chapter 7: slutsky equation

Question 1

substitution effect.

Answer 1

The change in demand due to the change in the rate of exchange between the two goods is called the substitution effect.

The substitution effect always moves opposite to the price movement.

Question 2

income effect

Answer 2

The change in demand due to the change in purchasing power is called the income effect.

The income effect can be positive or negative, depending on whether the good is a normal good or an inferior good

Question 3

pivot line

Answer 3

The pivoted line is a budget line with the same relative prices as the final budget line, but purchasing power is the same as in the original choice.

Question 4

if we have a normal good, in the slutsky identity

Answer 4

If we have a normal good, the substitution and income effect work in the same direction.

Question 5

if we have an inferior good, in the slutsky identity. (+ why?)

Answer 5

If we have an inferior good, the income effect and substitution effect work in the opposite direction.

• If the income effect outweighs the substitution effect, the total change in demand associated with a price increase is positive.
• This is the case for Giffen goods: the increase in price has reduced the purchasing power of the consumer so much that he has increased the. consumption of the inferior good.
• Not all inferior goods are Giffen goods.

Question 6

The law of demand

Answer 6

If the demand for a good increases when income increases, then the demand for that good must decrease when its price increases.

Question 7

Examples of income and substitution effects

Answer 7

• Perfect complements
• Perfect substitutes
• Quasilinear preferences

Question 8

Slutsky substitution effect

Answer 8

• The change in demand when prices change and consumer’s purchasing power is held constant.

Question 9

Hicks substitution effect

Answer 9

• The change in demand when prices change and consumer’s utility is held constant to a level ¯u.

The Hicks substitution effect must be negative, in a direction opposite to the price change.

Question 10

Marshallian demand functions

Answer 10

Marshallian demand functions show the relationship between the price of a good and the quantity of that good purchased holding other prices and income constant.

Question 11

Hicksian or compensated demand functions

Answer 11

Hicksian or compensated demand functions show the relationship between the price of a good and the quantity of that good purchased holding other prices and utility constant.

Question 12

When the price of a good changes, there are two sorts of effects:

Answer 12

1. The rate at which you can exchange one good for another changes.
2. The total purchasing power of your income changes.

Question 13

When the price of a good changes, there are two sorts of effects:

Answer 13

1. The rate at which you can exchange one good for another changes.
2. The total purchasing power of your income changes.

Question 14

We can distinguish between the substitution and income effect by breaking the price movement into two steps.

Answer 14

1. Let the relative prices change and adjust money income so as to hold purchasing power constant.
2. Let purchasing power adjust when holding the relative prices constant.

Question 15

The total change in demand,

Answer 15

∆x1, is the change in demand due to the change in price, holding income constant:

Question 16

what does the Hicksian demand functions tell us?

Answer 16

The Hicksian demand functions tell us what consumption bundle achieves a
target level of utility and minimizes total expenditures.

Question 17

Shephard’s Lemma:

Answer 17

The Hicksian demand functions can be obtained from the
expenditure function.

Question 18

The utility maximization problem and expenditure minimization problem will
give the same outcome:

->This observation leads to the following 2 identities:

Answer 18

1. The Marshallian demand at income m is the same as the Hicksian demand
   at utility v(p1, p2, m).
2. The Hicksian demand at utility ¯u is the same as the Marshallian demand
   at income m = e(p1, p2, u¯).