8

Slutsky Equation

Varian, H. 2010. Intermediate Microeconomics, W.W. Norton.

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
• 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.

• Income effect: the consumer’s budget of $m can purchase more than

before, as if the consumer’s income rose, with consequent income effects
on quantities demanded.
Effects of a Price Change
• Breaking the price movement into two parts.

• First, let relative prices change, and ask how much we’d need to adjust
money income to hold purchasing power constant.

• Then, we will let purchasing power adjust while holding relative prices
constant.

• “Pivot and Shift” as a way to think about what’s going on…

Effects of a Price Change
Consumer’s budget is $m.
x2
m Original choice
p2

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

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

x1
Effects of a Price Change
• Changes to quantities demanded due to this ‘extra’ income are
the income effect of the price change.
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
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.
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’

x1’ x1
Pure Substitution Effect Only
x2

x2’

x1’ x1
Pure Substitution Effect Only
x2

x2’

x1’ x1
Pure Substitution Effect Only
x2

x2’

x2’’

x1’ x1’’ x1
Pure Substitution Effect Only
x2

x2’

x2’’

x1’ 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’’

x1’ 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’’

x1’ x1’’ x1
Calculating the Substitution Effect
• Suppose we have the following demand function:
m
x1 ( p1, m) = 3+
5p1

• Suppose income is m = $200 and p1 = $10

• Quantity demanded will be:

200 200
x1 ( p1, m) = 3+ = 3+ =7
5*10 50

• What percent of the change in demand is due to the substitution

effect when the price falls to p1’ = 5?
Calculating the Substitution Effect
• When the price falls, we want to know how much we need to
change income to keep the original bundle just affordable:
m' = p1!x1 + p2 x2
m = p1 x1 + p2 x2
• Subtracting the second equation from the first gives:
m'− m = x1 ( p1" − p1 )
Δm = x1Δp1
• Which just says that the change in money income needed to
make the old bundle affordable at new prices is just the original
amount of the consumption of good 1 times the change in
prices.
Calculating the Substitution Effect
• However, the original bundle, while still affordable may not be
optimal any longer. Instead, the consumer will want to increase
her consumption of good 1 (the substitution effect)

• More precisely, the substitution effect is the change in the

demand for good 1 when the price changes to p1! and at the same
time income increases to m!

Δx1s = x1 ( p1", m") − x1 ( p1, m)

Calculating the Substitution Effect
• Suppose we have the following demand function:
m
x1 ( p1, m) = 3+
5p1

• Suppose income is m = $200 and p1 = $10

• Quantity demanded will be:

200 200
x1 ( p1, m) = 3+ = 3+ =7
5*10 50

• What percent of the change in demand is due to the substitution

effect when the price falls to p1’ = 5?
Calculating the Substitution Effect
• First, we compute the total change in demand.
x1 ( p1, m) = 7
m 200
x1! ( p1!, m) = 3+ = 3+ = 11
5* p1! 5* 5
Δx1 = 4
• So if we want to adjust income to make the original bundle just
affordable at the new prices:

Δm = x1Δp1 = 7 * (5 −10) = −35

• This implies that, to keep the consumer’s purchasing power

constant at the new prices, income would be reduced to:
m! = m + Δm = 200 − 35 = 165
Calculating the Substitution Effect
• What is the consumer’s demand at m’ and p’?

m 165
x1 ( p1!, m!) = x1 (5,165) = 3+ = 3+ = 9.6
5* p1! 5* 5

• So the substitution effect is:

Δx1s = x1 ( p1", m") − x1 ( p1, m)

s
Δx = 9.6 − 7 = 2.6
1
• And as a percentage of total change in demand:
Δx1s 2.6
= = 65%
Δx1 4
And Now The Income Effect
x2

x2’ (x1’’’,x2’’’)

x2’’

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

x2’ (x1’’’,x2’’’)

x2’’

x1’ x1’’ x1
Calculating the Income Effect
• The income effect Δx1 is the change in demand for good 1 when
n

we change income from m’ to m, holding the price of good 1

fixed at the new price p1’
Δx1n = x1 ( p1", m) − x1 ( p1", m")

• So returning to our example, the income effect is the remaining

change in demand, once we’ve accounted for the substitution
effect:
Δx1n = x1 ( p1", m) − x1 ( p1", m") = 11− 9.6 = 1.4

• Which is 35% of the change in total demand.

