Question

By observing an individual's behavior in the situations outlined below, determine the relevant income elasticities of demand for each good (i.e., whether it is normal or inferior). If you cannot determine the income elasticity, what additional information do you need? a. Bill spends all his income on books and coffee. He finds \(\$ 20\) while rummaging through a used paperback bin at the bookstore. He immediately buys a new hardcover book of poetry. b. Bill loses \(\$ 10\) he was going to use to buy a double espresso. He decides to sell his new book at a discount to a friend and use the money to buy coffee. c. Being bohemian becomes the latest teen fad. As a result, coffee and book prices rise by 25 percent. Bill lowers his consumption of both goods by the same percentage. d. Bill drops out of art school and gets an M.B.A. in stead. He stops reading books and drinking coffee. Now he reads the Wall Street Journal and drinks bottled mineral water.

Short answer

From Bill's behavior, we can infer that for him books and coffee can be considered normal goods under small income changes. But with substantial income changes, books and coffee can act as inferior goods.

Step-by-step solution

Identify income change and corresponding change in demand for a product

Start by identifying when there is a change in Bill's income and whether this leads to an increase or decrease in demand for a particular product. In situation a, Bill finds $20 and immediately spends it on a book, indicating that books may be a normal good for him.

Analyze reactions to income loss

Analyze how the individual reacts to losing income. In situation b, Bill loses $10 which he planned on using to buy coffee. Instead of going without coffee, he sells his book to get money for it. This might indicate that for Bill, coffee is a normal good and books are inferior goods, as he's willing to give up a book to afford coffee.

Determine responses to price changes

Observe the reaction to price increase. In situation c, the prices of coffee and books both increase 25 percent and Bill lowers his consumption of both goods by the same percentage. Even though it doesn't relate to income elasticity directly, this scenario illustrates Bill's price elasticity of demand for these goods, which appears to be greater than 1 (elastic), because the proportionate decrease in quantity demanded is greater than the proportionate increase in price.

Identify reactions to long-term income changes

In situation d, it seems like Bill's income may have increased with his career change. He stops reading books and drinking coffee altogether, substititing these goods with the Wall Street Journal and bottled mineral water, suggesting that coffee and books can be considered inferior goods, while the Wall Street Journal and bottled mineral water are normal goods here.

Key concepts

Normal Goods

Normal goods are products for which demand increases when an individual's income rises. When people have more money at their disposal, they are willing to spend more on these goods because they are seen as more desirable or higher quality.
In the exercise we saw Bill find $20 and immediately buy a new book. This behavior suggests that, for him, books could be classified as normal goods. When his income increased, even temporarily, he chose to increase his consumption of books.
Common characteristics of normal goods include:

• Improved quality or luxury aspect
• Higher consumer desirability
• Optional but preferable over basic alternatives

Normal goods often align with consumer preferences for leisure, fashion, or new technology, making them sensitive to income fluctuations.

Inferior Goods

Inferior goods have the opposite reaction to changes in income when compared to normal goods. The demand for inferior goods decreases as income rises. People tend to buy these goods when their budget is tight because they are considered lower quality or more basic.
In the scenario where Bill loses $10 and sells his book to buy coffee, we could think of books as an inferior good for Bill. When his income decreased, he decided to forego books to maintain his coffee consumption.
Typical traits of inferior goods include:

• Lower price compared to alternatives
• Basic or minimal use
• Temporary use or substitutes when better options are unavailable

Inferior goods are chosen over normal goods when consumers are looking to save money or need cost-effective solutions.

Price Elasticity of Demand

Price elasticity of demand measures how sensitive the quantity demanded of a good is to its price change. When the price of a good increases, consumers tend to buy less of it, and vice versa. To be precise, if the percentage change in quantity demanded is greater than the percentage change in price, the demand is considered elastic.
In the exercise scenario, prices of both coffee and books rose by 25%, and Bill reduced his consumption by a similar rate. This suggests that both goods have some degree of price elasticity for Bill, as his change in demand mirrored the price change.
Key aspects of price elasticity include:

• Available substitutes
• Necessity versus luxury
• Time period in consideration

Understanding price elasticity helps businesses decide on pricing strategies and anticipate consumer response to price changes.

Income Changes

Income changes can significantly impact consumer purchasing behavior depending on the nature of goods they prefer. When someone experiences an income rise or fall, their buying patterns adjust to their income level.
For Bill, dropping out of art school and getting an MBA seems correlated with an income rise. This resulted in substituting books and coffee for Wall Street Journal and bottled mineral water, potentially due to increased financial capacity and lifestyle changes.
When assessing the impact of income changes, consider:

• Types of goods preferred
• Lifestyle shifts
• Consumer priorities

Analyzing income changes provides insights into which goods become more or less desirable depending on consumers' financial status.