Answer to Question #298080 in Macroeconomics for shanks

Question

Define an indifference curve. Explain how a consumer attains equilibrium under the indifference curve approach. Also decompose the price effect into income effects and substitution effect when price of commodity measured along X-axis decreases.

Answer 1

An Indifference curve is a curve showing different combinations of two commodities that yields the same amount of utility to the consumer.

A consumer attains equilibrium when the slope of the Indifference curve is equal to the slope of the budget line.

The diagram below represents the effects of decrease in price of good X:

When the price of good X reduces, the consumer is left with extra income. This extra income he can use it to acquire more of good X thus the demand curve shifts from X1 to X2.

The consumer may also decide to use the extra income in acquiring more of good Y. This is known as the Substitution effect.