giffen's paradox

CHANAKYA NATIONAL LAW UNIVERSITY

A Project On

INCOME EFFECT: GIFFEN’S PARADOX

Made By: Nidhi Navneet

2nd year (3rd sem)ROLL No.570

B.A.LL.B. (Hons)

SUBMITTED TO: - Dr. P. C. Verma

FACULTY: - Economics I

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Income Effect: Giffen’s Paradox

ACKNOWLEDGEMENT

I am feeling highly elated to work on the case law “Income Effect:

Giffen’s Paradox ” under the guidance of my Economics teacher. I am very grateful to

him for his exemplary guidance. I would like to enlighten my readers regarding this

topic and I hope I have tried my best to pave the way for bringing more luminosity to

this topic.

I also want to thank all of my friends, without whose cooperation this

project was not possible. Apart from all these, I want to give special thanks to the

librarian of my university who made every relevant materials regarding to my topic

available to me at the time of my busy research work and gave me assistance. And at

last I am very much obliged to the God who provided me the potential for the

rigorous research work.

At finally yet importantly I would like to thank my parents for the

financial support.

-----------

Thanking you

Nidhi Navneet

C.N.L.U.

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CONTENTS

RESEARCH METHODOLOGY........................................................................................3

INTRODUCTION...............................................................................................................4

PRICE EFFECT: INCOME & SUBSTITUTION EFFECT................................................5

GIFFEN PARADOX...........................................................................................................8

GIFFEN GOODS...............................................................................................................10

REQUISITES FOR GIFFEN GOOD........................................................................12

EFFECT OF GIFFEN GOOD...................................................................................13

CONCLUSION..................................................................................................................15

BIBLIOGRAPHY..............................................................................................................16

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RESEARCH METHODOLOGY

Research Methodology

The project is basically based on the doctrinal method of research as no field work is

done on this topic.

Aims & Objectives

To do an in depth analysis of the concept of sale under transfer of property act and to

determine the legal incidents which arise with sale along with the nature of transfer which

is involved in sale by analysing, interpreting and scrutinising pertinent sections of the sale

in the Act.

Sources of DataThe whole project is made with the use of secondary source. The following secondary

sources of data have been used in the project-

1. Books

2. Websites

Mode of Citation

The researcher has followed a uniform mode of citation throughout the course of this

research paper.

Type of Study

For this topic, the researcher has opted for Descriptive and Explanatory type of study as

in this topic, the researcher is providing the descriptions of the existing facts.

Hypothesis

This project takes its hypothesis as the Law of Demand applies equally on all the Inferior

goods as it applies universally on the Normal goods, i.e., A decrease in price leads to an

increase in quantity demanded, or, an increase in price causes quantity demanded to fall

for all types of goods.

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INTRODUCTION

Consumer theory is a theory of microeconomics that relates preferences to

consumer demand curves. The link between personal preferences, consumption, and the

demand curve is one of the most complex relations in economics. Preferences are the

desires by each individual for the consumption of goods and services, and ultimately

translate into employment choices based on abilities and the use of the income from

employment for purchases of goods and services to be combined with the consumer's

time to define consumption activities. Prominent variables used to explain the rate at

which the good is purchased (demanded) are the price per unit of that good, prices of

related goods, and wealth of the consumer.

Price and quantity demanded move in opposite directions, ceteris paribus i.e.,

holding everything else constant. A This is the fundamental theorem of demand which

states that the rate of consumption falls as the price of the good rises. But this

fundamental theorem has seen its exception in the form of Giffen’s paradox.

In economics and consumer theory, a Giffen good is one which people paradoxically

consume more of as the price rises, violating the law of demand. In normal situations, as

the price of a good rises, the substitution effect causes consumers to purchase less of it

and more of substitute goods. In the Giffen good situation, the income effect dominates,

leading people to buy more of the good, even as its price rises.

The impacts of price change on quantity demanded are divided into two

effects. They are Substitution effect and Income effect, which are to be discussed in detail

in the subsequent chapters.

Substitution effect is the change in an item’s consumption associated with a

change in the item’s price with the utility level held constant. As prices rise, consumers

will substitute away from higher priced goods and services, choosing less costly

alternatives. Therefore, the substitution effect of a change in price also tells us that as

price rises the quantity demanded would fall. Income effect is a change in an item’s

consumption associated with a change in purchasing power with the price held constant.

As the price of a commodity rises, it may be considered as if the income of the consumer

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has declined. Therefore, the income effect of a change in price tells us that as price rises

quantity demanded would fall.

