4.

SUBSTITUTION EFFECTS & CONSUMER’S WELFARE ••

1. Substitution vs. income effect
2. Slutsky equation
3. Substitution effect is always negative
4. Law of demand: normal vs. inferior goods
5. Slutsky matrix
6. Price and income elasticities
7. Engel and Cournot aggregation
8. Compensating and equivalent variation
9. Changes in consumer’s surplus
10. Welfare compensation in the case of quasi-linear utility
SUBSTITUTION VS. INCOME EFFECT ••

A change in prices facing consumers triggers two effects:

Substitution effect: cheaper goods are chosen at the

expense of more expensive ones

Income effect: purchasing power changes and this

affects the demand for all goods

Hicksian demand isolates the substitution effect while

Mashallian demand captures both
SLUTSKY EQUATION ••

Marshallian demand x(p, m)

Hicksian demand xh (p, u)
Indirect utility v(p, m) = u∗

Slutsky equation:

∂xi (p, m) ∂xhi (p, u∗ ) ∂xi (p, m)

= − · xj (p, m)
∂pj ∂pj ∂m
SUBSTITUTION EFFECT ••

It follows from Shephard’s lemma and the concavity of

expenditure on prices that the substitution effect is always
negative.
∂xhi (p, u∗ )
≤0
∂pi
LAW OF DEMAND ••

1. From Slutsky equation for i = j we see that the

demand of a normal good is always decreasing in own
price.

∂xi (p, m) ∂xi (p, m)

≥0⇒ ≤0
∂m ∂pi
2. Alternatively, if the demand of a good increases with its
own price, the good must be inferior.

∂xi (p, m) ∂xi (p, m)

>0⇒ <0
∂pi ∂m
SLUTSKY MARTRIX ••

Substitution effects are symmetric since they

correspond to second cross derivatives of expenditure

∂xhi (p, u) ∂xhj (p, u)

=
∂pj ∂pi
Slutsky matrix: s(p, m) = (sij (p, m))i,j=1,...,n with

∂xhi (p, v(p, m))

sij (p, m) =
∂pj
By concavity of expenditure on prices, the Slutsky
matrix is negative semi-definite
ELASTICITIES ••

Income elasticity

∂xi (p, m) m
ηi =
∂m xi (p, m)
Price elasticity

∂xi (p, m) pj
ij =
∂pj xi (p, m)
SOME ELASTICITY RELATIONS ••

Share of income devoted to the consumption of good i

pi xi (p, m)
si =
m
Engle aggreation:
n
X
si ηi = 1
i=1

Cournot aggregation:
n
X
si ij = −sj
i=1
COMPENSATING & EQUIVALENT VARIATION ••

Monetary compensation to consumer after a change in pi

Compensating variation
Z p1i
e(p1 , u0 ) − e(p0 , u0 ) = xhi (p, u0 )dpi
p0i

Equivalent variation
Z p1i
e(p1 , u1 ) − e(p0 , u1 ) = xhi (p, u1 )dpi
p0i
CONSUMER’S SURPLUS ••

Used as a monetary measure of welfare changes after a

change in pi

Defined as area under Marshallian demand

Z p1i
∆CS = xi (p, m)dpi
p0i

In general it gives an intermediate value between

compensating and equivalent variation
WELFARE COMPENSATION IN QUASI-LINEAR CASE ••

Let u(x0 , x1 , . . . , xn ) = x0 + φ(x1 , . . . , xn )

Marshallian demand for goods i = 1, . . . , n is

independent of income

Hicksian demand for goods i = 1, . . . , n is

independent of utility target

Compensating, equivalent variation, and change in

consumer’s surplus coincide