L 07 Slutsky Equation Previous Class Demand

L 07 Slutsky Equation

Previous Class Demand function How the demand is affected by a) p 1 change, holding p 2 and m constant b) m change, holding p 2 and m constant c) p 2 change, holding p 1 and m constant Geometric and analytical answer! Classification of goods

Price Change Fix p 2=1 and m=10. Change p 1=2, p 1’=1, x 2 What happens to 1) a relative price? 2) a purchasing power (real income)? Can we separate the two effects? x 1

Today 2 questions u How to measure Real Income (PP) u Decomposition of the change in demand – The effect resulting from the change of a relative price (substitution effect) – The effect resulting from the change of real income (income effect)

Change of Real Income p 1=2, p 2=1 and m=10 and What m’ makes x 2 just affordable at Geometrically: x 1 p 1’=1,

Real Income Change u 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 x 2 Suppose p 1, p 2 changes to p 1’, p 2’ Original budget constraint and choice New budget constraint Real income? x 1

Real Income Changes x 2 Suppose p 1, p 2, changes to p 1’, p 2’ Original budget constraint and choice New budget constraint Real income? x 1

Real Income Changes x 2 Suppose P 1, P 2 changes to p 1’, p 2’ Original budget constraint and choice New budget constraint Real income? x 1

Substitution and Income Effect u If P 1 changes, both relative price and real income are affected u Slutsky isolates the change in demand due only to the change in relative prices KEY IDEA: u “What is the change in demand when the consumer’s income is adjusted (to m’) so that, at the new prices, her real income is the same? ”

Total Change x 2 T. CH x 1

Income Effect Substitution effect x 2 SE IE x 1

Substitution and Income Effect u What happens to the demand Total Change u Instead of going directly, 2 steps: SE IE

Cobb-Douglass example Data , change

Perfect Complements , change

Normal, Inferior and Giffent goods u Normal Goods u Inferior goods u Effects: Reinforce or cancel out?

Normal Goods x 2 x 1

Slutsky’s Effects for Income-Inferior Goods u Normal good: demand increases in income. u The substitution and income effects change demand in the same direction after own price changes.

Inferior Goods x 2 x 1

Slutsky’s Effects for Inferior Goods u Some goods are inferior (i. e. demand is reduced by higher income). u The substitution and income effects oppose each other when an incomeinferior good’s own price changes.

Giffen Goods x 2 x 1

Slutsky’s Effects for Giffen Goods u 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.