1. Under Slutsky’s definition of ‘real income’ the income effect is always smaller than under the Hicksian definition of ‘real income’. True or False. Explain
2. The substitution effect under the Hicksian definition of real income will always be greater than under the Slutsky’s definition when the good is an inferior good. True or False. Explain
When approaching questions like the above, many of us tend to be confused on where to start. It is always a good idea to eliminate, one by one, the factors which are redundant in the process of formulating our answer.
The first redundant factor we are going to eliminate is the type of economic good we are looking at: normal, inferior or giffen goods. Why is it reasonable to leave this out of our analysis? The type of economic good is going to determine the size and direction of the income effect. However, the difference in size of the income effect between the 2 definitions of real income would be cause by the substitution effect. So, we can neglect the type of economic good X is going to be.
The second redundant factor is whether X & Y are gross substitutes or complements. The reasoning would be the same as why we ignore the type of economic good.
The third redundant factor is the price elasticity of demand of good X. Since the substitution effect, which affects the income effect, is the effect where the consumer makes the first step of his decision to change his bundle would be the comparison between the new price X and original price of Y, price elasticity of demand has nothing to do with it.
So, what would affect the relative size of the Hicksian and Slutsky substitution effect? Think about it. We have been taught to decrease the price of X when analysis consumer behavior. That is our default thing to do. This would end up in making the Hicksian S.E. larger than the Slutsky S.E.
Well, the difference in size is all because of the shape of the indifference curve and where point C (under both Hicksian and Slutsky) lands.
Attempt INCREASING the price of x instead of decreasing the price of X…