒ(P1, P2,m) = M,
• Which is known as adding up, Walras’
law or budget balanced ness
Consumer Behaviour

Consumer Choices
- Marshallian demand function
(Properties)
• If we differentiate w.r.t y (income)
then we get a property known as
Engel aggregation:

• It is clear from this that not all

goods can be inferior (ℰ i < 0),
• Not all goods can be luxuries (ℰ >
1) and not all goods can be
necessities (ℰi < 1)
 Consumer Behaviour
Marshallian demand function (Properties)
(b) Homogeneity
 If we were to double all prices and income,
 the optimal quantities demanded will not change
 Doubling prices and income leaves the budget
constraint unchanged
Xi* = di(P1,P2,…,Pn,I) = di(tP1,tP2,…,tPn,tI)
 Individual demand functions are homogeneous of
degree zero in all prices and income
 Consumer Behaviour
Marshallian demand function (Properties)
With a Cobb-Douglas utility function
Utility = U(X,Y) = X0.3 Y0.7
the demand functions are

0.3I 0.7 I
X*  Y* 
PX PX

• Note that a doubling of both prices and income

would leave X* and Y* unaffected
 Consumer Behaviour
- Marshallian demand function (Properties)
With a CES utility function
Utility = U(X,Y) = X0.5 + Y0.5
the demand functions are
1 I 1 I
X*   Y*  
1  PX / PY PX 1  PY / PX PY

• Note that a doubling of both prices and income

would leave X* and Y* unaffected
Consumer Behaviour

Marshallian demand function

(Properties)
(c) Negativity
• The Weak Axiom of Revealed
Preference WARP, stated for the most
general case, that if any quantity q1
(X1) is chosen from a budget set
(B)which also contains q2 (X2)
• Then there exists no other budget
set (B1) containing q1 (X1) and q2
X2) from which q2 X2) is chosen
and not q1 (X1)
• It is a statement of consistency in
 Consumer Behaviour
Marshallian demand function (Properties)
(d) The Slutsky equation
• Considering demand function X1 = ƒ(P1, P2,m)
• How the demand for good X changes when PX changes? i.e. dX/PX
• Differentiation of the first-order conditions from utility maximization can be performed to
solve for this derivative
• However, this approach is cumbersome and We use an indirect approach
minimum expenditure (m) = E(PX,PY,U)
• Then, by definition
hX (PX,PY,U) = dX [PX,PY,E(PX,PY,U)]

• The two demand functions are equal when income is exactly what is needed to
attain the required utility level
 Consumer Behaviour

Marshallian demand function (Properties)

By differentiating this equality w.r.t Px
hX (PX,PY,U) = dX [PX,PY,E(PX,PY,U)]

We get following equations

hX d X d X E
  
PX PX E PX
d X hX d X E
  
PX PX E PX
 Consumer Behaviour

Marshallian demand function (Properties)

(d) The Slutsky equation
d X hX d X E
  
PX PX E PX
• The first term is the slope • The second term shows how
of the compensated changes in PX affect the
demand curve showing demand for X via changes in
movement on same IC . expenditure levels
• This is the mathematical • This is the mathematical
representation of the representation of the income
substitution effect effect
 Consumer Behaviour

Marshallian demand function (Properties)

(d) The Slutsky equation
• The substitution effect can be written as
h X X
substituti on effect  
PX PX U cons tant

• The income effect can be written as

d X E X E
income effect      
E PX I PX
 Consumer Behaviour
Marshallian demand function (Properties)
(d) The Slutsky equation
The utility-maximization hypothesis shows that the substitution and
income effects arising from a price change can be represented by

d X
 substituti on effect  income effect
PX shows that the substitution and income effects arising from a price change can be
The utility-maximization hypothesis
represented by
d X X X
 X
PX PX U  cons tant
I

• SE will always be negative as long as MRS is diminishing

• The slope of the compensated demand curve will always be
negative