Substitution and income effects
(Available online: Substitution and income effects: alternative possibilities (Java))

Consider an individual who consumes two goods, x and y.  Suppose the price of x falls. This price decline will influence the individual's consumption of x in two ways:
   1. THE SUBSTITUTION EFFECT: The consumer will have an incentive to substitute the now relatively cheaper x for the relatively more expensive y, consuming more x and less y until the relative value of x equals the new, lower opportunity cost of x.
                   Fall in Px/Py => fall in optimal MRS (= MUx/MUy).
The substitution effect answers the question: What would happen to your consumption of x if its price changes and your real income (utility) is held constant instead of your money  income?
   2. THE INCOME EFFECT: The individual will adjust consumption of x in the process of moving to a higher attainable level of utility at the new, lower price of x.
                   Fall in Px/Py => increase in attainable U.
The income effect answers the question: What will happen to your consumption of x as you move to a new level of welfare (utility) as a result of a price change?

Three possibilities arise:
Case 1: Normal good	Case 2: Inferior good	Case 3: Giffen good

     For normal goods, the substitution and income effects reinforce each other. For inferior goods, the income effect offsets part of the substitution effect. Giffen goods are an extreme case of inferior goods in which the income effect actually overwhelms the substitution effect.
    The left-hand diagram in the bottom row illustrates the consumer's demand curve for good X.
   Diagram the demand curve for the cases of inferior and Giffen goods illustrated above.
   Can the demand curve for a normal good ever slope up? Why or why not?
   Can the demand curve for an inferior good which is not a Giffen good ever slope up? Why or why not?