Chapter 8

Slutsky Equations

De…nition: Let
X
m= pi xi (1)
where x is called an endowment. The Slutsky Demand Function is de…ned as:

xsi (p; x) xi (p; m) i = 1; 2::n (2)

When n = 2, the Slutsky demand functions become:

xs1 (p; x) x1 (p1 ; p2 ; [p1 x1 + p2 x2 ]) (3)

xs2 (p; x) x2 (p1 ; p2 ; [p1 x1 + p2 x2 ]) (4)

where the xi functions are the ordinary, or "Marshallian" demand func-
tions.

The Slutsky Equation

Di¤erentiating the de…nition of xs , we get

@xsi @xi @xi

= + xi (5)
@pi @pi @m
The …rst term in the equation above is called the substitu-
tion e¤ect, and the second is called the income e¤ect.

The Slutsky budget constraint

Changes in prices cause the Slutsky budget constraint to pivot

around the point (x1; x2 ).
dxs1
Result: dp1 is negative.
Proof: Let p01 > p11 ; p02 = p12 ; m0 = m1 :Let (x1 ; x2 ) = (x1 (p0 m0 ); x2 (p0 m0 ))
= (x01 ; x02 ):Now, consider the new price vector (p11 ; p12 ) where p01 > p11 and p02 = p12
(xs1 ; xs2 ) has to lie on f(x1 ; x1 ) : p11 x1 + p12 x2 = p11 x01 + p12 x02 g and to the right
dxs
of x01 , so that xs1 > x01 in response to a decline in p1 . Hence dp11 < 0.
Result: The Slutsky substitution e¤ect is always negative.

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 Hicksian Demand Functions

De…nition: The Hicksian demand function vector solves:

M in fp1 h1 + p2 h2 : u(h1 ; h2 ) = u0 g (6)

(h1 ;h2 )

and is represented by the vector function:

h(p; uo ) = h1 (p; uo ); :::hn (p; uo ) (7)

It is also called the compensated demand function because it traces
out the amount demanded when prices change and utility is held constant by
compensating individuals for the price change.

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 Examples

1. Cobb Douglas
u(x1 ; x2 ) = xa1 1 xa2 2
a 1 a
p1 a1 h1 1 h2 2
M infp1 h1 + p2 h2 : ha1 1 ha2 2 = u0 g gives p2 = a2 ha1 h1 a2
1 2
p1 a1 h2 a1 a2 p2 a1 a1 a2
or p2 = a2 h1 :Combine this with h1 h2 = u0 to get p1 a2 h2 h2 = u0
or
a1
ha2 1 +a2 = u0 pp21 aa21 : This leads to
a1

0 0a 1 p1 a2 a1 +a2
h2 (p1 ; p2 ; u ) = u 1 +a2 (8)
p2 a1
and a2

0 0a 1 p2 a1 a1 +a2
h1 (p1 ; p2 ; u ) = u 1 +a2 (9)
p1 a2
and so that @h @h2
@p1 and @p2 are negative. These are the Hicksian substi-
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tution e¤ects.
2. Quasi-linear.
u(x1 ; x2 ) = a1 ln (x1 )+x2 : minf(p1 h1 +p2 h2 ) : a1 ln (h1 )+
h2 = u0 g gives pp21 = ha11 so that
a1 p2
h1 (p1 ; p2 ; u0 ) = (10)
p1
and
a1 p2
h2 (p1 ; p2 ; m) = u0 a1 ln (11)
p1
with dh dh2
dp1 < 0 and dp2 < 0:Notice that the Hicksian and Marshallian demand
1

functions are the same. Why?

3. Square Root
1
1 1 1 1 1 2
p1 2 h1
u(x1 ; x2 ) = x12 + x22 : minf(p1 h1 + p2 h2 ) : h12 + h22 = u0 g gives p2 = 1 =
1 2
2 h2
1
1 1 1 1 1
h22 p1 2 p1 2 p1 +p2
1 so that h22 = p2 h1 or h12 + p2 h2 = u0 ) h12 + p2 = u0 so that
h12

2
p2 u0
h1 (p1 ; p2 ; u0 ) = 2 (12)
(p1+ p2 )
and
2
0 p1 u0
h2 (p1 ; p2 ; u ) = 2 (13)
(p1+ p2 )
dh1 dh2
with dp1 < 0 and dp2 < 0:

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 Slutsky Equation (Hicksian)

@xi @hi @xi

= xi (14)
@pi @pi @m

Law of Demand

@xi
@pi < 0 if good i is normal or when @x
@m > 0:
i