Tsinghua Micro Ch8 021011.ppt

Chapter Eight
Slutsky Equation
What Are We Doing in this Chapter?
We take a further look at parative statics of demand function with respect to prices;
We divide the changes in demand due to price changes into two effects:
Substitution effect;
e effect?
Why? Deeper economic intuition.
Effects of a Price Change
What happens when modity’s price decreases?
Substitution effect: modity is relatively cheaper, so consumers substitute it for now relatively more expensive modities.
Effects of a Price Change
e effect: the consumer’s budget of $y can purchase more than before, as if the consumer’s e rose, with consequent e effects on quantities demanded.
Effects of a Price Change
x1
Lower price modity 1
pivots the constraint outwards.
Consumer’s budget is $y.
x2
Effects of a Price Change
x1
Lower price modity 1
pivots the constraint outwards.
Consumer’s budget is $y.
x2
Now only $y’ are needed to buy the original bundle at the new prices,  as if the consumer’s e has increased by $y - $y’.
The Idea behind the Slutsky Equation
Divide the total changes to demand from a price change into
pure substitution effect;
2) an e effect.
Pure Substitution Effect
“What is the change in demand when the consumer’s e is adjusted so that, at the new prices, she can only just buy the original bundle?”
., changes in demand without changes in real e
Pure Substitution Effect Only
x2
x1
x2’
x1’
Pure Substitution Effect Only
x2
x1
x2’
x2’’
x1’
x1’’