ECON 10A CHAPTER 8

Which statement best distinguishes Hicks and Slutsky compensation?

Hicks holds prices fixed; Slutsky holds income fixed

Hicks applies only to normal goods; Slutsky only to inferior goods

Hicks keeps utility constant; Slutsky keeps the old bundle affordable

Hicks keeps the old bundle affordable; Slutsky keeps utility constant

Hicks compensation holds utility constant after the price change. Slutsky compensation instead adjusts income so that the original bundle is still just affordable at the new prices.

For a normal good, when its price rises, the substitution effect and income effect on demand for that good are:

substitution effect negative, income effect positive

both positive

substitution effect nonpositive, income effect negative

substitution effect positive, income effect negative

both zero

When the price of a good rises, the substitution effect for that good is weakly negative: holding purchasing power fixed in the appropriate compensated sense, the consumer does not buy more of the good whose relative price increased. Under standard smooth, strictly convex preferences with an interior optimum, this effect is strictly negative. But in cases such as perfect complements, the substitution effect can be zero.

If the good is normal, the fall in purchasing power caused by the price increase also reduces demand for the good, so the income effect is negative.

The Hicks decomposition isolates the substitution effect by:

adjusting income so that utility stays at its original level after the price change

making the new optimum equal to the old one

adjusting income so that the original bundle remains affordable

keeping the slope of the budget line unchanged

holding money income fixed

In the Hicks decomposition, income is adjusted so that the consumer can reach the original utility level after the price change. This isolates the substitution effect while keeping utility constant.

For an inferior good, when its own price rises, the substitution effect on demand for that good is \_\_\_\_, while the income effect is \_\_\_\_.

nonpositive; positive

positive; negative

positive; positive

negative; negative

zero; ambiguous

A rise in the good's own price makes that good relatively more expensive. The substitution effect on demand for that good is therefore weakly negative: the consumer does not substitute toward the good whose relative price increased. Under smooth, strictly convex preferences with an interior optimum, this effect is strictly negative, but it can be zero in cases such as perfect complements.

If the good is inferior, then the loss in purchasing power caused by the price increase tends to raise demand for the good. Thus the income effect is positive.

The total effect is ambiguous: if the positive income effect is large enough to dominate the substitution effect, the good is a Giffen good.