ECON 306

Chapter 8: The Slutsky Equation

RUST, CHO, DIAZ

 Introduction

• The Slutsky Equation decomposes the total change in demand caused by a change
in prices into two pieces, the Substitution effect and the Income effect.
• What happens when the price of a good changes? Assume that the price of x1 goes
down from p1 to p’1:
1) Good x1 becomes cheaper relative to other goods. The price ratio p1/p2 (or the
relative price) goes down so the new budget line becomes flatter.
2) Consumer’s purchasing power changes as well. Some bundles that were
unfeasible before are affordable now.
• Look first at the movements in the budget constraint as the price of x1 goes down
(Fig 8.1).
• Pivot: changes the relative price (the slope) leaving the purchasing power
constant (so the consumer can afford exactly the initial bundle).
• Shift: changes the purchasing power leaving the relative price constant.
08.01
 The Substitution effect

• The Substitution effect measures the change in the demand of a good caused by a
change in the relative price keeping the purchasing power constant. This isolates
the pure effect from changing the relative price.
• Why do we need to keep the purchasing power constant? When the price of a good
decreases (increases) the consumer’s purchasing power increases (decreases).
1) For normal goods, the increase in purchasing power allows the consumer to
increase further the demand for the good.
2) For inferior goods consumer reduces quantity demanded as the purchasing
power increases.
• If we allow the purchasing power to change, we confound the change in demand
caused by the change in the relative price (the good becomes cheaper or more
expensive) with the change caused by a higher or lower “real income”.
• So, we need consumers facing the new price ratio while maintaining the original
demanded bundle just affordable.
 The Substitution effect (cont.)

• How to keep the purchasing power constant? We need to compensate the consumer after
the price change such that the original bundle is just affordable. This implies to find a new
amount of money m’ such that the original bundle is affordable at the new set of prices.
• The original bundle X=(x1,x2) must satisfy both m’= p’1 x1+ p2 x2 and m = p1 x1+ p2 x2.
• The amount of money required to keep purchasing power constant (to compensate the
consumer) is m’-m = x1(p’1-p1) or ∆m=x1∆p1.
• This is the Slutsky compensation.
• Now we are ready to compute the Substitution effect:
• The original purchased quantity of x1 is x1(p1,p2,m)
• The compensated quantity of x1 is x1(p’1,p2,m’)
• So the substitution effects is just ∆xs1= x1(p’1,p2,m’) - x1(p1,p2,m)
• ∆xs1 measures the change in demand for x1 caused solely by the change in the price ratio. In
Fig 8.2 this corresponds to the movement form bundle X to bundle Y.
 x2

m /p 2

m' /p 2

X
Z

m /p 1 Pivot Shift

x 1(p 1,p 2,m ) x 1(p '1,p 2,m ') x 1(p '1,p 2,m ) m /p' 1 x1
s
∆x 1
n
Substitution effect ∆x 1

Income effect
∆x 1 Total change in demand
Fig 8.2 Substitution effect and Income effect
 The Substitution effect (cont.)

• The Substitution effect must be negative for any kind of good: quantity moves opposite the
direction of price.
• Why?
• Remember that the price of x1 went down, so ∆p1<0.
• Consider the points to the left of bundle X on the pivoted line. All these bundles were
affordable at the old prices (p1,p2) but they weren’t purchased. Instead bundle X was
purchased.
• Given that the consumer chooses the best affordable bundle; we can conclude that
bundle X must be preferred to all the bundles on the pivoted line that lies inside the
original budget set.
• Thus, the optimal bundle on the pivoted line must be X itself or any other bundle on the
pivoted line outside the original budget set.
• But this means that demanded quantity of good 1 when prices are (p’1,p2) and income
m’, must be greater or equal than the original demanded quantity, or equivalently ∆x1 0.
• This reasoning is independent of the type of good.
The Income effect

• The Income effect measures the change in demand caused by a change in real income
or purchasing power keeping prices constant.
• Prices are held constant at the new price ratio p’1/p2 when we change income.
• Lets compute the Income effect:
• The compensated demand is x1(p’1,p2,m’)
• The final demanded quantity is x1(p’1,p2,m)
• So, the Income effect is ∆xn1= x1(p’1,p2,m) - x1(p’1,p2,m’)
• In Fig 8.2 this corresponds to the movement form bundle Y to bundle Z.
• The sign of the Income effect depends on the type of good. The Income effect can
increase or decrease demand depending on whether we have a normal or inferior
goods.
The Slutsky Equation

• The Slutsky Equation decomposes the total change in demand into two pieces, the
substitution effect and the income effect. Therefore we can write it as:
∆x1 = ∆x1s + ∆x1n
• Define ∆x 1m = − ∆x 1n . Plug this into the above equation and divide everything by
∆p1 to get
∆x1 ∆x1s ∆x1m
= −
∆p1 ∆p1 ∆p1

• From the budget constraint we know that ∆m = x 1∆p1 ⇒ ∆p1 = ∆m / x 1

• Plugging this into the last term of the right hand side we obtain the Slutsky Equation as a
rate of change
∆x1 ∆x1s ∆x1m
= − x1
∆p1
{ ∆p1
{ ∆2
1m3
Total change in Substitution Effect Income Effect
demand
The Slutsky Equation (cont.)