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’’

x1’ x1’’ x1
Change in Total Demand
• The change in total demand Δx1 is the change in demand due to
the change in price holding income constant:
Δx1 = x1 ( p1", m) − x1 ( p1, m)

• And this is just the sum of the income and substitution effects:
Δx1 = Δx1s + Δx1n
x1 ( p1", m) − x1 ( p1, m) = [x1 ( p1", m") − x1 ( p1, m)]
+[x1 ( p1", m) − x1 ( p1", m")]

• The income effect can go either direction (depending on

whether a good is normal or income inferior), BUT
Substitution Effect
• Notice that the sign of the substitution effect is always negative.
• Here’s why:
• Suppose we pivot a budget line outward to find the substitution effect resulting
from a price decrease on good 1. There will be bundles on that budget line that
were affordable at the initial prices but which were not chosen.

• Given that we assume consumers choose optimally, the consumer must prefer
the original bundle to all those currently affordable bundles that were in the
original budget set.

• Thus at the new prices, the preferred bundle must either be the original bundle
or some newly affordable bundle to the right (which means that the new
optimal choice always increases the consumption of good 1!)

• Changes in demand due to the substitution effect always go in

the opposite direction of the price change!
Change in Total Demand (with calculus)
• Consider the definition of the substitution effect in which
income is adjusted so the consumer has just enough money to
buy the original consumption bundle ( x1, x2 ) at the new prices.

• If prices are ( p1, p2 ) then the consumer’s demanded bundle will

depend on both ( x1, x2 ) and ( p1, p2 ).

• We can write the Slutsky demand function for good 1 as

x1s ( p1, p2 , x1, x2 )

Change in Total Demand
• Now suppose the original demanded bundle ( x1, x2 ) is found at
prices ( p1, p2 ) and income m .

• The Slutsky demand function tells us what the consumer would

demand if she faced some different prices ( p1, p2 ) and income
p1 x1 + p2 x2. Or in other words, it tells you the ordinary demand
at that income and price level, i.e.
x1s ( p1, p2 , x1, x2 ) = x 1 ( p1, p2 , p1 x1 + p2 x2 )

• To repeat, the Slutsky demand at prices (p1, p2) is just the

amount that the consumer would demand if she had enough
income to buy her original bundle.
Change in Total Demand
• Differentiating that identity with respect to p1 and applying the
chain rule gives:
∂x1s ( p1, p2 , x1, x2 ) ∂x 1 ( p1, p2 , m ) ∂x1n ( p1, p2 , m )
= + x1
∂p1 ∂p1 ∂m

• We can rearrange the expression to get:

∂x 1 ( p1, p2 , m ) ∂x1s ( p1, p2 , x1, x2 ) ∂x1n ( p1, p2 , m )

= − x1
∂p1 ∂p1 ∂m

• This says that the total effect of a price change is composed of a

substitution effect (term 1) and an income effect (term 2)
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’’

x1’ 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’’

x1’ 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.

• Law of Demand: If demand for a good increases when income

increases, then the demand for that good must decrease when its
price increases.
Perfect Substitutes?
• When we tilt the budget line, consumers either

• continue to consume their same bundle (e.g. spending all of their money
on x2)

or

• if the budget line rotates far enough, they switch to spending their entire
budget on x1

Thus, there changes in demand are driven entirely by the substitution effect!
Perfect Complements?
• When we pivot the budget line around our chosen point, the
demanded bundle doesn’t change at all!

• There is no substitution effect, only an income effect.

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’

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

x2’

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

x2’

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

x2’

x2’’

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

x2’

x2’’

x1’ 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’’

x1’ 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.

x1’ 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’’

x1’ 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 fall 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.

x2’

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

x2’

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

x2’

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.
Slutsky’s Effects for Giffen Goods
• Thus all Giffen goods are income inferior goods.

• But not all income inferior goods are Giffen goods.

The Other Substitution Effect (Hicks)
• The Hicks substitution effect

• Suppose that rather than pivoting the budget line, we now roll
the budget line around the indifference curve through the
original bundle.

• This allows us to present the consumer with a new budget line

that has the same relative prices as the final budget but has a
different income.

• The consumer wouldn’t be able to buy the original bundle, but

she would be able to afford an equally preferred bundle.
The Hicks Substitution Effect

x2’

x1
x1’
The Hicks Substitution Effect

x2’

x1
x1’
The Hicks Substitution Effect

x2’

x1
x1’
The Hicks Substitution Effect

x2’

Substitution
x1
x1’
The Hicks Substitution Effect

x2’

Substitution
x1
x1’ Income
The Hicks Substitution Effect
• Note that the Hicks Substitution Effect holds utility constant
(rather than purchasing power).

• As with the Slutsky Substitution Effect, the Hicks Substitution

Effect must be negative.

• But the total change in demand is still decomposed into the

(Hicks) Substitution Effect and the Income Effect
Summary
• A change in demand resulting from a change in price can be
decomposed into an income effect and a substitution effect.
• The income effect describes how demand changes as a result of changes
to real income (purchasing power)
• The substitution effect describes how demand changes due to changes in
relative prices

• The Law of Demand says that normal goods must have

downward sloping demand curves.