giffen's paradox

CHANAKYA NATIONAL LAW UNIVERSITY

INCOME EFFECT: GIFFEN’S PARADOX

SUBMITTED TO: - Dr. P. C. Verma FACULTY: - Economics I

Made By: Nidhi Navneet nd

rd

2  year (3  sem) ROLL No.570 B.A.LL.B. (Hons)

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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Income Effect: Giffen’s Paradox

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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Income Effect: Giffen’s Paradox

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 Data The whole project is made with the use of secondary source. The following secondary sources of data have been used in the project1. 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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Income Effect: Giffen’s Paradox

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

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Income Effect: Giffen’s Paradox

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 Graph showing substitution effect

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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Income Effect: Giffen’s Paradox

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

2

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

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Income Effect: Giffen’s Paradox

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 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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Income Effect: Giffen’s Paradox

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

6

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Income Effect: Giffen’s Paradox

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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Income Effect: Giffen’s Paradox

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.

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Income Effect: Giffen’s Paradox

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 semiluxury 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

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

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Income Effect: Giffen’s Paradox

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

10

 Supra note 4.  http://en.wikipedia.org/wiki/Giffen_good#cite_note-0.

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Income Effect: Giffen’s Paradox

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  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 X b while the income effect lowers the quantity demanded from X b to X c. 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 12

 Ibid.

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Income Effect: Giffen’s Paradox

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.  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.

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Income Effect: Giffen’s Paradox

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 celebrityendorsed 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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Income Effect: Giffen’s Paradox

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-withgraphs.html

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