Giffen Paradox or Giffen Goods: Income & Substitution Effects

Income and Substitution Effects of Giffen Goods

Goods where the law of demand does not apply, are known as Giffen goods. In the case of Giffen goods, the substitution effect is positive while the income effect is negative, and the negative income effect is greater than the positive substitution effect. Therefore, when the price of an inferior good of the Giffen type decreases, its demand decreases, and vice versa.

This phenomenon shows a paradoxical situation, i.e., when the price of an inferior good increase, its quantity demanded increases. This happens because in order to meet the minimum consumption need, the consumer has to cut his expenditure on superior goods and spend the saved amount on inferior good, which is cheaper even after the rise in its price.

As a result, the demand for inferior goods increases due to an increase in its price. This paradox is known as the Giffen Paradox. Giffen paradox is an exception to the law of demand.

Let us now suppose that the consumer is initially in equilibrium at point P. Now, let the price of inferior goods X decrease so that the consumer moves to equilibrium point R on IC₂. Because of this movement, the quantity of X demanded decreases by X₁X₂. This is the price effect.

Now in order to separate the income and substitution effects of the price effect in the case of Giffen goods. Let’s eliminate the income effect by drawing an imaginary budget line M₂N₂ parallel to the budget line M₂N₃ and tangent to the original indifference curve IC₁. The imaginary budget line is tangential to IC₁ at point Q. The consumer’s movement from P to Q and the consequent increase by X₂X₃ in the quantity of X demanded is the substitution effect. However, the Income effect would be:

IE = PE – SE

IE = X₁X₂ – X₂X₃ = – X₁X₃

According to the above diagram, the income effect is greater than the substitution effect, whose net effect is the fall in quantity demanded of X due to a fall in its price. This is contrary to the law of demand.

However, note that all Giffen goods are inferior goods, but all inferior goods are not Giffen goods. This is so because in both cases, the substitution effect is positive, and the income effect is negative but in the case of Giffen goods, the negative income effect outweighs the positive substitution effect. Hence the demand curve slopes upward.

However, in the case of inferior goods, the negative income effect is less than the positive substitution effect and thus, the demand curve for this is downward sloping.

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