What is Giffen’s paradox?

What is Giffen’s paradox?

Giffen’s Paradox is a rare economic phenomenon that manifests itself as an increase in the price of cheap goods, which further increases the demand for those goods. For this reason, it is considered an anomaly, since in theory, in such a situation, demand should decrease and supply should increase. The occurrence of this phenomenon indicates the deteriorating state of a country’s economy.

This is the case with basic, necessary for survival goods (also called Giffen goods) – such as bread. Poorer members of society in particular can’t afford to give them up or find cheaper substitutes because they often don’t exist.

Giffen goods

Giffen goods must meet several criteria. These are:

• The amount spent on the purchase of this good should be more than half of the household budget expenditures,
• There are no substitutes or they are much more expensive than the basic good (even after a general price increase),
• They are usually of lower quality than other products.

Giffen goods can be, for example, potatoes, bread, and rice.

Demand and supply in Giffen’s paradox

Giffen’s paradox is related to the income effect. It illustrates how changes in the prices of products affect the demand for those products. Higher prices for basic goods reduce the consumers’ purchasing power, forcing them to limit their spending to basic goods.

While the income effect is more evident, the substitution effect is weaker. Because of the scarcity or lack of substitutes for the Giffen good, the demand for it is even greater.

Giffen’s paradox – examples

Below are some examples from history where different countries had to face the effects of the Giffen paradox.

• Famine in Ireland

The Giffen paradox was first observed and described in the 19th century during the Irish famine. Its cause was the appearance of protozoa, which led to huge losses in agriculture and the death of many people due to infection or lack of food. This was the first time that a trend defying the previous laws of economics was noticed. One of the consequences of this event was a sharp increase in the price of bread, but this did not reduce spending on this particular commodity. People gave up other foods to be able to afford expensive flour products.

• Rising rice prices in Bangladesh

An economic analysis conducted in Bangladesh in 2008 found that the spending of another 8.5% of families fell below the poverty line. This obviously had an impact on the consumption behavior of the population. Rising inflation at the time, resulting from the outbreak of the global financial crisis, is identified as the main reason for this situation. The research showed that despite the significant increase in prices, higher rice consumption was observed among the poorest households. This indicates the occurrence of the Giffen paradox in question.

• Tobacco products

It can be assumed that Giffen’s paradox occurs in the case of tobacco products. Despite a significant price increase, smokers are unlikely to stop buying cigarettes due to a lack of other alternatives. Giving up cigarettes involves a struggle with addiction – physical and psychological dependence on nicotine, which takes time and effort.

Giffen goods vs. Veblen goods

It’s also worthwhile to mention the Veblen effect as the opposite of the Giffen paradox. As we explained earlier, Giffen goods are inexpensive assortments, necessary for people’s daily lives. Veblen goods, on the other hand, are exclusive items, such as jewelry, perfume, wine, and cars. Demand for these goods increases gradually as prices rise, usually among wealthier people. This happens when people want to mark their social position and good financial situation.

Summary

To date, there have been few real-life examples of Giffen goods. Of course, this does not exclude their existence or the risk of their appearance in the future. It requires a dynamic change in a number of market factors, such as demand, supply, inflation, minimum wages, or the availability of substitutes. Moreover, this phenomenon points to the problem of growing social inequality, which mainly affects extremely poor households. Better-off families are less likely to experience the negative consequences of Giffen’s paradox.

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