Economics 401

The Choice-Based Approach

Consider a three-good example of Proposition 2.F.1 in MWG (p. 30) and the discussion
that follows it. Let x1 (a 3 by 1 column vector) denote quantities demanded at prices p1
(which is also a 3 by 1 vector). Now let prices change to p2 and adjust wealth w so that x1
is just affordable at prices p2 . Let x2 denote the bundle purchased at prices p2 with adjusted
wealth. The required change in wealth is






w = p21 p11 x11 + p22 p12 x12 + p23 p13 x13 .
Now
(p)> x
=

> 2


p2 p 1
x x1

>

>

>

>
p 2 x2 p 1 x2 p 2 x1 + p 1 x1

By construction, the cost of bundle 2 at the 2 prices and the cost of bundle 1 at the 2
prices are the same; note that this means that bundle 2 is revealed preferred to bundle 1.
So the first and third terms in the last line cancel each other leaving
(p)> x = p1

>

x2 + p 1

>

x1

IF this term were positive it would say that bundle 2 was affordable with wealth and
prices at 1, that is bundle 1 would be revealed preferred to bundle 2. But this cannot be
true if WARP holds because WARP rules out inconsistencies like 2 revealed preferred to 1
and 1 revealed preferred to 2. Therefore, if WARP holds, it must be that
(p)> x 0.
Now suppose the demand system is differentiable so the result can be written in terms
of infinitesimals, that is
dp> dx 0
where

dp1
dp = dp2
dp3

x1
dp1 +
p1
x
2
dx = p1 dp1 +
x3
dp1 +
p1

x1
p1
x2
p1
x3
p1

x1
p2
x2
p2
x3
p2

1
1
+ x
dp3 + x
dw
p3
w
2
2
+ x
dp3 + x
dw

p3
w
x3
3
+ x
dp
+
dw
3
p3
w

x1
dp1
w

2
dw
dp2 + x
w
x3
dp3
w

x1
dp2
p2
x2
dp2
p2
x3
dp2
p2
x1
p3
x2
p3
x3
p3

But

dp1
dp2 (from the first equation in this note)
dp3

dw =

x11 x12 x13

so

dx =

x1
p1
x2
p1
x3
p1

x1
p2
x2
p2
x3
p2

x1
p3
x2
p3
x3
p3

x1
p1
x2
p1
x3
p1

x1
p2
x2
p2
x3
p2

x1
p3
x2
p3
x3
p3

x1

dp1
dp
1
w
 1 1 1 

2
x1 x2 x3 dp2
dp2 + x
w
x3
dp3
dp3
w

1 x1

1
1
x13 x
x1 w x12 x
dp1
dp1
w
w

2
2
2
dp2
x12 x
x13 x
dp2 + x11 x
w
w
w
x
x
x
dp3
dp3
x11 w3 x12 w3 x13 w3

dp1
= S dp2 ,
dp3
where

x1
p1
x2
p1
x3
p1

1
+ x11 x
w
2
+ x11 x
w
3
+ x11 x
w

x1
p2
x2
p2
x3
p2

1
+ x12 x
w
2
+ x12 x
w
3
+ x12 x
w

x1
p3
x2
p3
x3
p3

1
+ x13 x
w
2
+ x13 x
w
3
+ x13 x
w

Thus saying that, for all changes in prices, the persons choices satisfy WARP means
dp> dx 0 or
dp> Sdp 0, for all dp
This implies that the matrix S must be negative semi-definite (see p. 932 of MWG).
Among other things, this means that the entries down the main diagonal of S cannot be
2

positive. S is the Slutsky substitution matrix the matrix of substitution effects. Why?
Well, look at any element, say, the second entry in the first row.
x1
x1
+ x2
p2
w
The first term is the total price effect on the demand for good 1 of raising the price of
good 2 by a dollar. When the price of good 2 goes up by a dollar and the person is already
consuming x2 units of good 2 the price increase in good 2 is like losing x2 dollars of wealth
and each dollar lost has x1 /w effect on the purchase of good 1. So the income effect of
raising the price of good by a dollar is
x1
.
w
Since, by definition, the total price effect is the sum of the substitution effect and the
income effect,
x2

x1
x1
+ x2
the substitution effect.
p2
w
With three goods there are nine substitution effects and each of them corresponds to some
element in S. The choice-based approach implies that if prices are changed, and wealth is
altered so that the person is just able to purchase the original bundle of goods, then it must
be that the person does not buy more of a good that has gone up in price.