Unit 2.4: Consumer and producer behaviour (HL only)

Introduction

Under the previous curriculum this page would have been included in the section on consumer utility and can also be used as the basis for a TOK exercise.  Under the new syllabus this section has been expanded to include some new concepts, which are listed on the key terms at the beginning of the activity handout.

Enquiry question

Why does the utility (level of enjoyment) diminish as consumption of a good or service rises.  What is the relationship between consumption of a product and total utility?

Lesson time: 1 hour

Lesson objectives:

  1. To understand and define the key concepts of marginal and total utility, rationality and a consumers saturation point
  2. To understand why the marginal utility of a good or service diminishes as consumption rises
  3. To understand the concept of rationality and why it is so difficult for consumers to be rational.

Teacher notes:

1. Place and scale - exemplification - begin the lesson with either the short video or the beginning activity.  I will always start this lesson with the chocolate activity, as it is very popular with my classes and a fun activity that they will remember.  I then follow this with the video activity. (15 minutes)

2. Processes - technical Vocabulary - the students can learn the key concepts through the class handout, the opening video and the two activities included. (20 minutes)

3. Explaining processes - start with either the short video or the beginning activity.  Students should plot their findings on the graph paper included in the chocolate activity.  This activity can be printed off and completed by those students taking part in the activity.  After this print off the class handout and have the your classes read the notes and either highlight or underline the key concepts. 

Then complete the activity where students list the expenditures they make in an average month.  Next to each record the utility gained from each good or service consumed.  Particular attention needs to be taken to the question of rational consumption and why is it so difficult for consumers to practise rational consumption? (15 minutes)

4. Fact sheet - assessment - the lesson contains two activities which illustrate the relationship between consumption and diminished utility.  The essay question can be set as a homework exercise.  (10 minutes)

Key terms:

Utility - This can simply be defined as the amount of pleasure gained from consuming one unit of a good or service, measured in utils.

Marginal utility - the additional satisfaction a consumer gains when they consume one extra unit of a good or service.

Total utility - the total satisfaction that a consumer enjoys when they consume a specific good or service.

Law of diminishing marginal utility – the theory that states that as an individual consumes more of a good or service then the marginal utility enjoyed by each additional unit falls.

Saturation point – the point of consumption after which total utility falls and marginal utility falls below zero.

Rational consumer - a consumer is rational if he / she decides on the option that maximises his/her utility, based on the choices and budgetary constraints available to them.

Behavioural nudges - alternatives to using standard government interventions in markets e.g. through taxes and subsidies to influence the choices that people make in their everyday lives.

Biases - anchors create a bias in favour of a particular decision. For example, what individuals first encounter, see or hear, become the anchor from which future decisions are assessed.

Bounded rationality - the idea that in decision-making, rationality of individuals is limited by the information they have, the cognitive limitations of their minds, and the finite amount of time they have to make a decision.

Bounded self-control - to question the idea that individuals are able to exercise self-control when presented with certain choices.

Available as a class handout at:  Utility 

Activity 1

Begin with this fun activity.  Firstly ask for one or two (willing) volunteers and you will also need several bars of chocolate.  Ask each student to eat half a bar of chocolate and then indicate the level of enjoyment gained, measured in utils.  Write down this score before having the students eat the second half of the bar of chocolate.  Having consumed the remainder of the chocolate bar have each student should record the utils of pleasure gained on the following table:

Chocolate bars consumedUtils of pleasure gainedTotal utility
000
half
1
1.5
2
2.5

Repeat the exercise for bars of chocolate two and three.  The records should show a gradual fall in the level of utility gained as consumption of the chocolate bars increases (decreasing marginal utility).

Lastly plot your results on the graph.

Activity 2: An example of utility

The photograph to the left shows Batuhan, a young man who loves to drink tea.  Each unit of tea provides him with 20 utils of pleasure.  He also enjoys chips and each packet provides him with 6 utils of pleasure. He also spends money on skiing and a days skiing provides him with 15 utils of pleasure.

Prices: chips $ 3, tea $ 2, one days skiing = $ 15

His weekly consumption is as follows:

3 bags of chips, 6 cups of tea and 1 day per week skiing.

So based on the above information, complete the table below and then decide, is Batuhan being rational in his choice of consumption?

Product

Price ($)

Utility per unit

Utility per $ spent

Tea (per cup)

2

20

10 utils

Chips (per packet)

3

6

2 utils

Skiing (per day)

15

15

1 utils

Clearly not, the theory of rationality states that consumers should spend their money in the way that provides them with the maximum utility for their money and Batuhan is not doing this. He gains more utility per $ spent from drinking tea than either of the other two options. Rationally, therefore, he should spend a much larger proportion of his disposable income on tea and should certainly think twice about spending any of his income on skiing.

Activity 3: What prevents Batuhan from consuming rationally?

