Dominick Salvatore Schaums Outline of Microeconomics, 4th edition Schaums Outline Series 2006

CHAPTER 5
Advanced Topics in
Consumer Demand
Theory
5.1 THE SUBSTITUTION EFFECT ACCORDING TO HICKS AND SLUTSKY
The substitution effect of a price change defined in Section 4.11 and shown graphically in Problems 4.32
(Fig. 4-28) and 4.33 (Fig. 4-29) is known as the Hicksian substitution effect. This differs from the Slutsky substitution
effect, which keeps real income constant by rotating the original budget line through the original equilibrium
point until it is parallel to the new budget line after the price change. The movement from the original
equilibrium point to the point where the rotated budget line is tangent to the higher (than the original) indifference
curve represents the Slutsky substitution effect.
EXAMPLE 1. Figure 5-1 is the same as panel A of Fig. 4-28 except that budget line K 00 J 00 has been added. Budget line
K 00 J 00 goes through point E (the original equilibrium point on budget line KL before the price change), is parallel to budget
line KJ (after the price change), and is tangent to indifference curve II 0 (which is higher than II). The movement from
point E to point H (3X) is the Slutsky substitution effect, compared to the Hicksian substitution effect of 2X given by
the movement from E to G. Note that Hicks keeps real income constant by keeping the consumer on the original indifference
curve II. On the other hand, Slutsky keeps real income constant in the sense that the consumer could purchase the
original basket of X and Y given by point E. The consumer, however, will move to point H on the higher indifference
curve II 0 , so that the Slutsky substitution effect exceeds the Hicksian substitution effect. The Slutsky measure is generally
preferred to the Hicksian measure because it relies on observable prices and quantities. The Slutsky demand curve
(showing only the Slutsky substitution effect) is more elastic than the Hicksian demand curve, and both are less
elastic than the usual demand curve showing both the substitution and income effects (see Problem 5.1).
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