Elasticities and the

Slutsky Equation

Elasticities

Topic 6:
Elasticities and the Slutsky Equation

Compensated
Demand
Price Elasticity of
Compensated
Demand
The Slutsky
Equation
Laws of Demand

Textbook: Chapters 4.2 and 4.3 (all editions)

Real World Giffen

Goods?

1 / 24

Elasticities and the

Slutsky Equation

Elasticities

Elasticities

The Price Elasticity of Demand:

Compensated
Demand

D1
D1
p1
p1

p1 0

dD1
D1
dp1
p1

dD1 p1
=
dp1 D1

epsilon

Price Elasticity of
Compensated
Demand
The Slutsky
Equation
Laws of Demand

Percentage change in D1 if price p1 increases by 1%.

Real World Giffen

Goods?

The Income Elasticity of Demand:

D1
D1
Y
Y

Y 0

dD1
D1
dY
Y

dD1 Y
=
dY D1

xi

Percentage change in D1 if income Y increases by 1%.

2 / 24

Elasticities and the

Slutsky Equation

Example

Elasticities
Compensated
Demand
Price Elasticity of
Compensated
Demand

D1 = 10 p1
dD1
dp1
=

dD1 p1
dp1 D1

The Slutsky
Equation
Laws of Demand

= 1

Real World Giffen

Goods?

p1
10 p1

3 / 24

Elasticities and the

Slutsky Equation

Example

Elasticities
Compensated
Demand
Price Elasticity of
Compensated
Demand

U1 (q1 , q2 ) = q1 q2
D1 (p1 , p2 , Y ) =

The Slutsky
Equation

1Y
2 p1

D1 p1
p1 D1

D1 Y
Y D1

Laws of Demand

1 Y p1
= 1
2 (p1 )2 12 pY

Real World Giffen

Goods?

1 1 Y
=1
2 p1 12 pY
1

4 / 24

Recall: Income and Substitution Effects

Elasticities and the

Slutsky Equation

A price increase has an income and a substitution effect:

Elasticities
Compensated
Demand
Price Elasticity of
Compensated
Demand
The Slutsky
Equation

q2

e*
e1

Real World Giffen

Goods?

e2

Laws of Demand

0
q1

5 / 24

Elasticities and the

Slutsky Equation

Expenditure Minimization
e solves an expenditure minimization problem:
Given prices p1 = 2, p2 = 1 and target utility
U = 25, which consumption bundle e = (q1 , q2 )
achieves U with the smallest expenditure?

Elasticities
Compensated
Demand
Price Elasticity of
Compensated
Demand
The Slutsky
Equation
Laws of Demand
Real World Giffen
Goods?

q2

e*

e1

0
q1

6 / 24

The Expenditure Minimization Problem

Elasticities and the

Slutsky Equation

Elasticities
Compensated
Demand

Given
I

prices p1 , p2 ;

target utility level U;

Price Elasticity of
Compensated
Demand

which consumption bundle (q1 , q2 ) achieves U with the

smallest expenditure?

The Slutsky
Equation
Laws of Demand
Real World Giffen
Goods?

Define:
I

to be the expenditure minimizing q1 .

H1 (p1 , p2 , U)
Compensated demand for good 1
to be the expenditure minimizing q2 .
H2 (p1 , p2 , U)
Compensated demand for good 2

7 / 24

Solving the Expenditure Minimization Problem

Elasticities and the

Slutsky Equation

With monotone and convex preferences,

Elasticities

when the quantities of both goods are strictly positive:

MRS = price ratio
U
q1
U
q2

p1
p2

Compensated
Demand
Price Elasticity of
Compensated
Demand
The Slutsky
Equation
Laws of Demand
Real World Giffen
Goods?

utility = target utility

U(q1 , q2 ) = U

8 / 24

Elasticities and the

Slutsky Equation

Example
U(q1 , q2 ) = q1 q2

Elasticities
Compensated
Demand

Finding compensated demand:

Price Elasticity of
Compensated
Demand
The Slutsky
Equation

MRS = price ratio

U
q1
U
q2

q2
q1

Laws of Demand

p1
p2
p1
p2

Real World Giffen

Goods?

utility = target utility

U(q1 , q2 ) = U
q1 q2 = U
9 / 24

Elasticities and the

Slutsky Equation

Example
Solving the first equation:

Elasticities

q2 =

p1
q1
p2

Compensated
Demand
Price Elasticity of
Compensated
Demand

Substituting into the second equation:

q1

The Slutsky
Equation

p1
q1 = U
p2
p2
(q1 )2 =
U
p1
r
p2
q1 =
U
p1

Laws of Demand
Real World Giffen
Goods?

Substituting back:

q2 =

p1
p1
q1 =
p2
p2

p2
U=
p1

s

p1
p2

2

p2
U=
p1

p1
U
p2
10 / 24

Elasticities and the

Slutsky Equation

Example

Elasticities
Compensated
Demand

The compensated demand functions:

r
= p2 U
H1 (p1 , p2 , U)
p1
r
= p1 U
H2 (p1 , p2 , U)
p2

Price Elasticity of
Compensated
Demand
The Slutsky
Equation
Laws of Demand
Real World Giffen
Goods?

