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Chapter Eight Slutsky’s Equation Effects of a Price Change What happens when the price of a commodity decreases? First, the commodity becomes relatively cheaper, so consumers substitute towards it and away from now relatively more expensive other commodities. This is the substitution effect of the price change. Effects of a Price Change Second, the consumer’s budget of $y can purchase larger bundles than before. It is as if the consumer received an increase in income. The consequent changes in quantities demanded are the income effects of the price change. Effects of a Price Change x2 y p2 Consumer’s budget is $y. Original choice x1 Effects of a Price Change x2 y p2 Consumer’s budget is $y. Lowered price for commodity 1 pivots outwards the budget constraint. x1 Effects of a Price Change x2 y p2 y' p2 Consumer’s budget is $y. Lowered price for commodity 1 pivots outwards the budget constraint. Now only $y’ are needed to buy the original bundle at the new prices. It is as if the consumer’s income has increased by $y - $y’. x1 Effects of a Price Change The change to quantities demanded due to this ‘extra’ income is the income effect of the price change. Effects of a Price Change Slutsky’s insight was that the effects on quantities demanded of any price change can always be decomposed into a pure substitution effect and an income effect. The overall change in quantities demanded due to a price change is the sum of the substitution and income effects. Pure Substitution Effect Slutsky isolated the change in quantities demanded due only to the change in relative prices by asking “What is the change in quantities demanded 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 x 2’ x 1’ x1 Pure Substitution Effect Only x2 x 2’ x 1’ x1 Pure Substitution Effect Only x2 x 2’ x 1’ x1 Pure Substitution Effect Only x2 Lowering p1 makes good 1 relatively cheaper and causes a substitution from good 2 to good 1. The change from (x1’,x2’) to (x1’’,x2’’) is the pure substitution effect. x 2’ x2’’ x 1’ x1’’ x1 And Now The Income Effect x2 The income effect is the change from (x1’’,x2’’) to (x1’’’,x2’’’). (x1’’’,x2’’’) x 2’ x2’’ x 1’ x1’’ x1 The Overall Change in Demand x2 The overall effect on demands of the change in p1 is the sum of the income and substitution effects. This is the (x1’’’,x2’’’) change from (x1’,x2’) to (x1’’’,x2’’’). x 2’ x2’’ x 1’ x1’’ x1 Slutsky’s Effects for Normal Goods x2 Good 1 is normal because an increase to income causes demand to rise. (x1’’’,x2’’’) x 2’ x2’’ x 1’ x1’’ x1 Slutsky’s Effects for Normal Goods x2 Good 1 is normal because an increase to income causes demand to rise. So the income and substitution (x1’’’,x2’’’) effects reinforce each other. x 2’ x2’’ x 1’ x1’’ x1 Slutsky’s Effects for Normal Goods Since both the substitution and income effects increase demand when own-price decreases, the ordinary demand curve for a normal good must slope downwards. The Law of Downward-Sloping Demand therefore always applies to normal goods. Slutsky’s Effects for Income-Inferior Goods Some goods are income-inferior; that is, demand is reduced by an increase in income. Slutsky showed that, for incomeinferior goods, the substitution and income effects oppose each other when a good’s own price changes. Slutsky’s Effects for Income-Inferior Goods x2 The pure substitution effect is as for a normal good. But, …. x 2’ x2’’ x 1’ x1’’ x1 Slutsky’s Effects for Income-Inferior Goods x2 x 2’ The pure substitution effect is as for a normal good. But, the income effect is in the opposite direction. (x1’’’,x2’’’) x2’’ x 1’ x1’’ x1 Slutsky’s Effects for Income-Inferior Goods x2 x 2’ 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 because an increase to income 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 income effects. (x ’’’,x ’’’) 1 x 2’ 2 x2’’ x 1’ x1’’ x1 Giffen Goods In the rare case of extreme incomeinferiority, the income effect may be larger in size than the substitution effect, causing quantity demanded to decrease as own-price decreases. Such goods are called Giffen goods. Slutsky’s Effects for Giffen Goods x2 A decrease in p1 causes a decrease in the quantity demanded of good 1. x 2’ x 1’ x1 Slutsky’s Effects for Giffen Goods x2 A decrease in p1 causes a decrease in the quantity demanded of good 1. x2’’’ x 2’ x1’’’ x1’ x1 Slutsky’s Effects for Giffen Goods x2 A decrease in p1 causes a decrease in the quantity demanded of good 1. 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 incomeinferior goods.