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Slutsky Equation Derivation Explained

The document derives the Slutsky equation, which describes how the consumption of commodity X2 (x2) changes in response to a change in the price of commodity X1 (p1). It shows that the total change in x2 with respect to a change in p1 can be expressed as the sum of two terms: (1) the pure substitution effect (∂x2/∂p1)u holding utility constant, and (2) the income effect (∂x2/∂I) multiplied by the change in real income (x1). Through taking the total differential of the consumer's optimization problem and solving the resulting system of equations, it arrives at the Slutsky equation in

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17 views5 pages

Slutsky Equation Derivation Explained

The document derives the Slutsky equation, which describes how the consumption of commodity X2 (x2) changes in response to a change in the price of commodity X1 (p1). It shows that the total change in x2 with respect to a change in p1 can be expressed as the sum of two terms: (1) the pure substitution effect (∂x2/∂p1)u holding utility constant, and (2) the income effect (∂x2/∂I) multiplied by the change in real income (x1). Through taking the total differential of the consumer's optimization problem and solving the resulting system of equations, it arrives at the Slutsky equation in

Uploaded by

frankofori
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd

QUESTION 2 :

DERIVATION OF THE SLUTSKY EQUATION FOR A CHANGE IN THE CONSUMPTION


OF COMMODITY X2 AS A RESULT OF A CHANGE IN THE PRICE OF COMMODITY X1.

with budget constraint ,


Suppose a consumers utility function is U ( X 1 , X 2 , X 3 ) I = P1 X 1 + P2 X 2 + P3 X 3

then he can maximize his utility as shown below.

L = u ( x1 , x 2 , x3 ) + λ ( I − p1x1 − p 2x 2 − p 3x 3)
∂L ∂u
= − λ p1 = 0
∂x1 dx1
u1 − λ p1 = 0 .....................(1)
∂L ∂u
= − λ p2 = 0
dx2 dx2
u2 − λ p2 = 0 ...................(2)
∂L ∂u
= − λ p3 = 0
∂x3 ∂x3
u3 − λ p3 = 0 .....................(3)
∂L
= I − p1 x1 − p 2 x 2 − p3 x3 = 0
∂λ
I − p1 x1 − p2 x2 − p3 x3 = 0 ...............(4)

Where is the Lagrange function and is the Lagrange multiplier which represents the marginal
L λ
utility of money and >0. Taking the total differentials of (1),(2),(3), and (4), we have;
λ

u11dx1 + u12 dx2 + u13 dx3 − λ dp1 − p1 d λ = 0


u21dx2 + u22 dx2 + u23 dx3 − λ dp2 − p2 d λ = 0
u31dx3 + u32 dx2 + u33 dx3 − λ dp3 − p3 d λ = 0
− p1dx1 − p2 dx2 − p3 dx3 − x1 dp1 − x2 dp2 − x3 dp3 + dI = 0
In matrix form, we have;

 u11 u12 u13 − p1   dx1   λ dp1  λ 0 0 0   dp1 


       
 u21 u22 u 23 − p 2   dx2   λ dp 2  = 0 λ 0 0   dp2 
=
 u31 u32 u 33 − p 3   dx3   λ dp3  0 0 λ 0   dp3 
        
 − p1 − p2 − p3 0   d λ   x1dp1 + x2dp 2 + x3dp 3 − dI   x1 x2 x3 − 1  dI 

let

u11 u12 u13


∆ = u21 u22 u23
u31 u32 u33
Now, the total change in x2 as a result of a change in p1 , we have

u11 λ u13 − p1
u21 0 u23 − p2
u31 0 u3 3 − p3
∂x2 − p1 x1 − p3 0
=
∂p ∆

u21 u23 − p2 u11 u13 − p1


u31 u33 − p3 u21 u23 − p2
∂x2 − p1 − p3 0 u31 u33 − p3
=λ + x1
∂p1 ∆ ∆

u21 u 23 − p2 u 11 u 13 − p1
let ∆12 = u31 u 33 − p3 and ∆ 42 = u 21 u 23 − p2
− p1 − p3 0 u 31 u 33 − p3

therefore,

∂x2 ∆ ∆
= λ 12 + x1 42
∂p1 ∆ ∆
Now, we consider a change in x2 with respect to a change in income,

u11 0 u13 − p1
u21 0 u23 − p2
u31 0 u33 − p3
∂x2 − p1 − 1 − p3 0
=
∂I ∆

u11 u13 − p1
u21 u23 − p2
∂x2 u31 u33 − p3
=
∂I ∆

∂x2 ∆
= − 42 ................(5)
∂I ∆

Also, we try to investig1ate the effect of a change in p1 holding p2, p3 and I (income) constant.
We then have;

3
∴ ∑ pi dxi = 0
i =1
3
The budget line is also given as I= ∑ pi xi
1=1
3 3
dI = ∑ pi dxi + ∑ xi dpi
i =1 i =1

but
3

∑ p dx
i =1
i i =0
3
∴ dI = ∑ xi dpi
i =1

with p2 and p3 constant, then dpi = 0, i = 2, 3


∴ dI = x1 p1
u = u ( x1 , x2 , x3 )
du = u1dx1 + u 2 dx2 + u3dx3 = 0
3
∴ ∑ ui dxi = 0
i =1

but, from (1)


u i = λ pi
3
so, λ ∑ pi dxi = 0
i =1

but λ ≠ 0, (since the marginal utility of money is positive).

Hence;

 u11 u12 u13 − p1  dx1   λ   dp1 


  
 u21 u22 u23 − p2  dx2   0   0 
=
 u31 u32 u33 − p3  dx3   0   0 
     
 − p1 − p2 − p3 0  d λ   0  0 

u11 λ u13 − p1
u21 0 u 23 − p 2
u31 0 u33 − p3
∂x2 − p1 0 − p3 0
− =
∂p1 u ∆

but
u22 u23 − p2
∆12 = λ u 32 u 33 − p3
− p2 − p3 0

∂x2 ∆12
∴ − =λ .......................... (6)
∂p1 u ∆
,
Now, from (5) and (6), we have that

∂x2 ∂x2 ∂x 2
= − − x1
∂p1 ∂p1 u ∂I

of a
This represents the Slutsky equation of a change in the quantity of commodity x2 as a result

change in the price of commodity X.

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