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 in 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. instead. He stops reading books and drinking coffee. Now he reads the Wall Street Journal and drinks bottled mineral water.

Short answer

a. Books are a normal good. Coffee is neither a normal good nor an inferior good; it is a neutral good

b. Books are a normal good, and coffee appears to be a neutral good and neither normal nor inferior good.

c. Books and coffee are both normal goods.

d. His tastes have changed completely; therefore, additional information is needed.

Step-by-step solution

Explanation of part (a)

You can see that when the income of Bill increased after finding the $20, he immediately used that additional income to buy a book only and not coffee. Therefore looking at this behavior, it can be concluded that the books are normal goods since Bill’s consumption for books increased due to an increase in his income.Therefore, income elasticity is > 1.

While his consumption for the coffee remained the same even after his income increased, this signifies that coffee for Bill is neutral good and is neither a normal nor an inferior good. Income elasticity is zero here.

Explanation of part (b)

When the income of Bill decreased by $10, he chose to sell his new book to compensate for the loss and buy coffee. Therefore, by this behavior, books are normal goods since their consumption decreased with a decrease in income. At the same time, the consumption of coffee remained constant since he kept buying double espresso even when his income is decreased by $10.

Therefore, in the case of books, income elasticity is >1, and in the case of coffee, income elasticity = 0.

Explanation of part(c)

When the prices of both books and coffee increased by 25 %, Bill reduced his consumption for both the goods. Depicting that his real income has reduced due to an increase in the prices, it can be concluded that both coffee and books are normal goods since their consumption reduced due to a fall in real income, and their income elasticity is > 1.

Explanation of part(d)

The consumption pattern of Bill has changed since his preferences are more towards Wall Street journals than books and coffee. One cannot determine by the given information why such preferences are changed, whether it was due to changes in income or not; therefore, the answer cannot be determined.