CHANAKYA NATIONAL LAW

UNIVERSITY

A Project On




INCOME EFFECT: GIFFENS
PARADOX


Made By: Nidhi Navneet
2
nd
year (3
rd
sem)
ROLL No.570
B.A.LL.B. (Hons)
SUBMITTED TO: - Dr. P. C. Verma
FACULTY: - Economics I
Income Effect: Giffens Paradox


1

ACKNOWLEDGEMENT
I am feeling highly elated to work on the case law Income Effect:
Giffens Paradox under the guidance of my Economics teacher. I am very grateful to
him for his exemplary guidance. I would like to enlighten my readers regarding this
topic and I hope I have tried my best to pave the way for bringing more luminosity to
this topic.

I also want to thank all of my friends, without whose cooperation this
project was not possible. Apart from all these, I want to give special thanks to the
librarian of my university who made every relevant materials regarding to my topic
available to me at the time of my busy research work and gave me assistance. And at
last I am very much obliged to the God who provided me the potential for the
rigorous research work.

At finally yet importantly I would like to thank my parents for the
financial support.

-----------
Thanking you
Nidhi Navneet
C.N.L.U.


Income Effect: Giffens Paradox


2

CONTENTS

RESEARCH METHODOLOGY ........................................................................................ 3
INTRODUCTION ............................................................................................................... 4
PRICE EFFECT: INCOME & SUBSTITUTION EFFECT................................................ 5
GIFFEN PARADOX ........................................................................................................... 8
GIFFEN GOODS ............................................................................................................... 10
REQUISITES FOR GIFFEN GOOD ........................................................................ 12
EFFECT OF GIFFEN GOOD ................................................................................... 13
CONCLUSION .................................................................................................................. 15
BIBLIOGRAPHY .............................................................................................................. 16


Income Effect: Giffens Paradox


3
RESEARCH METHODOLOGY
Research Methodology
The project is basically based on the doctrinal method of research as no field work is
done on this topic.
Aims & Objectives
To do an in depth analysis of the concept of sale under transfer of property act and to
determine the legal incidents which arise with sale along with the nature of transfer which
is involved in sale by analysing, interpreting and scrutinising pertinent sections of the sale
in the Act.
Sources of Data
The whole project is made with the use of secondary source. The following secondary
sources of data have been used in the project-
1. Books
2. Websites
Mode of Citation
The researcher has followed a uniform mode of citation throughout the course of this
research paper.
Type of Study
For this topic, the researcher has opted for Descriptive and Explanatory type of study as
in this topic, the researcher is providing the descriptions of the existing facts.
Hypothesis
This project takes its hypothesis as the Law of Demand applies equally on all the Inferior
goods as it applies universally on the Normal goods, i.e., A decrease in price leads to an
increase in quantity demanded, or, an increase in price causes quantity demanded to fall
for all types of goods.
Income Effect: Giffens Paradox


4
INTRODUCTION
Consumer theory is a theory of microeconomics that relates preferences to
consumer demand curves. The link between personal preferences, consumption, and the
demand curve is one of the most complex relations in economics. Preferences are the
desires by each individual for the consumption of goods and services, and ultimately
translate into employment choices based on abilities and the use of the income from
employment for purchases of goods and services to be combined with the consumer's
time to define consumption activities. Prominent variables used to explain the rate at
which the good is purchased (demanded) are the price per unit of that good, prices of
related goods, and wealth of the consumer.
Price and quantity demanded move in opposite directions, ceteris paribus i.e.,
holding everything else constant. A This is the fundamental theorem of demand which
states that the rate of consumption falls as the price of the good rises. But this
fundamental theorem has seen its exception in the form of Giffens paradox.
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.
The impacts of price change on quantity demanded are divided into two
effects. They are Substitution effect and Income effect, which are to be discussed in detail
in the subsequent chapters.
Substitution effect is the change in an items consumption associated with a
change in the items price with the utility level held constant. As prices rise, consumers
will substitute away from higher priced goods and services, choosing less costly
alternatives. Therefore, the substitution effect of a change in price also tells us that as
price rises the quantity demanded would fall. Income effect is a change in an items
consumption associated with a change in purchasing power with the price held constant.
As the price of a commodity rises, it may be considered as if the income of the consumer
has declined. Therefore, the income effect of a change in price tells us that as price rises
quantity demanded would fall.
Income Effect: Giffens Paradox


