Question

James has $100 to spend on books and all other goods. Books cost $20 each and James’ optimal consumption bundle is at 3 books and $40 worth of other goods currently. James’ grandmom wants to give James either a book or $20 for his birthday. Which gift does James prefer? Explain why.

Answer 1

James has $100 to spend on books and all other goods where price of book is $20.

Optimal consumption bundle is 3 books and $40 on other goods.

From $100, he can consume 3 books and spend rest of $40 on other goods.

If his grandmother is willing to give $20 or book, he must take $20 because he is already consuming books at optimal level while he can spend $20 cash on other goods (because other goods can be any good, spending on it might raise total utility. On the other hand, spending more than optimal bundle on books will reduce marginal utility from book).