• We can express the Slutsky Equation using calculus:

∂x1 ∂x1s ∂x1m
= − x1
∂p ∂p ∂m
123
{1 {1
Total change in Substitution Effect Income Effect
demand
• Proof: Let the original consumption bundle be ( x1 , x 2 ) and m the amount of money that allows
the consumer afford this bundle when prices are p1 and p2.
• The Slutsky demand function at ( p1 , p2 , x1 , x 2 ) is the ordinary demand function evaluated at p1 and
p2 when the income level is m . That is:
647 m 4 8
x 1s ( p1 , p2 , x1 , x 2 ) = x1 ( p1 , p2 , p1x1 + p2 x 2 )
• Now take partial derivative with respect to p1 using the chain rule:
∂x 1s ( p1 , p2 , x1 , x 2 ) ∂x1 ( p1 , p2 , m ) ∂x1 ( p1 , p2 , m )
= + x1
∂p1 ∂p1 ∂m

• Rearranging we obtain the Slutsky Equation:

∂x 1 ( p1 , p2 , m ) ∂x1s ( p1 , p2 , x1 , x 2 ) ∂x1 ( p1 , p2 , m )
= − x1
∂p1 ∂p1 ∂m
The Slutsky Equation (cont.)
• What is the sign of the total change in demand as the price changes?
• A. Substitution effect is always negative.
• B. Income effect depend on whether we have normal or inferior goods
• Normal goods
• The income effect is positive (quantity moves in the same direction of income).
• It reinforces the substitution effect.
• Thus, the total change in quantity moves opposite the direction of prices.
• Inferior goods (Fig. 8.3)
• The income effect is negative (quantity moves opposite the direction of income).
• Giffen case: the income effect moves quantity opposite the direction of the substitution effect and
is so large that it outweigh the substitution effect. Therefore the total change in quantity moves
the same direction of prices.
• Non-Giffen case: the income effect moves quantity opposite the direction of the substitution
effect but this doesn’t outweigh the substitution effect. Therefore the total change in quantity
moves opposite the direction of prices.
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.
08.03
Example: Perfect Complements

• Recall that under perfect complements the

indifference curves have an “L-shape”.
• The optimal bundle will be at the kink of the
highest indifference curve.
• Lets assume that u ( x1 , x 2 ) = min{x1 , x 2 }
• Demand function given by
m
x1 = x 2 =
p1 + p2
• When pivot the budget line around the
original bundle, the compensated bundle is
exactly the same. The substitution effect is
zero.
• Slutsky Equation: the change in demand is
due entirely to the income effect.
Example: Perfect Substitutes

• Under perfect substitutes the

indifference curves are straight lines, so
the MRS is constant.
• Assuming u ( x1 , x 2 ) = x1 + x 2 the
MRS = -1.
• The optimal bundle will be at a corner
unless p1=p2; in which case the optimal
bundle will take any value x1 ∈ [0, m / p1 ]
• When pivot the budget line, the
demanded bundle jumps from the
vertical axis to the horizontal axis.
• Slutsky Equation: the change in
demand is due entirely to the
substitution effect.
 Slutsky and Hicks Substitution effects

• We have used the Slutsky compensation to derive the substitution effect.

• This is one possible way to compensate the consumer.
• Another possibility is Hicks compensation. Instead of making the original bundle just
affordable after the price change, Hicks compensation gives the consumer enough
money to get back to his old indifference curve.
• This compensation makes the consumer just indifferent between the original optimal
bundle and the compensated bundle. Using this strategy to compensate the consumer
allows defining the Hicks substitution effect (Fig. 8.9). Hicks substitution effect keeps
utility constant rather than keeping purchasing power constant.
• The Hicks substitution effect is also negative (Fig A.1).
• We can derive the Slutsky and Hicks “compensated” demand functions (Fig A.2).
• Compensated demand functions are steeper than ordinary demand. They do not include
the income effect.
08.09
Slutsky and Hicks Substitution effects

x2

m /p 2

m' /p 2

X
Z

YSlutsky
YHicks

x1 x 1Hicks x 1Slutskt x' 1 m /p' 1 x1

Fig A.1 Slutsky and Hicks Substitution effect
Compensated and Ordinary Demand Functions
p1

p1
X

YSlutsky Z
p '1
YHicks Sultsky demand "Ordinary" Demad

Hicks demand
Hicks Slutskt
x1 x1 x1 x' 1 x1
Fig A.2 Slutsky and Hicks Demand Functions