Giffen Good - Analysis

Analysis

There are three necessary preconditions for this situation to arise:

  1. the good in question must be an inferior good,
  2. there must be a lack of close substitute goods, and
  3. the good must constitute a substantial percentage of the buyer's income, but not such a substantial percentage of the buyer's income that none of the associated normal goods are consumed.

If precondition #1 is changed to "The good in question must be so inferior that the income effect is greater than the substitution effect" then this list defines necessary and sufficient conditions. As the last condition is a condition on the buyer rather than the good itself, the phenomenon can also be labeled as "Giffen behavior".

This can be illustrated with a diagram. Initially the consumer has the choice between spending their income on either commodity Y or commodity X as defined by line segment MN (where M = total available income divided by the price of commodity Y, and N = total available income divided by the price of commodity X). The line MN is known as the consumer's budget constraint. Given the consumer's preferences, as expressed in the indifference curve I0, the optimum mix of purchases for this individual is point A.

If there is a drop in the price of commodity X, there will be two effects. The reduced price will alter relative prices in favour of commodity X, known as the substitution effect. This is illustrated by a movement down the indifference curve from point A to point B (a pivot of the budget constraint about the original indifference curve). At the same time, the price reduction causes the consumers' purchasing power to increase, known as the income effect (an outward shift of the budget constraint). This is illustrated by the shifting out of the dotted line to MP (where P = income divided by the new price of commodity X). The substitution effect (point A to point B) raises the quantity demanded of commodity X from Xa to Xb while the income effect lowers the quantity demanded from Xb to Xc. The net effect is a reduction in quantity demanded from Xa to Xc making commodity X a Giffen good by definition. Any good where the income effect more than compensates for the substitution effect is a giffen good.

Read more about this topic:  Giffen Good

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