Answer to Question #135208 in Macroeconomics for Sadman Sakif

Question

There are two goods A and B, with prices PA and PB respectively. Carry out a graphical Slutsky decomposition when the price of A falls from PA to PA1. Graphically derive the compensated and uncompensated demand curves

Answer 1

The slutsky decomposition shows that the change in price of the good is divided between two parts which are substitution and income effect. In other words, the price effect is summation income effect and substitution effect. 

Explanation:

This decomposition of slutsky is indicated as follows:

Point A shows the initial equilibrium and when price decreases then the original budget line rotates rightwards. The income effect and substitution effect is indicated as follows:

Income effect = X3 - X2

Substitution effect = X2 - X1

The Marshallian demand is called uncompensated demand curve which considers both income and substitution effect but on the other hand, the Hicksian demand curve is called compensated demand curve which considers only substitution effect in demand. The Marshallian demand is flatter than the Hicksian demand curve. These demand curves can be derived as follows: