Differentiate between Inferior goods and Giffen goods in the context of income effect and substitution effect

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COURSE TITLE: MANAGERIAL ECONOMICS

In economics, an inferior good is a good that decreases in demand when consumer income rises, unlike normal goods, for which the opposite is observed. Normal goods are those for which consumers' demand increases when their income increases. This would be the opposite of a superior good, one that is often associated with wealth and the wealthy, whereas an inferior good is often associated with lower socio-economic groups. In economics and consumer theory, a Giffen good is one which people paradoxically consume more of as the price rises, violating the law of demand. In normal situations, as the price of a good rises, the substitution effect causes consumers to purchase less of it and more of substitute goods. In the Giffen good situation, the income effect dominates, leading people to buy more of the good, even as its price rises. All Giffen goods are inferior goods, but not all inferior goods are Giffen goods. Giffen goods are difficult to find because a number of conditions must be satisfied for the associated behavior to be observed. One reason for the difficulty in finding Giffen goods that is Giffen originally envisioned a specific situation faced by individuals in a state of poverty. Modern consumer behavior research methods often deal in aggregates that average out income levels and are too blunt an instrument to capture these specific situations. Furthermore, complicating the matter are the requirements for limited availability of substitutes, as well as that the consumers are not so poor that they can only afford the inferior good. It is for this reason that many text books use the term Giffen paradox rather than Giffen good. Income Effect

The income effect is defined as the result of a change in a product's price relative to the consumer's disposable income. When the price of a good changes, the real, or actual, income of the consumer who wants that good changes. If the price goes up, then the consumer is worse off, since he has less disposable income. Therefore, he can buy less of the good, or not buy it at all. Substitution Effect

The substitution effect occurs when, as the result of a price increase, the consumer will substitute another product in its place, or forgo the product altogether. This concept, however, depends on what sort of product has gone up in price, and how the consumer views that product. If the product is a necessity, then the substitution effect will become clear, since the consumer, who cannot do without the product, will shift, or substitute, a lower-cost version of the same item.

A special type of inferior good may exist known as the Giffen good, which would disobey the "law of demand". Quite simply, when the price of a Giffen good increases, the demand for that good increases. This would have to be a good that is such a large proportion of a person or market's consumption that the income effect of a price increase would produce, effectively, more demand. The observed demand curve would slope upward, indicating positive elasticity. It was noted by Sir Robert Giffen III that in Ireland during the 19th century there was a rise in the price of bread. The poor people were forced to reduce their consumption of meat and expensive items as eggs etc. Now bread being still the cheapest food, so they started consuming more of it though its price was rising. This phenomenon is often described as "Giffen's Paradox".

Conditions for Giffen goods
Total consumption on the good forms a large part of the budget The total amount the consumer spends on the good should form a large fraction of the consumer's budget. Only in such a case does an increase in the price of the good create a budget shortage significant enough to cause a shift in other consumption patterns. In other words, an increase in its price should produce a significant income effect. The good must be inferior

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