The Slutsky-Equation and Various Elasticity Calculations R. Pope In Figure 5.3 of the text, a price change is decomposed into income and substitution effects. This turns out to be a very important exercise so stay with it. In the Figure the price of x falls. The original equilibrium is at x* and y*. As pxfalls, the equilibrium consumption changes to x** and y**. Thus, x isn’t a Giffen good. As pxfalls more of the good is consumed.
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The movement from x* to x** are two points on an ordinary demand curve. Now, decompose the movement from x* to x** into an income effect and a substitution effect. The substitution effect lets price change but keeps a person’s real income constant. Here real income constant means that one is on the same indifference curve. It can be thought of as the following: if pxfalls, real income has gone up. Let the new price of x prevail but take away enough income so that the individual is on the same indifference curve. That level of income is shown as a dotted line in Figure 5.3. What would the person consume in such an experiment: B in Figure 5.3 were the new budget (price ) line is tangent to the original indifference curve. xBis a point on the compensated demand curve xc(px,py,U) that we have seen before. It is not yet shown on the graph but we can px x(px,py,I) px2 px1 x* xB x**