Example

The Cobb-Douglas Slutsky Equation

U ( X 1 , X 2 ) X 1a X 21 a X 1 * ( M , P1 , P2 )
1 a

aM (1 a ) M
v( M , P1 , P2 )

P2
P1

h1 (U , P1 , P2 ) aP

1 a

1 P2

a 1 a

1 a

aP2
U

(1 a ) P1

h1 P1 , P2 , v( P1 , P2 , M )

1 a

X 1
aM
2
P1
P1

h1 ( P1 , P2 ,U )
1 P
a (a 1) P1a 2 2
P1
a 1 a
P1

1 a

a 1 a

P1 P2

1 a

P P
e(U , P1 , P2 ) 1 2
a 1 a
a 1
1

aM
(1 a ) M
, X 2 * ( M , P1 , P2 )
P1
P2

U
1 a

a 2
1

a (a 1) P

1 P2

a 1 a

a a 1 a 1 a
2

M a (a 1) P1 M
P1 P2

X 1 a

M P1

a aM
h1 X 1

X 1 a (a 1) P12 M
P1 M
P1 P1

aM X 1

P1
P12

48
Elasticity
Definition:

ii

own-price elasticity of demand

Definition:

ij

cross-price elasticity of demand

Definition:

% in X i
P X i
i
% in Pi
X i Pi

M M

Pj X i
% in X i

% in Pj
X i Pj

M M

own-price elasticity of compensated demand

Definition:

cross-price elasticity of compensated demand

M X i
X i M

Definition:

income elasticity of demand

Definition:

Two goods i, j are substitutes if ij 0

Definition:

Two goods i, j are complements if ij 0

Definition:

Two goods i, j are gross substitutes if ij 0

Definition:

Two goods i, j are gross complements if ij 0

Definition:

Good i is a normal good if i 0 .

Good i is an inferior good if i 0 .

Definition:

Some useful identities:

1.
Slutsky equation:

X j ( P, M )

h j ( P, u )

X j ( P.M )

Xi
Pi
M
P X j ( P, M ) Pi h j ( P, u ) Pi X j ( P.M )
M
i

Xi
Xj
Pi
Xj
Pi
Xj
M
M
Pi

Pi X j ( P, M ) Pi h j ( P, u ) M X j ( P.M ) Pi X i

Xj
Pi
Xj
Pi
Xj
M
M

ji ji ji

i : expenditure share of good i

48

ii

ij

Pi X i
X i Pi

U U

Pj X i
X i Pj

U U

49
2.

Assume non-satiation, we have

PX
i 1

Differentiating with respect to P1 :

X n
X
X 2
P1 1 X 1 P2
... Pn
0
P1
P1
P1
P X n
P X 1
P X 2
1
1 2
... n
0
X 1 P1
X 1 P1
X 1 P1
P X n X n P1
P X 1
P X 2 X 2 P1
1
1 2
... n
0
X 1 P1
X1 P1 X 2 P1
X 1 P1 X n P1
PX
PX
11 1 21 2 2 ... n1 n n 0
P1 X 1
P1 X 1
P X PX
PX
PX
P X PX
1 1 11 1 1 2 2 1 1 21 ... n n 1 1 n1 0
M
M
P1 X 1 M
P1 X 1 M
111 1 2 21 ... n n1 0

111 2 21 ... n n1 1
n

In general, 11 j 2 2 j ... n nj j

3.

PX
i 1

or

i 1

i ij

Differentiating with respect to M :

X n
X
X 2
P1 1 P2
... Pn
1
M
M
M
X n X n M
X X M
X 2 X 2 M
P1 1 1 P2
... Pn
1
M X 1 M
M X 2 M
M X n M
M X1 P1 X 1 M X 2 P2 X 2
M X n Pn X n

...
1
X1 M1 M
X 2 M M
X n M M
11 2 2 ... n n 1

or

i 1

49

50
Theorem (Eulers Theorem):
A differentiable function of n variables f ( x1 ,..., xn ) is homogeneous of degree r iff ( x1 ,..., xn ) ,
n
f ( x1 ,..., xn )
rf ( x1 ,..., xn )
xi
xi
i 1
4.

Note that X i ( P, M ) is homogeneous to degree 0.

From the Eulers Theorem, 0 (0) X i ( P, M )

X i
X
X
X
P1 i P2 ... i Pn i M
P1
P2
Pn
M

X i P1 X i P2
X P X M

... i n i
P1 X i P2 X i
Pn X i M X i
i1 i 2 ... in i 0
i
0

5.

compensated demand U U ( X 1 ,..., X n )

Differentiated with respect to P1 :

X n
X
U X1
U X n

...
0 or U1 1 ... U n
0
X1 P1
X n P1
P1
P1
U X n
X U X 2
1 2
... n
0
P1 U1 P1
U1 P1
U
P
At equilibrium, i i
i
U1 P1
P X n
X
P X 2
1 2
... n
0
P1 P1 P1
P1 P1
P X P X n
P X X
P X P X 2
1 1 1 1 2 2
... 1 n n
0
P1 X 1 P1 P1 X 2 P1 P1
P1 X n P1 P1
X P P X n
X P X1 X 2 P2 P1 X 2
1 1

... n n 1
0
P1 X 1 P1
P1 P1 X 2 P1
P1 P1 X n P1
PX
PX
PX
1 1 11 2 2 21 ... n n n1 0
M
M
M
111 2 21 ... n n1 0
n

In general,

i 1

i ij

or

i 1

i i1

j 1,..., n

50

51
Example:
The own price elasticity for apple ( AA ) is 1 ; the income elasticity of apple ( ) is 0.5 . What will be
the effect on the quantity of apples consumed when the price of all other goods goes up by 10%?
AA AO A 0 (1) AO (0.5) 0 AO 0.5

hence when Po 10% QA 5%

Example:
Claim: It is impossible that all goods are inferior goods, but it is possible that all goods are normal
goods.
11 2 2 ... n n 1
If all i 0 (inferior goods), then

i i

0 1.

If all i 0 (normal goods), then it is possible that

i i

1.

Example:
Claim: i)
In a 2-good world, these 2 goods must be substitutes
ii)
In a n good world, these n goods may or may not be complements.
i)
111 212 0
Since 11 0 21 0 (substitutes)
ii)

111 21 2 313 ... n1 n 0

Although 11 0 it is possible that 21 , 31 can be negative, i.e. complements .

Example:

Explain whether each of the following statement is TRUE or FALSE.

"Budget study show an income elasticity of demand for food of 0.5 for urban families and of 0.35 for
farm families. This implies that farm families have different tastes from urban families."
(FALSE)
This is due to the difference in the expenditure share of food in the budget of the rural families and of
the urban families.
Furban Furban Furban Furban

Frural Frural Frural Frural

Assume that Furban Frural and Furban Frural (since the taste of the families should be roughly the same).

Furban Furban Frural Frural

Since Furban Frural Furban Frural which is consistent with empirical evidences (the rural families are
poorer, therefore they spend more money on the necessitiesfood.)
[Educational note: In economics, we always try to avoid concluding that tastes are different.]
51