Giffen Goods theory with indifference curves

A Giffen good is a highly theoretical model that rarely occurs in the real-life economy. They are a type of inferior goods in the broad sense. In a narrower sense, Giffen goods are differentiated from inferior goods as inferior goods obey the law of demand (as price increases quantity demanded decreases, ceteris paribus, and vice versa.) while a Giffen good defies it. As price increases, the quantity demanded of a Giffen good increases, forming an upward-sloping demand curve. It is easier to use a real-life example to explain why, even though they are rare.   A famous example of a Giffen good is staple food. The staple food is the type of food that is basic to typical households, such as potatoes, wheat, and rice. They are inferior goods as people will consume less of them if they are on higher income or budget as they can afford diverse and healthy food rather than those that just provide calories.

Irish example Now consider an increase in the prices of this type of food, as was the price of potatoes during the Irish Potato Famine due to a shortage of potatoes. A poor consumer will consume large quantities of potatoes to get enough calories to meet the basic needs and spend any remaining income on meat. If the price of potatoes increases, the household can no longer afford the original bundle of foods. Increasing meat consumption would lead to an insufficient calorie intake, so the household must instead increase consumption of potatoes (which is still the cheapest source of calories) and cut back on meat.   The Giffen good was a trap: the more expensive the potatoes become, the less ability you had to anything other than potatoes.

Chinese Example However two Harvard economists (Jensen and Miller) used poor Chinese consumers who consume more rice or noodles (staple diet) as prices go up. As with the poor Irish, people need a certain amount of calories to survive. For the Chinese they get their calorie intake by eating rice, vegetables or meat. However to the poor Chinese meat is very expensive and as the price of rice goes up they can no longer afford the luxury of meat, yet they still need to get to their calories. So they eat rice instead, which is still relatively cheap compared to meat. Therefore this is a much accurate example of Giffen behaviour in action. So if food prices start to increase like they have in the last decade will this mean the demand for the staples will go up even further?

Giffen good and indifference curves.

The substitution and income effects of Giffen goods are the same as inferior goods. And the same arguments apply. The only difference in terms of these two effects is that the magnitude of the income effect is larger than that of the substitution effects for a Giffen good. It is the fundamental reason Giffen goods can defy the law of demand—the substitution effect that makes people buy more when the product is cheaper is not strong enough to overcome the income effect of the Giffen good.

Therefore, applying the same theory as before for a Giffen good:

• Good X experiences a fall in price

•  budget line moves from Budget 1 to Budget 2;

• The move from point J to point K is the substitution effect (positive);

• The move from point K to point L is the income effect (negative);

• These make up an overall move from point J to point L, which is the price effect (substitution effect + income effect = negative).

• As the income effect is negative, the substitution effect is positive, and the overall price effect is negative, good X is a Giffen good.

Sign up to elearneconomics for comprehensive key notes with coloured illustrations, flash cards, written answers and multiple-choice tests on Indifference Curves that provides for users with different learning styles working at their own pace (anywhere at any time).