In microeconomic theory, an indifference curve is a graph showing different bundles of goods between which a consumer is indifferent. That is, at each point on the curve, the consumer has no preference for one bundle over another. One can equivalently refer to each point on the indifference curve as rendering the same level of utility (satisfaction) for the consumer. A budget constraint represents all the combinations of goods and services that a consumer may purchase given current prices within his or her given income. For an individual, indifference curves and an assumption of constant prices and a fixed income in a two-good world will give the following diagram. The consumer can choose any point on or below the budget constraint line BC. This line is diagonal since it comes from the equation . In other words, the amount spent on both goods together is less than or equal to the income of the consumer. The consumer will choose the indifference curve with the highest utility that is within his budget constraint. Every point on I3 is outside his budget constraint so the best that he can do is the single point on I2 that is tangent to his budget constraint. He will purchase X* of good X and Y* of good Y.
The substitution effect is the effect observed with changes in relative price of goods. This effect basically affects the movement along the curve. These curves can be used to predict the effect of changes to the budget constraint. The graphic below shows the effect of a price increase for good Y. If the price of Y increases, the budget constraint will pivot from BC2 to BC1. Notice that because the price of X does not change, the consumer can still buy the same amount of X if he or she chooses to buy only good X. On the other hand, if the consumer chooses to buy only good Y, he or she will be able to buy less of good Y because its price has increased. To maximize the utility with the reduced budget constraint, BC1, the consumer will...
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