Giffen good

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A Giffen good is a product for which a rise in price of this product makes people buy even more of the product. Giffen goods may or may not exist in the real world, but there is an economic model that explains 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 does not enter the picture.

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:

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.

1 Analysis of Giffen goods
2 Empirical evidence for Giffen goods
3 The Irish Potato Famine
4 Gasoline as a possible Giffen good
5 See also
6 References
7 External links

[edit] 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.

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.

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 Io, the optimum mix of purchases for this individual is point A.

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 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.

[edit] Empirical evidence for Giffen goods

Despite years of searching, no generally agreed upon example has been found. A 2002 preliminary working paper by Robert Jensen and Nolan Miller of Harvard University made the claim that rice and noodles are Giffen goods in parts of China. 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, Battalio, Kagel, and Kogut were only able to show the existence of a Giffen good at an individual level and not the market level. Thus, at least one real-world example, albeit a weak example, of Giffen goods exists. 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. 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. 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 is 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.

[edit] 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 Giffen phenomenon could be explained by a normal demand model.

[edit] Gasoline as a possible Giffen good

Sasha Abramsky of The Nation conjectures that for some poor Americans who live far from their jobs, the recent (as of 2005) sharp rise in gasoline prices may make gasoline a Giffen good for certain populations of poor Americans. His model is that they will have to spend money on gasoline that otherwise might go for oil changes, tune-ups, minor repairs, or even to upgrade to more fuel-efficient vehicles. The result is that their "older, less well-maintained cars" will 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.

[edit] See also

[edit] References

DeGrandpre, R. J., Bickel, W. K., Rizvi, S. A., & Hughes, J. R. (1993). Effects of income on drug choice in humans. Journal of the Experimental Analysis of Behavior, 59, 483-500.
Abramsky, Sasha. Running on Fumes. [The Nation], October 17, 2005, p.15-19.