5
Graph showing substitution effect
PRICE EFFECT: INCOME & SUBSTITUTION EFFECT
When the price of q1 , p1 , changes there are wo effects on the consumer.
First, the price of q1 relative to the other products (q2 , q3, . . qn ) has changed. Second,
due to the change in p1 , the consumer's real income changes. When we compute the
change in the optimal consumption as a result of the price change, we do not usually
separate these two effects. Sometimes we might want to separate the effects.
The Substitution Effect is the effect due only to the relative price change,
controlling for the change in real income. In order to compute it we ask what is the
bundle that would make the consumer just as happy as before the price change, but if they
had to make their choice faced with the new prices. To find this point we consider a
budget line characterized by the new prices but with a level of income such that it is
tangent to the initial indifference curve. The substitution effect is the movement from
point e to point e
1
. This point is characterized by two things:
(1) It is on the same indifference curve as the original consumption bundle;
(2) it is the point where a budget line that is parallel to the new budget line is just tangent
to initial indifference curve. This "intermediate" budget line is attempting to hold real
income fixed so we can isolate the substitution effect.
The point G reflects the consumer's choice if faced
with the new prices (the budget line has the slope
reflecting the new prices) and the compensated
income (i.e., an income level that holds real income
fixed).
The substitution effect is the difference between the
original consumption and the new "intermediate"
consumption. When p1 goes up the Substitution
Effect will always be non-positive (i.e., negative or zero).
1

The Income Effect is the effect due to the change in real income. For
example, when the price goes up the consumer is not able to buy as many bundles that
she could purchase before. This means that in real terms she has become worse off. The

1
http://www2.econ.iastate.edu/classes/econ101/hallam/Income_Substitution.pdf.
Income Effect: Giffens Paradox


6
effect is measured as the difference between the intermediate" consumption at G and
the final consumption of q1 and q2 at E.
For example, say the consumers income is $15 and the price of apples is $1 and the price
of oranges is $3. At these prices the consumer purchases six apples and three oranges.
When the price of oranges falls to
$1, the consumer purchases eight
apples and seven oranges. Thus
on the demand curve for oranges,
the consumer purchases three
oranges when the price is three
dollars and seven oranges when
the price is one dollar.
Bringing the new budget
constraint back to the original
indifference curve allows us to break down the income and substitution effects. Since the
slope of the budget constraint reflects the ratio of prices, the substitution effect is the
increase in the number of oranges that would be purchased given the new prices, while
staying on the original indifference
curve that is moving from point A to
point B. The movement from point
B to point C is the income effect, the
additional consumption of oranges
due to the increased purchasing
power. With a decrease in the price
of oranges, the relative price of
apples has increased and fewer
apples would be consumed due to the substitution effect; however, due to increased
purchasing power, more apples are purchased as well as more oranges.
2


2
http://courses.byui.edu/ECON_150/ECON_150_Old_Site/Lesson_05.htm.
Income Effect: Giffens Paradox


7
Unlike the Substitution
Effect, the Income Effect can be both
positive and negative depending on
whether the product is a normal or
inferior good. By the way we
constructed them, the Substitution
Effect plus the Income Effect equals
the total effect of the price change.
The income elasticity for an inferior
good is negative. For example, as income rises the demand for used clothing decreases.
Looking at second-hand clothing on the x-axis, as the price declines the substitution will
be positive (movement from point A to point B); however, the income effect (movement
from B to C) will be negative.
Alternative Way of Analyzing a Price Change
One can also analyze the income and substitution effects by first considering
the income change necessary to move the consumer to the new utility level at the initial
prices. This constitutes the income effect. The movement along the new indifference
curve from the intermediate point to the new equilibrium as the slope of the price line
changes is then the substitution effect. See if you can identify the intermediate point on
the lower indifference curve by shifting the budget line (Hint: q1 and q2 both fall.).
3




3
Supra note 1.
Income Effect: Giffens Paradox


8
GIFFEN PARADOX
According to the law of demand, with everything else remaining constant, the
demand for a particular good increases with a decrease in its price and decreases with an
increase in its price. As such, there is an inverse relationship between the price of a
product and the quantity demanded. Demand for a product is, therefore, a function of its
price and this relation can be mathematically depicted as:
Qx = f(Px), where, x is the product, Qx is the quantity demanded of the product and Px is
the price of the product.
Giffen's paradox constitute of those phenomena or demand scenarios that
violate the law of demand and various examples of Giffen's goods act as exceptions to the
law of demand.
4
Scottish economist Sir Robert Giffen first proposed the paradox from his
observations of the purchasing habits of the poor Victorian era. He was attributed as the
author of this idea by Alfred Marshall in his book Principles of Economics.
As Mr.Giffen has pointed out, a rise in the price of bread makes so large a
drain on the resources of the poorer labouring families and raises so much the marginal
utility of money to them, that they are forced to curtail their consumption of meat and the
more expensive farinaceous foods: and, bread being still the cheapest food which they
can get and will take, they consume more, and not less of it. As quoted by Alfred
Marshall in his book The Principles of Economics (1895 ed.)
5
. The classic example given
by Marshall is of inferior quality staple foods, whose demand is driven by poverty that
makes their purchasers unable to afford superior foodstuffs. As the price of the cheap
staple rises, they can no longer afford to supplement their diet with better foods, and must
consume more of the staple food.
6

