Giffen good Totally Explained

Everything about Giffen Goods totally explained

In economic theory, a Giffen good is an inferior good for which a rise in its price makes people buy even more of the product as a consequence of the substitution effect and the income effect for that good. Evidence for the existence of Giffen goods is limited, but microeconomic mathematical models explain how such a thing could exist. Giffen goods are named after Sir Robert Giffen, who was attributed as the author of this idea by Alfred Marshall in his book Principles of Economics.
   For most products, price elasticity of demand is negative. In other words, price and demand pull in opposite directions; if price goes up, then quantity demanded goes down, or vice versa. Giffen goods are an exception to this. Their price elasticity of demand is positive. When price goes up, the quantity demanded also goes up, and vice versa. In order to be a true Giffen good, price must be the only thing that changes to get a change in quantity demand, and conspicuous consumption doesn't enter the picture (such a situation would indicate a Veblen good).
   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.
   Marshall wrote in the 1895 edition of Principles of Economics:
ť 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're 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.

Giffen goods are also related to experience goods and credence goods in that the two often exhibit increases in demand with price, yet different in that close substitutes are available for the latter types.

Analysis of Giffen goods

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.
If there's 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 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.

Empirical evidence for Giffen goods

Evidence for the existence of Giffen goods has generally been limited. A 2002 preliminary working paper by Robert Jensen and Nolan Miller of Harvard University made the claim that rice and wheat/noodles are Giffen goods in parts of China by tracking prices of goods. A further 2007 working paper by the same authors experimentally demonstrated the existence of Giffen goods among humans at the household level by directly subsidizing purchases of rice and wheat flour for extremely poor families. It is easier to find Giffen effects where the number of goods available is limited, as in an experimental economy: DeGrandpre et al (1993) provide such an experimental demonstration. In 1991, Battalio, Kagel, and Kogut proved that quinine water is a Giffen good for some lab rats. However, they were only able to show the existence of a Giffen good at an individual level and not the market level.
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're 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. If a price change modifies consumers' perception of the good, they should be analysed as Veblen goods. Some economists question the empirical validity of the distinction between Giffen and Veblen goods, arguing that whenever there's a substantial change in the price of a good its perceived nature also changes, since price is a large part of what constitutes a product. 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.

The Irish Potato Famine

Potatoes during the Irish Potato Famine were long believed to be the only example of a Giffen good. This theory was debunked by Sherwin Rosen of the University of Chicago in his 1999 paper Potato Paradoxes. Rosen showed that the phenomenon could be explained by a normal demand model.

Gasoline as a possible Giffen good

Sasha Abramsky of The Nation conjectured in a 2005 article that gasoline, in certain circumstances, may act as a Giffen good. Increases in gasoline prices, Abramsky argues, may force poor drivers to devote more money to gasoline that they otherwise might have spent on oil changes, tune-ups, minor repairs, or even upgrades to more fuel-efficient vehicles. As a consequence, their "older, less well-maintained cars" may have "decreased gas efficiency", resulting in an increase in gasoline consumption. (Abramsky, 2005, 18) This corresponds to the Giffen model, with maintenance and upgrades constituting the superior goods and gasoline the inferior Giffen good. There is little empirical evidence to support this hypothesis to date, however.

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