Takeaway

Economists use the language of prices and marginal utilities to analyze consumer decisions and, in general, consumers choose to allocate their dollars so the marginal utility per dollar of all purchases is equalized. To maximize utility, allocate dollars such that

This equation may look tough, but it simply reflects what happens when consumers allocate their money wisely.

The budget constraint represents how much money a consumer has to spend and the prices that the consumer faces. If we put together a budget constraint and information about consumer preferences—as expressed in the form of indifference curves—we can solve for a consumer’s optimal consumption bundle. This is a standard economic story, namely that preferences and constraints come together to shape an outcome.

The concepts of income and substitution effects, and more generally preferences and constraints, are useful for analyzing many economic problems. This includes how labor supply responds to welfare programs, how much Costco should charge for membership, and whether you should replace a lost concert ticket.