Batuhan is a human being like everyone else. He is unable to spend rationally because he is unaware of the exact number of utils (pleasure units) that the consumption of each good provides. Batuhan also has to weigh up the relative utils gained immediately versus future utility gained. Batuhan is aware that drinking tea and eating chips provides him with immediate utility but no future utility. Once his tea or packet of chips has been consumed his utility falls to zero. Drink too much tea or eat too many chips and he might even feel nauseous afterwards (negative utility). By contrast his day spent skiing, in addition to providing him with immediate pleasure, will also improve his physical fitness, body tone and general well being. In the case of skiing therefore, Batuhan enjoys a smaller immediate utility but greater deferred utility. This is what makes it difficult for Batuhan to spend his money wisely (in a rational way). Batuhan also suffers from the law of diminishing marginal utility.

Activity 4

Watch the following video which explains the concepts of marginal utility and then explain why riding a roller coaster, or indeed completing any enjoyable activity provides proportionally less utility as consumption rises?

Activity 5: Applying the law of diminishing marginal utility to Batuhan

As stated above Batuhan enjoys tea - he really enjoys tea. So much that it provides him with more utils of pleasure per $ spent than any other good or service. So he goes into a tea house and downs his first cup of tea. This provides him with 20 utilis of pleasure.  He enjoys it so much that he orders another and after that, another. Unfortunately his second cup of tea, while enjoyable, did not provide him with quite as much pleasure as the first - only 12 utils.  The third cup of tea, while enjoyable provided him with significantly less utils than the first.  This is the law of diminishing marginal utility - each subsequent unit consumed giving less pleasure than the last.  The 4th cup provides him with a utility of just 4 utils.  By the 5th cup, Batuhan has reached his saturation point as it provides him with a MU of zero.

(a) Plot this information on the graph paper provided.

(b) At what level of consumption should Batuhan stop drinking tea?

Just 4 because the 4th cup provides him with the same utilis per $ as the next best alternative which is to eat a pack of chips.  He should definitely not drink the 5th.  At the 5th cup he has reached his saturation point, where he gains no pleasure at all from that cup.  A rational consumer would know to stop before this point.  Does Batuhan?  Maybe not.

(c) Is the rate of diminishing marginal utility constant for all goods and services?

No, the rate of diminishing utility can be gradual, such as with the consumption of water or a much steeper decline such as a plasma television. One plasma TV provides a large amount of utility where as it is doubtful that owning a second Television provides much more pleasure than just owning one.

Activity 6: Are you a rational consumer?

1. Write down a list of the expenditures that you make in an average month.

2. By each item outline the utility (pleasure) out of 10 that you receive when you consume each of the above. Are you a rational consumer? If not, why not?

In reality you are probably not?  Only those consumers who know exactly how many utils of pleasure per $ spent can be rational.  Even then the consumer would have to ignore peer pressure and the need for immediate gratification to be truly rational.

Activity 7: Links to TOK 

Examples of relevant TOK essays on utility:

  1. What is meant by “rationality” in economics? Are there different types of “economic rationality”?
  2. If economics studies actual human behaviour, should it also study irrational human behaviour?

Link to the assessment

Marginal utility and the law of diminishing returns is also a concept that your HL students will revisit during unit 2.11: Theory of the firm, when the course looks at the relationship between rising output and declining productivity levels.

8. Homework essay

What is a rational human being? Why are humans very rarely rational?

An essay template for this homework exercise can be accessed at: Essay template

Mark scheme

What is a rational human being? Why are humans very rarely rational?

Students should begin their response by defining the key terms.  A rational consumer is one spends their scarce resources on goods and services providing them with the largest marginal utility per $ spent.

Responses should also include a diagram showing marginal utility falling as the consumer increases their units of consumption.  An example of this is shown opposite.

Responses should then explain the diagram in terms of how consumers suffer from diminishing marginal utility, as the number of units consumed rises.  For example in the diagram opposite the consumer still continues to receive utility from consumption of the product up to and including the consumption of the 4th unit.  After which total utility falls to zero and marginal utility falls below 0.  This point is known as the saturation point.  In reality the consumer should stop consuming this product long before this product as each unit reduces their scarce resources (money).  The rate of decline in marginal utility depends on the individual consumer but also the product being consumed.  For instance the marginal utility enjoyed from consuming a product such as chocolate diminishes rapidly, as the consumer quickly feels sick from over consumption.  By contrast a product such as water has a slower rate of diminishing MU.

The second part of the question then focuses on what prevents humans being rational.  Examples might include:

Advertising and marketing which gives consumers a false sense of a products utility

Social pressure to purchase certain good and services such as cigarettes, alcohol or fashion items

Less than perfect knowledge of utility

Choice architecture - default, restricted, and mandated choices, nudge theory

Biases - rule of thumb, anchoring and framing, availability, bounded rationality, bounded self-control

A good way to answer this question is for the candidate to include examples from their own purchases as a way of demonstrating their own 'economic irrationality'.

The mark scheme is available as a PDF file at: Homework markscheme  

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