Notes on Slutsky and Hicksian Compensation for Price Changes

We have studied several examples of compensated demand in lecture, focusing almost

entirely on Slutsky compensation, which is defined as a change in wealth that enables a
consumer to afford the bundle he was purchasing prior to the price change.
Suppose that under initial conditions, a consumer has wealth W, faces prices (p, q) and
purchases bundle A = (x*, y*). Figures 1 and 2 show a typical relationship where point
A is tangent to the initial budget line, which has intercepts (0, W/q), (W/p, 0). The
consumer achieves utility u(x*, y*) = u-bar, which can also be written in indirect utility
form u-bar = v(p, q, W).
Suppose that price p increases to p but price q remains fixed. Figure 1 shows the change
in the budget line after Slutsky compensation. As a result of the price change, the slope
of the budget line changes from p/q to p/q. The new budget line includes A by
definition, and is steeper than the old budget line because p > p.
Figure 2 shows the change in the budget line after Hicksian compensation. Once again,
the slope of the new budget line is p/q and the new budget line is steeper than the old
budget line. But with Hicksian compensation, the budget line is tangent to the original
indifference curve at point B = (hX, hY), since Hicksian compensation is defined as the
minimum wealth necessary to maintain the original utility level.
Hicksian compensation is weakly less than Slutsky compensation since Slutsky
compensation guarantees that it is possible to attain utility u-bar by choosing (x*, y*)
after the compensated price change. Further, with differentiable and strictly convex
preferences, Hicksian compensation is strictly less than Slutsky compensation because, as
shown in Figure 1, if (x*, y*) represents a tangency between indifference curve and
original budget line, it cannot also represent a tangency between indifference curve and
new budget line.
Signing Compensated Changes in Demand
In class, we proved the Law of (Slutsky) Compensated Demand in two ways that can also
be used to prove that hX < x*, hY > y*.
First, we can use revealed preference. Both Hicksian and Slutsky compensation produce
intercepts to the left of (W/p, 0) and above (0, W/q). That is, the compensated price
change increases the consumers buying power for good y alone (since wealth increased
but q is constant), but reduces the consumers buying power for good x alone. The new
budget set for each type of compensation leaves out the lower right corner of the original
budget set and includes bundles in the upper left of the graph that were not available in
the original budget set.

Bundle A is the best choice in the original budget set and is also available after Slutsky
compensation. Therefore, the consumer will either continue to choose A after Slutsky
compensation or will change to another bundle that was not available in the original
budget set. So the consumer would only change to a bundle to the left of A and above the
original budget line. If the optimal compensated bundle is (sX, sY), then the consumer
will either set (sX, sY) = (x*, y*) in which case sX = x* or the consumer will choose a
different bundle with sX > sY.
Second, if we assume differentiable and strictly convex preferences, then we can simply
observe that when with price p > p, the tangency between budget line and indifference
curve must shift to the left because (1) price ratio p / q > p / q and (2) with decreasing
MRS, the slope of an indifference curve is decreasing as x increases. By comparative
statics analysis corresponding to the relationships between budget lines and
indifference curves as shown in Figures 1 and 2 we know that hX, sX < x*, hY, sY > y*.
(Note that with differentiable and strictly convex preferences, the law of compensated
demand can be written as a strict inequality for both Hicksian and Slutsky compensation).