Giffen's Paradox - Dejargonised

Although, Veeru earns Rs. 18000 per month, he likes his job and cherishes his experiences on road. He also likes to enjoy a few drinks at the end of a day. He prefers not to drive for over 12 hours in a day for health and safety reasons. However, on this particular day, Veeru had to drive for 15 hours to achieve his target. By the end of the day, he decided to call it a night and treat himself with some alcohol and take a nap in his truck.

 

 

He had an allowance of Rs. 120 for dinner. He was planning to spend Rs. 44 on 2 pegs of his favourite desi daaru (cheap Indian liquor) and Rs. 60 on some meat (Rs. 46) and rice (Rs. 20). However, the price of alcohol had increased to Rs. 26 per peg and he could no longer afford 2 pegs of alcohol with food. He could either have meat, rice and 1 peg for Rs. 102 or he could have 2 pegs of alcohol with rice and curry (Rs. 22) for a total of Rs. 94 and would still be left with Rs. 26. Veeru was confused.

 

He knew he needed more than just 1 peg and decided to go for option two and spent the remaining Rs. 26 on another peg. Even though the price of alcohol had increased, Veeru spent more on alcohol than he would have when the price was lower.

The law of demand states that, ceteris paribus, when the price of a good/ service increases, the demand for it decreases and vice-versa. However, Giffen’s Paradox is an exception to this law. Sir Robert Giffen, who was an Economist in the 19th century, found that when the price of bread increased, its demand increased as well. This was because the rise in the price of bread drained the resources of the poorer families and they had to cut down their consumption of meat and purchase more bread instead which was the cheapest food available. Such goods are called Giffen goods. In case of Giffen goods, the income effect always outweighs the substitution effect which causes the demand to rise with a rise in price.

 

There are two essential conditions for a good to be a Giffen good:

1. There should be a negative income effect.

2. The substitution effect must be small.

 

There’s a debate over the existence of Giffen goods, however, a study conducted in China by Harvard economists showed strong evidence of Giffen behaviour exhibited by households where the staple food is rice. In this study, selected households were given vouchers that subsidised the price of rice, their staple food. The fall in price was followed by fall in quantity demanded and vice-versa. In the real world, empirical evidence of Giffen goods is rare.