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Understanding Slutsky's Price Effects

The document discusses the Slutsky Method, introduced by economist Eugene Slutsky, which decomposes the effects of price changes into income and substitution effects. It explains how these effects operate differently for normal and inferior goods, with normal goods seeing both effects reinforcing demand, while inferior goods experience opposing effects. Additionally, it highlights the concept of Giffen goods, where the income effect can outweigh the substitution effect, leading to an increase in quantity demanded as price falls.

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26 views22 pages

Understanding Slutsky's Price Effects

The document discusses the Slutsky Method, introduced by economist Eugene Slutsky, which decomposes the effects of price changes into income and substitution effects. It explains how these effects operate differently for normal and inferior goods, with normal goods seeing both effects reinforcing demand, while inferior goods experience opposing effects. Additionally, it highlights the concept of Giffen goods, where the income effect can outweigh the substitution effect, leading to an increase in quantity demanded as price falls.

Uploaded by

habib.d408
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd

Price Change: Income and Substitution Effects

Dr. Muhammad Shahadat Hossain Siddiquee


Professor, Department of Economics
University of Dhaka
Email: [Link]@[Link]
Contact: +8801719397749
THE SLUTSKY METHOD

• Eugene Slutsky (1880-1948)


• Russian economist expelled from the University of Kiev for
participating in student revolts.
• In his 1915 paper, “On the theory of the Budget of the Consumer”
he introduced “Slutsky Decomposition”.
THE SLUTSKY METHOD…
THE SLUTSKY METHOD…
THE SLUTSKY METHOD…
THE SLUTSKY METHOD…

• Slutsky claimed that if, at the new prices,


– less income is needed to buy the original bundle then “real
income” has increased
– more income is needed to buy the original bundle then “real income”
has decreased
• 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, s/he can just afford to buy the original
bundle?”
THE SLUTSKY METHOD…

• To isolate the substitution effect we adjust the consumer’s money


income so that s/he change can just afford the original consumption
bundle.
• In other words we are holding purchasing power constant.
THE SLUTSKY METHOD…
THE SLUTSKY METHOD…
THE SLUTSKY METHOD…
THE SLUTSKY METHOD…
THE SLUTSKY METHOD…
THE SLUTSKY METHOD 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.
THE SLUTSKY METHOD FOR NORMAL GOODS
THE SLUTSKY METHOD FOR NORMAL GOODS

• Since both the substitution and income effects increase demand


when own-price falls, a normal good’s ordinary demand curve
slopes downwards.
• The “Law” of Downward-Sloping Demand therefore always applies to
normal goods.
THE SLUTSKY METHOD: INFERIOR GOODS

• Some goods are (sometimes) inferior (i.e. demand is


reduced by higher income).
• The substitution and income effects “oppose” each
other when an inferior good’s own price changes.
THE SLUTSKY METHOD: INFERIOR GOODS…
GIFFEN GOODS…

• In rare cases of extreme inferiority, the income effect


may be larger in size than the substitution effect,
causing quantity demanded to rise as own price falls.
• Such goods are Giffen goods.
• Giffen goods are very inferior goods.
THE SLUTSKY METHOD FOR INFERIOR GOODS
SLUTSKY’S EFFECT 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 very inferior goods.
DECOMPOSITION OF TOTAL PRICE EFFECT: PERFECT COMPLEMENTS
DECOMPOSITION OF TOTAL PRICE EFFECT PERFECT SUBSTITUTES

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