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What is the importance of the Slutsky equation and how

are things changed by the introduction of endowments?


The Slutsky equation is an important tool in analysing consumer behaviour and
demand functions. It is a precise mathematical method by which the effects of a
price change on the consumers demand (optimal choices) can be determined,
and decomposed into the two different simultaneous effects: the income and
substitution effect. The equation is derived thusly:
If the constraint in the utility maximisation problem is the level of expenditure,
obtained from the expenditure minimisation problem then the values of the
Marshallian and Hicksian demand functions will be equal. This is expressed
mathematically as:

H i ( p , u )=Di ( p , m ( p ,u ) )
By taking the derivative with respect to the price of another good, allowing
expenditure to increase or decrease such that utility is kept constant, we obtain
the result

H i Di Di m
=
+
pj pj M pj
The right hand term on the right hand side of the equation is equal to Shephards
lemma, so we obtain the Slutsky equation:

Di H i
Di
=
xj
p j pj
M
If i = j, then we can see that the effect of a change of price on its own demand.
The slope of the Marshallian demand function can be decomposed into the
substitution effect, the first term on the right hand side of the equation, which is
equal to the slope of the Hicksian/ compensated demand curve, and the income
effect which is the second term. To summarise, the total effect of a price change
is equal to the change due to the substitution effect and the change due to the
income effect.
This equation is important as it can explain to us the different effects of a price
change in terms of two different mechanisms, each of which may be having
contrasting effects on the overall change in quantity demanded by the
consumer: an increase in price may result in an increase in quantity demanded
by the income effect, but the substitution effect may be of larger magnitude and
in the opposite direction so the overall effect is quantity demanded decreases. In
addition, by isolating the income effect we can see whether the good is a normal
or inferior good; we can see what happens if the government compensates those

who suffer the costs of a government policy such as a fuel tax, and how this will
affect their demand and welfare.
We can represent the equation diagrammatically to illustrate the usefulness of
the equation. We can derive an individuals compensated and uncompensated
demand curve for a good, with other prices and incomes being held constant.
The uncompensated demand curve is the demand curve we usually refer to as a
demand curve, and is otherwise known as the Marshallian demand curve.
However, we may want to derive a demand curve where the consumer is
compensated such that utility is held constant, so we only see the change in
quantity demanded resulting from the substitution effect. The compensated
demand curve is also called the Hicksian demand curve. The compensated
demand function for good 1 is:

q1 =H ( p 1 , p2 , U )
Here utility is held constant. In the example in Perloff (2013), the price of good 1
is 50p, and the price of good 2 is 1, so the slope of the budget line is -1/2, and
is tangential to the indifference curve at the corresponding point according to the
original demand function, where 24 units of good 1 were purchased at 50p each.
This is then plotted as a point on the demand curve, at the point e2.
For the other points on the compensated demand curve, the consumers budget
is increased or decreased such that the budget line is tangential to the original
indifference curve, so when the price of good 1 falls to 25p, we decrease their
budget, achieving the new point e3, and when the price of good 1 rises to 1, we
increase their budget, achieving the new point e1.
The uncompensated demand curve is derived using the equation for the demand
function. It crosses the compensated demand curve at the original point because
here no compensation is required to achieve the same level of utility, and hence
the compensated and uncompensated demand curves intersect at this point. The
uncompensated demand curve is steeper than the compensated curve for prices
higher than this point because this good is a normal good, and therefore the
income effect will mean that quantity demanded will decrease by an additional
amount; the reverse applies for prices lower than e2.

Another way in which the Slutsky equation is useful is that it can help us
understand Giffen goods. Using the equation we can see that if the second term
is larger in magnitude than the first term, with the income effect happening in
the opposite direction to the change in quantity demanded caused by the
substitution effect, then the change in quantity demanded will be in the same
direction as the change in price, contrary to the law of demand.
The case of a Giffen good is illustrated below

In this diagram we can see the effects of a fall in the price of p1 for a normal
good: money income is held constant so a fall in the price of good 1 leads to the
budget line B1 to shift to B2, with an optimal bundle of x. However, if the
preferences of the consumer were such that they had an indifference curve of I3
then a fall in the price of good 1 would in fact lead to a fall in the quantity
demanded for the good. We can derive a demand curve for this good, where the
demand curve (i.e. the uncompensated demand curve) slopes upwards.
Endowments act as extra income because the consumer can sell their
endowment on: we can consider this part of their wealth or income. However, if
their endowment is in either of the goods being considered, then we must alter
the Slutsky equation to take into account the fact that the consumers effective
budget will vary with price. Moreover, the income effect can be decomposed into
two further parts: the endowment effect and the income effect. We denote the
endowment using the character omega,

. A change in the price of the good

will pivot the budget line around the initial optimal bundle, rather than around
one of the axis.

Because income does now change with price of either good as

M = p1 1 + p2 2
Now the Slutsky decomposition will include three components: the pure
substitution effect, pure income effect, and endowment income effect. We can
see this diagrammatically below:

The price of good 1 falls, so the budget line pivots around the initial optimal
bundle e1, and is tangential to the indifference curve I2. The budget line shifts
outwards due to the ordinary income effect, and then shifts inwards due the
endowment income effect. We can write this down this mathematically:

Di H i Di
=
+
( jx j )
p j p j M