THE HICKSIAN METHOD Y Optimal bundle is Ea, on indifference curve U1. Ea U1 xa X *Slides adapted from Suzanne O’neil, TCD 1

THE HICKSIAN METHOD Y X A fall in the price of X The budget line pivots out from P Y P* Ea U1 xa X 2

THE HICKSIAN METHOD Y X The new optimum is Eb on U2. The Total Price Effect is xa to xb Y Eb Ea U2 U1 xa xb X 3

THE HICKSIAN METHOD To isolate the substitution effect we ask…. “what would the consumer’s optimal bundle be if s/he faced the new lower price for X but experienced no change in real income?” This amounts to returning the consumer to the original indifference curve (U1) 4

THE HICKSIAN METHOD Y X The new optimum is Eb on U2. The Total Price Effect is xa to xb Y Eb Ea U2 U1 xa xb X 5

THE HICKSIAN METHOD Draw a line parallel to the new budget line and tangent to the old indifference curve Y Eb Ea U2 U1 xa xb X 6

THE HICKSIAN METHOD Y X Eb Ea U2 Ec U1 xa xc xb The new optimum on U1 is at Ec. The movement from Ea to Ec (the increase in quantity demanded from Xa to Xc) is solely in response to a change in relative prices Y Eb Ea U2 Ec U1 xa xc xb X 7

THE HICKSIAN METHOD Xa Xc Y X This is the substitution effect. Eb Ea 8

THE HICKSIAN METHOD To isolate the income effect … Look at the remainder of the total price effect This is due to a change in real income. 9

THE HICKSIAN METHOD Xc Xb Y X Eb Ea U2 Ec UI1 Income Effect The remainder of the total effect is due to a change in real income. The increase in real income is evidenced by the movement from U1 to U2 Y Eb Ea U2 Ec UI1 X Xc Income Effect Xb 10

THE HICKSIAN METHOD Y X Eb Ea U2 Ec U1 xa xc xb Sub Effect IncomeEffect 11

HICKSIAN ANALYSIS and DEMAND CURVES P A fall in price from p1 to p1* B A C X P A Marshallian Demand Curve (A & B) P1 B Hicksian Demand Curve (A & C) P1* C X 12

THE SLUTSKY METHOD Y X Optimal bundle is Ea, on indifference curve U1. xa X 13

THE SLUTSKY METHOD Y X A fall in the price of X The budget line pivots out from P Y P* U1 Ea xa X 14

THE SLUTSKY METHOD Y X The new optimum is Eb on U2. The Total Price Effect is xa to xb Y U1 Eb Ea U2 xa xb X 15

THE SLUTSKY METHOD Slutsky claimed that if, at the new prices, less income is needed to buy the original bundle then “real income” has increased more income is needed to buy the original bundle then “real income” has decreased Slutsky isolated the change in demand due only to the change in relative prices by asking “What is the change in demand when the consumer’s income is adjusted so that, at the new prices, s/he can just afford to buy the original bundle?” 16

THE SLUTSKY METHOD To isolate the substitution effect we adjust the consumer’s money income so that s/he change can just afford the original consumption bundle. In other words we are holding purchasing power constant. 17

THE SLUTSKY METHOD Y X The new optimum is Eb on U2. The Total Price Effect is xa to xb Y U1 Eb Ea U2 xa xb X 18

THE SLUTSKY METHOD Draw a line parallel to the new budget line which passes through the point Ea. Y U1 Eb Ea U2 xa xb X 19

THE SLUTSKY METHOD The new optimum on I3 is at Ec. The movement from Ea to Ec is the substitution effect Y Eb Ea U2 Ec U3 xa xc xb X 20

THE SLUTSKY METHOD The new optimum on I3 is at Ec. The movement from Ea to Ec is the substitution effect Y U1 Eb Ea U2 Ec U3 xa xc X Substitution Effect 21

THE SLUTSKY METHOD The remainder of the total price effect is the Income Effect. The movement from Ec to Eb. Y U1 Eb Ea U2 Ec U3 xc xb X Income Effect 22

THE SLUTSKY METHOD for NORMAL GOODS The income and substitution effects reinforce each other. U1 Eb Ea U2 Ec U3 xa xc xb X 23