Chapter 8
Review: Slutsky Equation
This chapter looks more closely at how a consumer’s choice of a good re-
sponds to a change in its price.
8.1 The substitution effect
When the price of a good changes, there are two effects: the rate at which
you can exchange one good for another, and the total purchasing power of
your income is altered.
Say, the price of good 1 falls, then you can buy more of good 1 (because
it is cheaper) and the purchasing power of your money goes up (you feel
richer). The first part - the change in demand due to the change in the
rate of exchange between two goods - is called the substitution effect.
The second effect - the change in demand due to having more (or less)
purchasing power - is called the income effect.
1
2 CHAPTER 8. REVIEW: SLUTSKY EQUATION
The “pivot-shift” operator gives us a convenient way to decompose
change in demand into two pieces. The “pivot” locates the change in de-
mand where the slope of the budget line changes (because relative prices
changes) while its purchasing power remains the same. That is, with the
pivot, the consumer’s purchasing power remains unchanged and the new
budget line passes through the original bundle so that it is just affordable.
So how much must we adjust money in order to keep the old bundle just
affordable? Let m0 be the amount of money income that will make the old
bundle just affordable; this will be the amount of income associated with
the pivoted budget line. Since (x1 , x2 ) is affordable at both (p1 , p2 , m) and
(p01 , p2 , m0 ), we have
m0 = p01 x1 + p2 x2
m = p1 x1 + p2 x2
Subtracting the second equation from the first gives
m0 − m = x1 [p01 − p1 ]
8.1. THE SUBSTITUTION EFFECT 3
which we can more compactly write as
4m = x1 4p1 (8.1)
This answers how much money should change if prices change to keep the
same bundle just affordable. Note that the change in price and income
always move in the same direction.
Although the original (x1 , x2 ) is affordable, it is generally not the op-
timal purchasing point. Rather the consumer would move from X to Y
(on the diagram above), which is is known as the substitution effect.
It indicates how the consumer “substitutes” one good for another when a
price changes while keeping purchasing power constant. More precisely, the
substitution effect, 4xs1 , is the hange in the demand for good 1 when prices
change from p to p0 and, at the same time, money income is adjusted to m0
which keeps the old bundle just affordable:
4 CHAPTER 8. REVIEW: SLUTSKY EQUATION
4xs1 = x1 (p01 , m0 ) − x1 (p1 , m)
8.2 The income effect
We know that a parallel shift of the budget line is the movement that
occurs when income changes while relative prices remain constant. The
second stage of he price adjustment is called the income effect. We simply
change income from m0 to m, keeping prices at (p01 , p2 ). In the figure above
his change is shown as a movement from Y to Z.
More precisely, the income effect, 4xn1 , is the change in demand for
good 1 when the income changes from m0 to m, holding the price of good
1 fixed at p01 .:
4xn1 = x1 (p01 , m) − x1 (p01 , m0 )
Note that the income effect can be positive or negative, depending on
whether we are talking about a normal or an inferior good.
8.3 Sign of the substitution effect
The substitution effect is always negative; it always moves in the opposite
direction to the price change. For example, if p1 > p01 , the price goes down,
then we must have x1 (p01 , m0 ) ≥ x1 (p1 , m), so that 4xn1 ≥ 0.
8.4 The total change in demand
The total change in demand, 4x1 , is the change in demand due to the price
change, holding income constant:
4x1 = x1 (p01 , m) − x1 (p1 , m)
We can break this into two changes: the substitution effect and income
effect. Symbolically,
8.4. THE TOTAL CHANGE IN DEMAND 5
4x1 = 4xs1 + 4xn1
x1 (p01 , m) − x1 (p1 , m) = [x1 (p01 , m0 ) − x1 (p1 , m)]
+ [x1 (p01 , m) − x1 (p01 , m0 )]
This equation is the Slutsky identity.Also note for a normal good, say
price of good 1 rises, then
4x1 = 4xs1 + 4xn1
(−) (−) (−)
On the other hand, if we have an inferior good, it might happen that
the income effect outweighs the substitution effect, so that when say price
increases, demand could might as well increase. This is case of the Giffen
good (see Figure 8-3 below). The signs are as follows
4x1 = 4xs1 + 4xn1
(?) (−) (+)
The Slutsky equation tells us that such perverse effect can only happen
with an inferior good. If a good is a normal good, then the income and
substitution effects move in the same direction reinforcing each other such
that demand moves in the “correct” direction to the price change.
6 CHAPTER 8. REVIEW: SLUTSKY EQUATION
8.5 The Slutsky in terms of rates of change
The Slutsky equation above is stated in absolute terms. To express it in
terms of rates of change it is convenient to define 4xm
1 as the negative of
the income effect:
4xm 0 0 0 n
1 = x1 (p1 , m ) − x1 (p1 , m) = −4x1
Given this definition, the Slutsky identity becomes
4x1 = 4xs1 − 4xm
1
and dividing each side by 4p1 , we get
4x1 4xs1 4xm1
= − (8.2)
4p1 4p1 4p1
8.6. THE LAW OF DEMAND 7
The first term on the right-hand side is simply the rate of the substitution
effect - the rate of change of demand when price changes and income is
adjusted so as to keep the old bundle affordable.
Let’s take a closer look at the second term. First recall 4m = x1 4p1 .
Hence solving for 4p1 gives
4m
4p1 =
x1
Substituting this into the last term of (8.2) gives the Slutsky equation in
terms of rates of change:
4x1 4xs1 4xm
1
= − x1
4p1 4p1 4m
8.6 The law of demand
If the demand for a good increases when income increases, then the demand
for that good must decrease when its price increases.
8.7 Hicks substitution effect
The Hicks substitution effect keep utility constant rather than keeping pur-
chasing power constant.
8 CHAPTER 8. REVIEW: SLUTSKY EQUATION
