The Slutsky equation is discussed in these notes. the substitution effect and income effect are analysed. The rate of change and law of demand are also discussed .
Principals of Microeconomics – Slutsky’s Decomposition
Income effect: if the price of a given good decreases, the consumer’s budget of $Y can purchase more than
before
Slutsky discovered that changes to demand from a price change are always the sum of a pure substitution
effect and an income effect.
Slutsky asserted that if, at the new prices,
o less income is needed to buy the original bundle then “real income” is increased
o more income is needed to buy the original bundle then “real income” is 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, she can only just buy
the original bundle?”
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.
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.
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.
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 decreases.
o Such goods are 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.
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