Slutsky Equation: Decomposing Price Effects

The Slutsky equation provides a framework in microeconomics to understand how a change in the price of a good impacts consumer demand.

It decomposes the total effect of a price change into two distinct components:

• Substitution Effect: This measures the change in consumption due only to the change in the relative prices of goods, assuming the consumer's purchasing power (real income) remains constant. Consumers tend to buy more of the relatively cheaper good and less of the relatively more expensive one.
• Income Effect: This measures the change in consumption resulting from the change in the consumer's real income (purchasing power) caused by the price change. If a price decreases, real income effectively increases, potentially leading to changes in demand depending on whether the good is normal, inferior, or Giffen.

The Slutsky equation mathematically relates the total effect of a price change to the sum of the substitution effect and the income effect. Therefore, it specifically explains the split between these effects when analyzing a price change's impact on demand.

Option 3 accurately reflects this decomposition explained by the Slutsky equation.