Principles of Microeconomics / Unit 5 MIC 0414 worked example, 60 to 90 seconds
Substitution or Income?
The idea
To classify a described response to a price change, ask which mechanism the description names. If it says the good became relatively dearer and the consumer moved toward alternatives, that is the substitution effect. If it says the consumer's real income or purchasing power fell and quantity fell as a result, that is the income effect. Both happen at once in any real price change, so a description picks one out by what it emphasizes. Elasticities and diminishing marginal utility are different concepts and are the usual distractors.
In practice
Worked example: when the price of a product rises, a consumer's real income falls, causing the consumer to buy less of the product. The description names real income, so this is the income effect. A second description: coffee gets dearer, so the consumer drinks more tea and less coffee. That names relative prices and a move to an alternative, so it is the substitution effect. A third, that each extra cup satisfies less, is diminishing marginal utility, not either effect.
Where people slip
The trap is the word income. The income effect is about purchasing power, not a pay change, so a description of a raise is a shift of the budget line and neither effect. And income elasticity, a distractor on this question, measures the response to actual income and belongs to unit four.
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