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1、Chapter Eight,Slutsky Equation,What Are We Doing in this Chapter?,We take a further look at the comparative statics of demand function with respect to prices; We divide the changes in demand due to price changes into two effects: Substitution effect; Income effect? Why? Deeper economic intuition.,Ef

2、fects of a Price Change,What happens when a commoditys price decreases? Substitution effect: the commodity is relatively cheaper, so consumers substitute it for now relatively more expensive other commodities.,Effects of a Price Change,Income effect: the consumers budget of $y can purchase more than

3、 before, as if the consumers income rose, with consequent income effects on quantities demanded.,Effects of a Price Change,x1,Lower price for commodity 1 pivots the constraint outwards.,Consumers budget is $y.,x2,Effects of a Price Change,x1,Lower price for commodity 1 pivots the constraint outwards

4、.,Consumers budget is $y.,x2,Now only $y are needed to buy the original bundle at the new prices, as if the consumers income 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 income effect.,Pure

5、Substitution Effect,“What is the change in demand when the consumers income is adjusted so that, at the new prices, she can only just buy the original bundle?” I.e., changes in demand without changes in real income,Pure Substitution Effect Only,x2,x1,x2,x1,Pure Substitution Effect Only,x2,x1,x2,x2,x

6、1,x1,Pure Substitution Effect Only,x2,x1,x2,x2,x1,x1,Lower p1 makes good 1 relativelycheaper and causes a substitutionfrom good 2 to good 1. (x1,x2) (x1,x2) is the pure substitution effect.,Pure Substitution Effect Is Always Negative!,x2,x1,x2,x2,x1,x1,(x1,x2) must always be on the right-hand-side o

7、f (x1,x2) by WRSP!,And Now The Income Effect,x2,x1,x2,x2,x1,x1,(x1,x2),And Now The Income Effect,x2,x1,x2,x2,x1,x1,(x1,x2),The income effect is (x1,x2) (x1,x2).,The Overall Change in Demand,x2,x1,x2,x2,x1,x1,(x1,x2),The change to demand due to lower p1 is the sum of the income and substitution effec

8、ts, (x1,x2) (x1,x2).,Question: What is the Contribution of Slutsky?Answer:1) A nice way to divide the total changes in demand;2) Show that the pure substitution effect is always negative.,Slutskys Effects for Normal Goods,Most goods are normal (i.e. demand increases with income). The substitution an

9、d income effects reinforce each other when a normal goods own price changes.,Slutskys Effects for Normal Goods,x2,x1,x2,x2,x1,x1,(x1,x2),Good 1 is normal becausehigher income increasesdemand,x2,x1,x2,x2,x1,x1,(x1,x2),Good 1 is normal becausehigher income increasesdemand, so the income and substituti

10、on effects reinforce each other.,Slutskys Effects for Normal Goods,Since both the substitution and income effects increase demand when own-price falls, a normal goods ordinary demand curve slopes down. The Law of Downward-Sloping Demand therefore always applies to normal goods.,Slutskys Effects for

11、Normal Goods,Slutskys Effects for Income-Inferior Goods,Some goods are income-inferior (i.e. demand is reduced by higher income). The substitution and income effects oppose each other when an income-inferior goods own price changes.,Slutskys Effects for Income-Inferior Goods,x2,x1,x2,x1,Slutskys Eff

12、ects for Income-Inferior Goods,x2,x1,x2,x2,x1,x1,Slutskys Effects for Income-Inferior Goods,x2,x1,x2,x2,x1,x1,The pure substitution effect is as fora normal good. But, .,Slutskys Effects for Income-Inferior Goods,x2,x1,x2,x2,x1,x1,(x1,x2),The pure substitution effect is as for a normal good. But, th

13、e income effect is in the opposite direction.,Slutskys Effects for Income-Inferior Goods,x2,x1,x2,x2,x1,x1,(x1,x2),The pure substitution effect is as for a normal good. But, the income effect is in the opposite direction. Good 1 is income-inferior because an increase to income causes demand to fall.

14、,Slutskys Effects for Income-Inferior Goods,x2,x1,x2,x2,x1,x1,(x1,x2),The overall changes to demand arethe sums of the substitution and income effects.,Giffen Goods,In rare cases of extreme income-inferiority, the income effect may be larger in size than the substitution effect, causing quantity demanded to fall as own-price rises. Such goods are Giffen goods.,Slutskys Effects for Giffen Goods,Slutskys decomposition of the effect of a price change into a pure substitution effect and an income effect thus explains why the Law of Downward-Sloping Demand is violated for extremely income-i