Graph showing substitution effect

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PRICE EFFECT: INCOME & SUBSTITUTION EFFECT

When the price of q1 , p1 , changes there are wo effects on the consumer.

First, the price of q1 relative to the other products (q2 , q3, . . qn ) has changed. Second,

due to the change in p1 , the consumer's real income changes. When we compute the

change in the optimal consumption as a result of the price change, we do not usually

separate these two effects. Sometimes we might want to separate the effects.

The Substitution Effect is the effect due only to the relative price change,

controlling for the change in real income. In order to compute it we ask what is the

bundle that would make the consumer just as happy as before the price change, but if they

had to make their choice faced with the new prices. To find this point we consider a

budget line characterized by the new prices but with a level of income such that it is

tangent to the initial indifference curve. The substitution effect is the movement from

point e to point e1. This point is characterized by two things:

(1) It is on the same indifference curve as the original consumption bundle;

(2) it is the point where a budget line that is parallel to the new budget line is just tangent

to initial indifference curve. This "intermediate" budget line is attempting to hold real

income fixed so we can isolate the substitution effect.

The point G reflects the consumer's choice if faced

with the new prices (the budget line has the slope

reflecting the new prices) and the compensated

income (i.e., an income level that holds real income

fixed).

The substitution effect is the difference between the

original consumption and the new "intermediate"

consumption. When p1 goes up the Substitution

Effect will always be non-positive (i.e., negative or zero).1

The Income Effect is the effect due to the change in real income. For

example, when the price goes up the consumer is not able to buy as many bundles that

she could purchase before. This means that in real terms she has become worse off. The 1 http://www2.econ.iastate.edu/classes/econ101/hallam/Income_Substitution.pdf.

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effect is measured as the difference between the “intermediate" consumption” at G and

the final consumption of q1 and q2 at E.

For example, say the consumers income is $15 and the price of apples is $1 and the price

of oranges is $3. At these prices the consumer purchases six apples and three oranges.

When the price of oranges falls to

$1, the consumer purchases eight

apples and seven oranges. Thus

on the demand curve for oranges,

the consumer purchases three

oranges when the price is three

dollars and seven oranges when

the price is one dollar.

Bringing the new budget

constraint back to the original

indifference curve allows us to break down the income and substitution effects. Since the

slope of the budget constraint reflects the ratio of prices, the substitution effect is the

increase in the number of oranges that would be purchased given the new prices, while

staying on the original indifference

curve that is moving from point A

to point B. The movement from

point B to point C is the income

effect, the additional consumption

of oranges due to the increased

purchasing power. With a decrease

in the price of oranges, the relative

price of apples has increased and

fewer apples would be consumed due to the substitution effect; however, due to increased

purchasing power, more apples are purchased as well as more oranges.2

Unlike the Substitution Effect, the Income Effect can be both positive and

negative depending on whether the product is a normal or inferior good. By the way we

constructed them, the Substitution Effect plus the Income Effect equals the total effect of

2 http://courses.byui.edu/ECON_150/ECON_150_Old_Site/Lesson_05.htm.

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the price change. The income elasticity

for an inferior good is negative. For

example, as income rises the demand

for used clothing decreases. Looking

at second-hand clothing on the x-axis,

as the price declines the substitution

will be positive (movement from point

A to point B); however, the income

effect (movement from B to C) will be

negative.

Alternative Way of Analyzing a Price Change

One can also analyze the income and substitution effects by first considering

the income change necessary to move the consumer to the new utility level at the initial

prices. This constitutes the income effect. The movement along the new indifference

curve from the intermediate point to the new equilibrium as the slope of the price line

changes is then the substitution effect. See if you can identify the “intermediate” point on

the lower indifference curve by shifting the budget line (Hint: q1 and q2 both fall.). 3

3 Supra note 1.

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GIFFEN PARADOX

According to the law of demand, with everything else remaining constant, the

demand for a particular good increases with a decrease in its price and decreases with an

increase in its price. As such, there is an inverse relationship between the price of a

product and the quantity demanded. Demand for a product is, therefore, a function of its

price and this relation can be mathematically depicted as:

Qx = f(Px), where, x is the product, Qx is the quantity demanded of the product and Px is

the price of the product.

