Economics • Economic BasicsHard
In consumer demand theory, how does the Slutsky Equation decompose the total effect of a price change on consumer demand into distinct economic components?
A. Into the substitution effect and the income effect✓ Correct Answer
B. Into the marginal utility effect and the satiety effect
C. Into the production cost effect and the profit margin effect
D. Into the psychological preference effect and the habit persistence effect
💡 Solution & Explanation
The Slutsky Equation mathematically separates the total change in quantity demanded resulting from a price fluctuation into two distinct phenomena: the substitution effect, which reflects changes in relative prices while holding purchasing power constant, and the income effect, which captures changes in purchasing power resulting from the price movement. John Hicks alternative decomposition holds utility constant rather than purchasing power. Understanding this decomposition is essential for analyzing Giffen and inferior goods behavior.
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