Giffen goods are consumed more with the increase in price
Vinod Anand | 22 Dec 2011

Giffen Paradox is what we witness when people consume particular goods more with the increase in their prices.

THESE ARE goods which do not obey the ‘law of demand’. They are consumed more as the prices rise. Rather, the demand of a Giffen good falls, as its price falls, and it therefore has a positively sloped demand curve. The expression is named after Sir R Giffen, to whom is attributed the observation that, among labouring classes, when the price of bread (the main item of diet) rose, their consumption rose, and when its price fell, consumption also fell. This is called GIFFEN PARADOX.

This he saw as a refutation of the law of demand. However, Giffen goods are nowadays seen as special cases of standard demand analysis, rather than refutations of it. If the total expenditure on a particular good by a consumer constitutes a large proportion of his income, then changes in price of that good have a significant effect on his real income. If a good is an inferior (a rise in consumer’s income causes a fall in demand, a fall in income causes a rise in demand), it is then possible that a rise in price could cause an increase in demand, and a fall in price could cause a fall in demand, via this income effect.

For quantity demanded actually to change in the same direction as price, it is not enough that the income effect works in the way just described; it must also be strong enough to outweigh the substitution effect. Given a change in the price of a good, if the consumer’s real income is held constant (by a compensating change in money income), the quantity of the good demanded will always change in the opposite direction to the price change: if the price rises, substitute goods whose prices have stayed the same, are now relatively cheaper than the goods in question, and so will be substituted by the latter; if price falls, substitute goods will now be relatively more expensive, and the good in question will be substituted for them.

The overall change in quantity of the good demanded, following a change in its price, is the resultant of these two effects; income effect and the substitution effect. If the income effect works so as to change demand in the same direction as the price changer (i.e. good is an inferior good), while the substitution effect works so as to change demand in the opposite direction to the price change (always the case), and if the former effect outweighs the latter, net effect is that the quantity demanded changes in the same direction as price. It was this special case which was observed by Giffen.