Giffen's paradox constitute of those phenomena or demand scenarios that

violate the law of demand and various examples of Giffen's goods act as exceptions to the

law of demand.4 Scottish economist Sir Robert Giffen first proposed the paradox from his

observations of the purchasing habits of the poor Victorian era. He was attributed as the

author of this idea by Alfred Marshall in his book Principles of Economics.

As Mr.Giffen has pointed out, a rise in the price of bread makes so large a

drain on the resources of the poorer labouring families and raises so much the marginal

utility of money to them, that they are forced to curtail their consumption of meat and the

more expensive farinaceous foods: and, bread being still the cheapest food which they

can get and will take, they consume more, and not less of it. As quoted by Alfred

Marshall in his book The Principles of Economics (1895 ed.)5. The classic example given

by Marshall is of inferior quality staple foods, whose demand is driven by poverty that

makes their purchasers unable to afford superior foodstuffs. As the price of the cheap

staple rises, they can no longer afford to supplement their diet with better foods, and must

consume more of the staple food. 6

Giffen’s paradox was propounded by Scottish economist, Sir Robert Giffen

(after whom it's named). According to this paradox, which Sir Robert Giffen arrived at

after observing the purchasing tendency of the poor Victorian subjects, the demand for a

particular good tends to increase even when its price increases. Sir Robert Giffen had

4 http://www.buzzle.com/articles/giffen-good-example.html.

5 Alfred Marshall (1895). Principles of Economics Bk.III, Ch.VI in paragraph III.VI.176 http://en.wikipedia.org/wiki/Giffen_good#cite_note-0.

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observed that when the price of necessary staple goods such as bread, food grain,

vegetables, etc., rose, the poorer sections of the Victorian society, who relied heavily on

these basic staple items, gave up on purchasing other goods and concentrated all their

purchasing power on procuring the necessary staples. This kept the demand for these

good high despite an increase in their price.

Conversely, when the prices of these staples go down, the consumer would,

out of the consumer's surplus (the price he has always paid and is ready to pay for the

good minus the decreased price) difference that has occurred due to the price plunge,

prefer to buy less of the staples and more of superior substitutes for consumptions. Say,

for instance, the price of 1 kg. of potatoes (a staple) goes down from $6 to $2. The

vegetable budget of the consumer is, say, $12. Previously he used to purchase 2 kg. of

potatoes for $12 every month. After the price plunge, he would want to buy just one kg of

potatoes for $2 and with the remaining $10, he can buy a larger variety of other

vegetables.7

7 Supra note 7.

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GIFFEN GOODS

Giffen Goods are a unique type of inferior goods that only exists in poverty.

First of all, inferior goods are goods for which demand falls as prices rise, this is because

consumers are now able to afford goods of better quality that perform the same functions.

Perhaps the best example is matches, as the price of goods increase in general, consumers

are likely to change their spending patterns and replace matches with lighters.

Examples of Giffen Goods are

rice and potatoes, they are as such because

of their importance to consumers. Being

the main staple food for their respective

cultures people are dependent on them

and would always purchase such products

regardless of its price. The price would

just affect the quantity purchased.

While the law of demand

states that as prices increase, the level of demand would fall, this is not observed for

giffen goods. A good way to understand this phenonmom is to use a short example.

When the price of rice is low the demand for rice is low. This is because the

people in poverty can purchase the same amount of rice that they would need for a lower

price, meaning they have more disposible income to buy better quality products such as

meat and vegetables. As prices increase, their real disposible income would fall, meaning

consumers would be unable to buy the better products and resort back to the purchase of

the staple good. This occurs because staple goods have NO substitutes.8

These are those inferior goods whose quantity demanded decreases with

decrease in price of the good. This can be explained using the concept of income effect

and substitution effect as discussed earlier. In case of such goods the positive income

effect is higher than the negative substitution effect resulting is an overall positive (direct)

relationship between price and quantity demanded.

8 http://ib-economics.blogspot.in.

http://2.bp.blogspot.com/_NXS1mcY2wvU/ShugH2xFzYI/AAAAAAAAABU/R8ceX0KKHGk/s1600-h/giffen+good.jpg

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As shown in the figure,

the substitution effect due to the

decrease in price increase the quantity

demanded from Q2 to Q5, while the

income effect gives more disposable

income which leads to decrease in

quantity demanded from Q5 to Q4. So

the net effect is a decrease in quantity

demanded from Q2 to Q4.9

Besides staples, there is a second category of goods, known as inferior goods,

that qualify as examples of Giffen's goods. These goods are those for which the demand

rises when the price that must be paid to procure them forms a relatively substantial part

of the buyer's income without eating into the amount of income set aside for the

consumption of other regular items. For instance, take for example, comfort or semi-

luxury goods like cars. An increase in the income of the buyer would result in a perceived

decrease in the price of a cheap car for the prospective buyer. He would, now that he can

afford it, prefer to go for a comparatively expensive car rather than the cheap car

although the latter costs less than the former. Here, the cheap car is an inferior good, not

in terms of quality but in terms of perception owing to the ease of affordability. Here, the

quality of life, expected to improve on acquisition of a superior quality item, is given

preference rather than quality of good when making a purchase decision.

