Alfred Marshall dominated economics in the early years of the 20th Century. His ‘Principles of Economics’ was published in 1890. It served as the major text for students before the Second World War. In 1946, 22 years after his death, an eighth edition was published. It was not until 1948 that Paul Samuelson published his classic undergraduate book on Economics superseding Marshall’s. Of nearly 900 pages of Marshall's Principles, only 10 lines are devoted to a dubious idea that is now legendary - Giffen goods.
There are however some exceptions (to downward sloping demand). For instance, as Sir R. 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. But such cases are rare; when they are met with, each must be treated on its own merits.
Alfred Marshall P132, Principles of Economics, Marshall A., Macmillan 1946
Giffen goods are a special type of inferior good. The quantity demanded for Giffen goods rises as their price rises, which is an exception to the law of demand.
When a demand curve is drawn there are only two variables; the price and the quantity demanded. Nothing else changes or as we like to say in economics, ‘other things remain equal’. It is important to understand that this means that income is a variable that does not change and it is helpful to call this nominal income at this stage of the argument. When the price of a good goes up, if our nominal income is fixed this means we can afford less. This is one reason the demand curve slopes downward and it is called the income effect. So if nominal income stays the same and prices rise we are poorer, our real income has fallen. Real income means the amount of goods and services our nominal income can buy.
Changes in income and inferior goods
If we relax the ‘other things being equal’ assumption this leads to the whole demand curve moving. When we change nominal income, then sometimes demand will increase (the demand curve moves to the right). A product like cars fits this description because the more we earn the more cars we buy; these we call normal goods.
However when nominal incomes increase sometimes demand decreases (the demand curve moves to the left). When our nominal income increases, the demand for a basic white loaf of bread might actually fall (moves left). This is because when we earn more we will buy other more luxurious types of bread instead, perhaps baguettes or croissants; conversely if incomes fall there is a tendency to buy more of it. This type of good we call an inferior good. This is not saying that white bread is poor quality, merely that if our incomes rise we buy less of it. If we return to our original demand curve where nominal income is fixed but price rises, real incomes are reduced and:
for normal goods the quantity demanded is under pressure to fall, i.e., there is a negative (real) income effect,
for inferior goods the quantity demanded is under pressure to rise, i.e., there is a positive (real) income effect.
Despite the argument above, if the price of inferior goods rises the quantity demanded still falls – the demand curve is downward sloping and the law of demand is preserved! This is because the income effect is not the only thing influencing demand. When the price of normal or inferior goods rise consumers look to buy alternative products. So if the price of cars or bread rises some people will choose to travel by bus or buy cheap breakfast cereal instead, there is always a negative substitution effect.
For normal goods there is a negative income effect and a negative substitution effect. So as price rises, the quantity demanded falls. For inferior goods there is a positive income effect and a negative substitution effect, but the negative substitution effect is more powerful and so as prices rise the quantity demanded still falls.
For Giffen goods the positive income effect is so strong that it overpowers the negative substitution effect. So when prices rise the quantity demanded rises. Giffen and Marshall are arguing that for ‘the poor labouring classes’ bread might fall into this category.
This of course breaks the law of demand and results in an upward sloping demand curve. All Giffen goods are therefore inferior goods because there is a positive income effect, but not all inferior goods are Giffen goods. But do Giffen goods really exist, and if so, how can there be a law of demand?
The Giffen Paradox is much debated but as one economist has noted, - if they exist someone should have found them by now. Look at the assumptions. They are very strict. Only bread, meat and farinaceous product (flour based products) are on offer, no time period is mentioned either. We must remember that economic models are not real, they are just models of reality. Some models are better than others and some are actually poor. The Giffen paradox is an interesting model, but there is little firm evidence to support it.
Finding the necessary evidence is difficult. As in many models we assume ceteris paribus. Whoever does find some data to support the Giffen paradox has to show that no other determinant of demand has changed which might have caused the whole demand curve to move to the right.
Robert T. Jensen and Nolan H. Miller writing in the American Economic Review (2008) claim to have found real evidence of what they call Giffen behaviour. They call their discovery ‘Giffen behaviour’ because the upward sloping demand is not a feature of the product but of the impoverished people of Hunan province in China. As the Giffen theory predicts demand for rice rose when the price rose. Furthermore, Jensen and Miller believe that after more than a hundred years of economists looking for Giffen goods, finding them is a vindication not only of Giffen and Marshall’s theory but also of neo-classical economic model building in general.
(Neo-classical economics is a term used for the mathematical approach taken by economists such as Alfred Marshall in the late 19th and early 20th century).
Try these multiple choice questions to check your understanding of Giffen goods.