Slutsky Revisited: A New Decomposition of the Price Effect

It is only the Slutsky equation that has been universally used to examine how the demand for a good responds to variations in its own price. This paper proposes an alternative to the Slutsky equation. It decomposes such a price effect into the “ratio effect” and the “unit-elasticity effect”. The “ratio effect” is positive (negative) if the expenditure spent on a good under consideration increases (decreases) when its own price rises, and it can be divided further into the familiar substitution effect and the “transfer effect” which reflects the income effect of other goods. The “unit-elasticity effect,” which is always negative, stands for unitary price elasticity of demand. It is also shown that the new method can be used for the analysis of the cross-price effect with and without initial endowments. The Slutsky equation and the new one are “complements”, but graphical representations as well as examples of the applications reveal that the latter is much easier to understand intuitively.