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There are two parts of the Slutsky equation, namely the substitution effect and income effect. In general, the substitution effect is negative. Slutsky derived this formula to explore a consumer's response as the price of a commodity changes. When the price increases, the budget set moves inward, which also causes the quantity demanded to decrease.
The Hicksian demand function isolates the substitution effect by supposing the consumer is compensated with exactly enough extra income after the price rise to purchase some bundle on the same indifference curve. [2] If the Hicksian demand function is steeper than the Marshallian demand, the good is a normal good; otherwise, the good is inferior.
The Hicks substitution effect is illustrated in the next section. Some authors refer to one of these two concepts as simply the substitution effect. The popular textbook by Varian [1] describes the Slutsky variant as the primary one, but also gives a good explanation of the distinction.
The income effect occurs when the change in prices of goods cause a change in income. If the price of one good rises, then income is decreased (more costly than before to consume the same bundle), the same goes if the price of a good falls, income is increased (cheeper to consume the same bundle, they can therefore consume more of their desired ...
The substitution effect is the effect that a change in relative prices of substitute goods has on the quantity demanded. It due to a change in relative prices between two or more substitute goods. When the price of a commodity falls and prices of its substitutes remain unchanged, it becomes relatively cheaper in comparison to its substitutes.
The book decomposes the change into the substitution effect and the income effect. The latter is the change in real income in theoretical terms without which the distinction between real and nominal values would be more problematic. The two effects are now standard in consumer theory. The analysis conforms with a proportionate change in money ...
The effect of the former type of change in available income is depicted by the income-consumption curve discussed in the remainder of this article, while the effect of the freeing-up of existing income by a price drop is discussed along with its companion effect, the substitution effect, in the article on the latter. For example, if a consumer ...
The book built on ordinal utility and mainstreamed the now-standard distinction between the substitution effect and the income effect for an individual in demand theory for the 2-good case. It generalised the analysis to the case of one good and a composite good, that is, all other goods. It aggregated individuals and businesses through demand ...