A third category of Giffen's goods comprises what is known as experience

goods. The viability, utility and characteristics of certain goods and services can be

observed and decided only after using those products or services. The quality of the good

or service of such items can only be ascertained upon their consumption. In such cases, a

drop in price is often interpreted by the prospective consumer as a drop in quality or

utility of the product or service. Examples of Giffen's goods in this category are health

and beauty care services. There is a sub-category of experience goods, the credence good

or post experience goods, which also fall under this category. These items are such that

the credibility of their quality and utility is difficult to exactly ascertain even after

9 http://www.assignmenthelp.net/assignment_help/microeconomics-demand.php.

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consumption and usually third party opinions and testimonials are heavily relied upon to

differentiate between close substitutes.

That was a simplified overview of what a Giffen's good is, enumerating the

various different categories of goods that qualify for inclusion under this paradox.

Various other mechanics and theories of economics such as price and income elasticity,

income effect, substitution effect and indifference curve analysis come into play in

explaining the metrics of Giffen's paradox. However, I have deliberately refrained from

including them in this article so that the reader gets a clear understanding of this

economic concept without getting confused by the numerical contraptions.10

REQUISITES FOR GIFFEN GOOD

There are three necessary preconditions for this situation to arise:

the good in question must be an inferior good, there must be a lack of close substitute goods, and, the good must constitute a substantial percentage of the buyer's income, but not

such a substantial percentage of the buyer's income that none of the associated normal goods are consumed.

If precondition #1 is changed to "The good in question must be so inferior

that the income effect is greater than the substitution effect" then this list defines

necessary and sufficient conditions. As the last condition is a condition on the buyer

rather than the good itself, the phenomenon can also be labeled as "Giffen behavior".

This can be illustrated with a diagram. Initially the consumer has the choice

between spending their income on either commodity Y or commodity X as defined by

line segment MN (where M = total available income divided by the price of commodity

Y, and N = total available income divided by the price of commodity X). The line MN is

known as the consumer's budget constraint. Given the consumer's preferences, as

expressed in the indifference curve I0, the optimum mix of purchases for this individual is

point A.11

If there is a drop in the price of commodity X, there will be two effects. The reduced

price will alter relative prices in favour of commodity X, known as the substitution effect.

This is illustrated by a movement down the indifference curve from point A to point B (a

10 Supra note 4.11 http://en.wikipedia.org/wiki/Giffen_good#cite_note-0.

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pivot of the budget constraint about the original indifference curve). At the same time, the

price reduction causes the consumers' purchasing power to increase, known as the income

effect (an outward shift of the budget constraint). This is illustrated by the shifting out of

the dotted line to MP (where P = income divided by the new price of commodity X). The

substitution effect (point A to point B) raises the quantity demanded of commodity X

from Xa to Xb while the income effect lowers the quantity demanded from Xb to Xc. The

net effect is a reduction in quantity demanded from Xa to Xc making commodity X a

Giffen good by definition. Any good where the income effect more than compensates for

the substitution effect is a giffen good.12

EFFECT OF GIFFEN GOOD

If a good is inferior, a drop in income (represented by a price increase)

increases the quantity of the good that is demanded. The substitution effect is negative

for any good that experiences a price increase. A giffen good faces an upward sloping

demand curve because the income effect dominates the

substitution effect, meaning that quantity demanded

increases as price rises. However, a good cannot have an

upward sloping demand curve forever, because eventually

the consumer will run out of money. Remember that

giffen goods have to be inferior goods, which implies that

the consumer purchasing them has little money to begin

with. At some point, the rising price of the giffen good

takes over the consumer’s entire budget, and a price increase will actually lower the

amount of the good the consumer is able to buy. This means that at high enough prices,

we will see the traditional downward sloping demand curve.

