Principles of Microeconomics / Unit 17 MIC 1613 worked example, 60 to 90 seconds
Sample Question Three: Income or Substitution
The idea
A price change does two things. It changes the good's price relative to others, so buyers substitute toward the cheaper good: the substitution effect. And it changes buying power, so buyers act as if income changed: the income effect, which raises the quantity of a normal good and lowers that of an inferior one. To classify a description, look for its key words: relative price, cheaper compared with, switch from, mean substitution; buying power, can afford, real income, mean income.
In practice
Worked example: the price of bus fares falls. A rider who now takes the bus instead of driving, because the bus is cheaper compared with the car, shows the substitution effect. A rider who, with the fare money saved, buys an extra coffee each morning shows the income effect on coffee. A rider who, feeling richer, takes the bus less and drives more shows the income effect on an inferior good working against the substitution effect. The exam's question describes buying power freed by a price fall and asks its name: the income effect.
Where people slip
For a normal good both effects push the same way and the law of demand holds without argument; for an inferior good they conflict, and the substitution effect almost always wins. And the effects are a decomposition of one observed change, not two separate purchases.
Your place on the trail
Every lesson rests on earlier ones and opens later ones. Tap any to jump.
Unlocks
- Nothing yet depends on this.
Something wrong in this lesson? Flag it