11 / 24

Elasticities and the

Slutsky Equation

Demand Functions
Regular (Marshallian) demand:

q1 = D1 (p1 , p2 , Y )
Elasticities
Compensated
Demand
Price Elasticity of
Compensated
Demand
The Slutsky
Equation
Laws of Demand

Alfred Marshall
Compensated (Hicksian) demand:

Real World Giffen

Goods?

q1 = H1 (p1 , p2 , U)

John Hicks
12 / 24

Elasticities and the

Slutsky Equation

The Price Elasticity of Compensated Demand

1 =

H1 p1
p1 H1

Elasticities
Compensated
Demand

Compensated demand always decreases in price: 1 < 0.

Price Elasticity of
Compensated
Demand

Example:

The Slutsky
Equation

=
H1 (p1 , p2 , U)

Laws of Demand

0.5
p2
U = (p2 )0.5 (p1 )0.5 U
p1

Real World Giffen

Goods?

1 = 0.5 (p2 )0.5 (p1 )1.5 U

p1

0.5

(p2 )0.5 (p1 )0.5 U

0.5

= 0.5
13 / 24

Elasticities and the

Slutsky Equation

The Slutsky Equation

Elasticities
Compensated
Demand

Definition:

Price Elasticity of
Compensated
Demand

pi Di (p1 , p2 , Y )
Y
share of income spent on good i

The Slutsky
Equation
Laws of Demand
Real World Giffen
Goods?

The Slutsky Equation:

price elasticity
of demand

price elasticity
of compensated demand
Substitution Effect

expenditure share
in income

income elasticity
of demand

Income Effect

14 / 24

The Slutsky Equation

Elasticities and the

Slutsky Equation

Elasticities
Compensated
Demand

Implications:
I

For normal goods ( > 0) the price elasticity of demand

is negative ( < 0).

For inferior goods ( < 0) the price elasticity of demand

is negative ( < 0) if they take a small share of income
( small).

An inferior good ( < 0) may be a Giffen good ( > 0)

if it takes a large share of income ( large).

Price Elasticity of
Compensated
Demand
The Slutsky
Equation
Laws of Demand
Real World Giffen
Goods?

15 / 24

Elasticities and the

Slutsky Equation

Example

Elasticities
Compensated
Demand
Price Elasticity of
Compensated
Demand
The Slutsky
Equation

1 1
= 1 = = 1
2 2

Laws of Demand
Real World Giffen
Goods?

16 / 24

Laws of Demand

Elasticities and the

Slutsky Equation

Elasticities
Compensated
Demand

Walras Law:
p1 D1 (p1 , p2 , Y ) + p2 D(p1 , p2 , Y ) = Y

Price Elasticity of
Compensated
Demand
The Slutsky
Equation
Laws of Demand

If a consumer buys consumption goods as if she were

maximizing monotonically increasing preferences:

Real World Giffen

Goods?

The consumer spends all her income.

17 / 24

Laws of Demand

Elasticities and the

Slutsky Equation

Elasticities
Compensated
Demand

If a consumer buys consumption goods as if she were

maximizing preferences:

Price Elasticity of
Compensated
Demand
The Slutsky
Equation
Laws of Demand

If all prices and income are multiplied by the same

number, then demand does not change.

Real World Giffen

Goods?

18 / 24

Elasticities and the

Slutsky Equation

Laws of Demand

Elasticities
Compensated
Demand

If a consumer buys consumption goods as if she were

maximizing preferences:

Price Elasticity of
Compensated
Demand
The Slutsky
Equation
Laws of Demand

If the demand for a good increases when income

increases, then the demand for that good must
decrease when its price increases.

Real World Giffen

Goods?

19 / 24

Are There Real World Giffen Goods?

Elasticities and the

Slutsky Equation

Elasticities

Slutsky Equation look for inferior goods on which a large

proportion of budget is spent. basic foods.

Compensated
Demand
Price Elasticity of
Compensated
Demand
The Slutsky
Equation
Laws of Demand
Real World Giffen
Goods?

Hunan
Rice

Gansu
Wheat

20 / 24

Elasticities and the

Slutsky Equation

Elasticities

Jensen and Millers data:

I

Observe price and consumed quantity of good.

Randomly distribute vouchers that reduce the price.

Observe subsidized price and consumed quantity of

good.

End the voucher distribution.

Observe price and consumed quantity of good.

Compensated
Demand
Price Elasticity of
Compensated
Demand
The Slutsky
Equation
Laws of Demand
Real World Giffen
Goods?

Unit of Observation: Households.

21 / 24

Results:

Elasticities and the

Slutsky Equation

Elasticities
Compensated
Demand
Price Elasticity of
Compensated
Demand

Poor households in Hunan: price elasticity of rice

demand is +0.45 ( Giffen good).
Poor households in Gansu: evidence of positive elasticity
of wheat demand is not statistically significant.

The Slutsky
Equation
Laws of Demand
Real World Giffen
Goods?

22 / 24

Data:

Elasticities and the

Slutsky Equation

Elasticities
Compensated
Demand
Price Elasticity of
Compensated
Demand
The Slutsky
Equation
Laws of Demand
Real World Giffen
Goods?

23 / 24

Data:

Elasticities and the

Slutsky Equation

Elasticities
Compensated
Demand
Price Elasticity of
Compensated
Demand
The Slutsky
Equation
Laws of Demand
Real World Giffen
Goods?

24 / 24