key term - Giffen Good

Definition

A Giffen good is a type of inferior good where the demand for the good increases as the price of the good increases, contradicting the typical law of demand. This occurs when consumers have limited budgets and substitute away from more expensive goods towards the Giffen good as their incomes decline.

5 Must Know Facts For Your Next Test

1. Giffen goods are a rare exception to the law of demand, which states that quantity demanded decreases as price increases.
2. The existence of Giffen goods depends on the relative strength of the substitution effect and the income effect for that good.
3. For a good to be a Giffen good, the income effect must outweigh the substitution effect, causing demand to rise as price rises.
4. Staple foods like rice or potatoes are commonly cited examples of potential Giffen goods, especially for very poor consumers.
5. The concept of Giffen goods was first theorized by Scottish economist Robert Giffen in the 19th century.

Review Questions

• Explain how the substitution effect and income effect interact to create a Giffen good.
  • For a good to be considered a Giffen good, the income effect must outweigh the substitution effect when the price of the good changes. The substitution effect would normally cause the consumer to buy less of the good as the price rises, but the income effect causes the consumer to buy more of the Giffen good as their real income decreases. This leads to an overall increase in quantity demanded as price increases, contradicting the typical law of demand.
• Describe the characteristics of goods that are likely to be Giffen goods.
  • Giffen goods are typically inferior goods that make up a large portion of a consumer's limited budget. Common examples include basic staple foods like rice, potatoes, or bread for very poor consumers. When the price of these essential goods rises, the income effect causes the consumer to shift consumption towards the now relatively cheaper Giffen good, even though the substitution effect would normally lead them to consume less. This unique dynamic is what defines a Giffen good.
• Analyze how the concept of Giffen goods relates to changes in income and prices affecting consumption choices.
  • The Giffen good represents a rare exception to the typical law of demand, where an increase in price leads to an increase in quantity demanded. This is because for Giffen goods, the income effect dominates the substitution effect - as the price rises, consumers' real incomes decline, causing them to shift consumption towards the now relatively cheaper Giffen good. This illustrates how changes in both income and prices can significantly impact consumer choices in ways that deviate from the standard demand theory. Understanding Giffen goods provides important insights into how consumers make decisions, especially for essential goods with limited substitutes when budgets are highly constrained.

Related terms

Inferior Good: An inferior good is a good where demand decreases as income increases, in contrast to a normal good where demand increases as income increases.

Substitution Effect:

The substitution effect refers to the change in consumption of a good caused by a change in its price, holding the consumer's utility or standard of living constant.

Income Effect:

The income effect refers to the change in consumption of a good caused by a change in the consumer's purchasing power, holding the prices of all goods constant.