Let’s go through an example of a giffen good, using potatoes and steak as the

choice set of the consumer. Imagine the consumer has a budget of $30, and the cost of a

potato begins at $0.50 and the price of a steak is $10.00. Also consider that the consumer

needs to buy meals for 10 days. With the original budget and prices, the consumer may

choose to consume 2 steaks, at $20, and 20 potatoes for $10 over this time frame to use

up their entire budget. This is a satisfactory amount because they will have on average 2

potatoes a day, and 2 steaks over the period.

12 Ibid.

http://1.bp.blogspot.com/-TcQrrwWRtBs/TyGlhfjiJmI/AAAAAAAAAaQ/RIzXV2GgOSI/s1600/giffen+good.png

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Now imagine a price increase of potatoes to $1 each. The consumer could

still buy 2 steaks, but could now only buy 10 potatoes. This might leave them hungry, so

it is possible they will buy less steak, and more potatoes in order to get their calories.

This means that 20 potatoes will still be purchased, but now only 1 steak is purchased.

If the price of a potato increased again, say to $1.25, then the consumer would

only be able to get 16 potatoes for $20, which may not be enough calories to survive.

They will decrease their steak consumption by one, and use that money to buy more

potatoes in order to get the necessary energy. In this example, potato consumption would

rise to 24 ($30/$1.25) and steak consumption would drop to zero. This shows how

consumption of a good would rise with a price increase (thus an upward sloping demand

curve).

At this point, the consumer’s entire budget is taken up by the giffen good, so

any price increase now will result in a decrease of the amount of good the consumer is

able to buy. Thus, we will have our typical downward sloping demand curve.13

13 http://www.freeeconhelp.com/2012/01/what-is-giffen-good-example-with-graphs.html.

http://1.bp.blogspot.com/-XpKSExq1U-0/TyGlmWY4XrI/AAAAAAAAAaY/24MKBvZQ69M/s1600/true+giffen+good+graph.png

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CONCLUSION

In general terms, Giffen’s goods are those that people consume more as price

rises. In common ways, if price of a commodity goes up, quantity demanded goes down

or vice versa. Giffen’s goods are exceptions to this. Giffen’s goods’ price elasticity is

positive. When the price goes up for them, the quantity demanded also goes up and vice

versa. Prof Giffen himself has given the example of the staple foods whose demand is

driven by poverty. When the price of bread increases, poor people curtail their expenses

on costlier foods like meat, etc. and purchase more of bread. So, increase of price brings

increase of demand which is contrary to the normal situation. Thus, this particular

phenomenon is known as Giffen’s paradox.

Giffen goods are difficult to find because a number of conditions must be

satisfied for the associated behavior to be observed. One reason for the difficulty in

finding Giffen goods is Giffen originally envisioned a specific situation faced by

individuals in a state of poverty. Modern consumer behaviour research methods often

deal in aggregates that average out income levels and are too blunt an instrument to

capture these specific situations. Furthermore, complicating the matter are the

requirements for limited availability of substitutes, as well as that the consumers are not

so poor that they can only afford the inferior good. It is for this reason that many text

books use the term Giffen paradox rather than Giffen good.

Some types of premium goods (such as expensive French wines, or celebrity-

endorsed perfumes) are sometimes claimed to be Giffen goods. It is claimed that

lowering the price of these high status goods can decrease demand because they are no

longer perceived as exclusive or high status products. However, the perceived nature of

such high status goods changes significantly with a substantial price drop. This

disqualifies them from being considered as Giffen goods, because the Giffen goods

analysis assumes that only the consumer's income or the relative price level changes, not

the nature of the good itself. However the theoretical distinction between the two types of

analysis remains clear; which one of them should be applied to any actual case is an

empirical matter.

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BIBLIOGRAPHY

Books referred

Satija Kalpana, ‘Textbook on Economics for Law Students’, Universal

publication.

Arora Surbhi, ‘Textbook on Economics for Law Students’, Universal publication.

Sites Referred

http://www2.econ.iastate.edu/classes/econ101/hallam/Income_Substitution.pdf.

http://courses.byui.edu/ECON_150/ECON_150_Old_Site/Lesson_05.htm.

http://www.buzzle.com/articles/giffen-good-example.html.

http://en.wikipedia.org/wiki/Giffen_good#cite_note-0.

http://ib-economics.blogspot.in.

http://www.assignmenthelp.net/assignment_help/microeconomics-demand.php.

http://www.freeeconhelp.com/2012/01/what-is-giffen-good-example-with-

graphs.html

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giffen's paradox