Question

By observing an individual’s behavior in the situations outlined below, determine therelevant income elasticities of demand for each good (i.e., whether the good is normal orinferior). If you cannot determine the income elasticity, what additional informationmight you need?

a. Bill spends all his income on books and coffee. He finds $20 while rummagingthrough a used paperback bin at the bookstore. He immediately buys a newhardcover book of poetry.
b. Bill loses $10 he was going to use to buy a double espresso. He decides to sell hisnew book at a discount to his friend and use the money to buy coffee.
c. Being bohemian becomes the latest teen fad. As a result, coffee and book pricesrise 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 anddrinking coffee. Now he reads The Wall Street Journal and drinks bottled mineralwater

Answer 1

Normal goods are those goods which see their demand rise when income rises and fall when income falls. Inferior goods on the other hand will see their demand fall when income rises and vice versa.

a. Book = Normal Good

Coffee = Neutral good

The demand for Books increased when Bill had more money which makes it a normal good.

The demand for coffee did not change when new income came thereby making it a neutral good.

b. Book = Normal Good

Coffee = Inferior good

The demand for Books decreased when Bill had less money which makes it a normal good.

The demand for coffee increased when Bill's income reduced thereby making it an inferior good.

c. Book = Normal Good = Coffee

Both coffee and books are normal goods because Bill is buying less of them when their prices increase because it means that Bill has less income to spend on them.

d. More information needed.

We are unable to tell which goods are normal or inferior as we are not given information on the relative changes in demand as a result of income changing.