9 - Slutsky - Slutsky Decomposition How can it possibly be...

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1 Slutsky Decomposition ± How can it possibly be that demand can be increasing in prices? Haven’t we learned before that there is a “law of demand”: demand falls in the price? ± Any price change has two effects: ± It changes the relative attractiveness of substitute goods for a consumer: The Substitution Effect ± It reduces the “real income” of the consumer: The Income Effect Slutsky Decomposition 1. Can the “Law of Demand” be rescued? When the price of one good rises, the “real income” of a consumer on fixed money income falls. Moreover, he may buy less of that good if it is non- Giffen or more if it is Giffen. Would this indeterminacy necessarily disappear if he were first compensated to restore his “real income”? The objective is to answer both a conceptual and a practical question:
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2 Slutsky Decomposition The objective is to answer both a conceptual and a practical question: 2. When one or more prices rise, social security recipients and others on fixed money incomes are injured. How much compensation is needed to just restore their “real income?” Effects of a Change in Realtive Price How does the change in the price ratio affect demand? It is useful to decompose the overall price change in two steps, each of which can be understood in isolation: 1. How would demand respond if one price changed but “real income” did not change?
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This note was uploaded on 04/02/2008 for the course ECON 401 taught by Professor Kuhn during the Fall '08 term at University of Michigan.

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9 - Slutsky - Slutsky Decomposition How can it possibly be...

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