Slutsky Equation

Question 1

What are the two effects that occur when there is a change in price (e.g. a decrease)?

Answer 1

• 1. SUBSTITUTION effect:
     Change in relative prices make consumers substitute away from other goods towards this good
• 2. INCOME effect:
     Changes in purchasing power make consumers’ budgets change, increasing Qd
• Total change in demand = IE + SE

Question 2

What is the Slutsky Equation?

Answer 2

• ΔX1 = ΔXs1+ΔXm1
• ΔX1 = X1(p’1,m) - X1(p1,m), where X1(p’1,m) is point 2 and X1(p1,m) is point 0
• This is because:
  SE = point 1 - point 0
  IE = point 2 - point 1
  hence point 1 cancels

Question 3

How do you know the direction of the SE/IE?

Answer 3

• SE always moves oppositely to the change in price
• IE can move either way depending on the type of good
• All giffen goods are inferior

Question 4

What is the difference between Slutsky and Hicks curves? Why would you prefer either?

Answer 4

• Stusky: Pivot around I gives the substitution effect & the shift gives the income effect
• This keeps purchasing power constant (CUTS B’ at o.g. point)
• Hicks: Pivot around B gives the substitution effect & the shift gives the income effect
• This keeps utility constant
• Slutsky is better examine mathematically, Hicks is better for welfare

Question 5

How do you calculate IE and SE mathematically [DEMAND]?

Answer 5

• Use the original demand function to find the initial point (X1)
• Use the new price point (p’1) to find the ending point (X’1)
• Find the variance of M (X1[p’1-p1]) and substitute this into the demand function (X$)
• SE = X$ - X1, IE = X’1 - X$

Question 6

How do you calculate IE and SE mathematically [UTILITY]?

Answer 6

• Use the original utility function to find the initial point (X1)
• Use the new price point (p’1) to find the ending point (X’1)
• Using the original utility, find x and y with this point, substituting in y in terms of x [HICKS] (X$)
• SE = X$ - X1, IE = X’1 - X$

Question 7

What are the two different types of variation?

Answer 7

• Compensating Variation
• Equivalent Variation

Question 8

What is the difference between CV and EV?

Answer 8

• CV measures the impact of a price change to identify the income change to restore the consumer to their original I.C.
• What we must give the consumer after the price change to make him just as well off as before the price change
• EV measures the impact of a price change and asks how much money there would have been before the price change to leave them on the same I.C.
• What we must take away from the consumer before the price change to make him just as well off as after the price change