Giffens paradox was propounded by Scottish economist, Sir Robert Giffen
(after whom it's named). According to this paradox, which Sir Robert Giffen arrived at
after observing the purchasing tendency of the poor Victorian subjects, the demand for a
particular good tends to increase even when its price increases. Sir Robert Giffen had

4
http://www.buzzle.com/articles/giffen-good-example.html.
5
Alfred Marshall (1895). Principles of Economics Bk.III, Ch.VI in paragraph III.VI.17
6
http://en.wikipedia.org/wiki/Giffen_good#cite_note-0.
Income Effect: Giffens Paradox


9
observed that when the price of necessary staple goods such as bread, food grain,
vegetables, etc., rose, the poorer sections of the Victorian society, who relied heavily on
these basic staple items, gave up on purchasing other goods and concentrated all their
purchasing power on procuring the necessary staples. This kept the demand for these
good high despite an increase in their price.
Conversely, when the prices of these staples go down, the consumer would,
out of the consumer's surplus (the price he has always paid and is ready to pay for the
good minus the decreased price) difference that has occurred due to the price plunge,
prefer to buy less of the staples and more of superior substitutes for consumptions. Say,
for instance, the price of 1 kg. of potatoes (a staple) goes down from $6 to $2. The
vegetable budget of the consumer is, say, $12. Previously he used to purchase 2 kg. of
potatoes for $12 every month. After the price plunge, he would want to buy just one kg of
potatoes for $2 and with the remaining $10, he can buy a larger variety of other
vegetables.
7



7
Supra note 7.
Income Effect: Giffens Paradox


10
GIFFEN GOODS
Giffen Goods are a unique type of inferior goods that only exists in poverty.
First of all, inferior goods are goods for which demand falls as prices rise, this is because
consumers are now able to afford goods of better quality that perform the same functions.
Perhaps the best example is matches, as the price of goods increase in general, consumers
are likely to change their spending patterns and replace matches with lighters.
Examples of Giffen Goods
are rice and potatoes, they are as such
because of their importance to
consumers. Being the main staple food
for their respective cultures people are
dependent on them and would always
purchase such products regardless of its
price. The price would just affect the
quantity purchased.
While the law of demand states that as prices increase, the level of demand
would fall, this is not observed for giffen goods. A good way to understand this
phenonmom is to use a short example.
When the price of rice is low the demand for rice is low. This is because the
people in poverty can purchase the same amount of rice that they would need for a lower
price, meaning they have more disposible income to buy better quality products such as
meat and vegetables. As prices increase, their real disposible income would fall, meaning
consumers would be unable to buy the better products and resort back to the purchase of
the staple good. This occurs because staple goods have NO substitutes.
8

These are those inferior goods whose quantity demanded decreases with
decrease in price of the good. This can be explained using the concept of income effect
and substitution effect as discussed earlier. In case of such goods the positive income
effect is higher than the negative substitution effect resulting is an overall positive (direct)
relationship between price and quantity demanded.

8
http://ib-economics.blogspot.in.
Income Effect: Giffens Paradox


11

As shown in the figure,
the substitution effect due to the
decrease in price increase the quantity
demanded from Q2 to Q5, while the
income effect gives more disposable
income which leads to decrease in
quantity demanded from Q5 to Q4. So
the net effect is a decrease in quantity
demanded from Q2 to Q4.
9


Besides staples, there is a second category of goods, known as inferior goods,
that qualify as examples of Giffen's goods. These goods are those for which the demand
rises when the price that must be paid to procure them forms a relatively substantial part
of the buyer's income without eating into the amount of income set aside for the
consumption of other regular items. For instance, take for example, comfort or semi-
luxury goods like cars. An increase in the income of the buyer would result in a perceived
decrease in the price of a cheap car for the prospective buyer. He would, now that he can
afford it, prefer to go for a comparatively expensive car rather than the cheap car
although the latter costs less than the former. Here, the cheap car is an inferior good, not
in terms of quality but in terms of perception owing to the ease of affordability. Here, the
quality of life, expected to improve on acquisition of a superior quality item, is given
preference rather than quality of good when making a purchase decision.
A third category of Giffen's goods comprises what is known as experience
goods. The viability, utility and characteristics of certain goods and services can be
observed and decided only after using those products or services. The quality of the good
or service of such items can only be ascertained upon their consumption. In such cases, a
drop in price is often interpreted by the prospective consumer as a drop in quality or
utility of the product or service. Examples of Giffen's goods in this category are health
and beauty care services. There is a sub-category of experience goods, the credence good
or post experience goods, which also fall under this category. These items are such that

9
http://www.assignmenthelp.net/assignment_help/microeconomics-demand.php.
Income Effect: Giffens Paradox


12
the credibility of their quality and utility is difficult to exactly ascertain even after
consumption and usually third party opinions and testimonials are heavily relied upon to
differentiate between close substitutes.
That was a simplified overview of what a Giffen's good is, enumerating the
various different categories of goods that qualify for inclusion under this paradox.
Various other mechanics and theories of economics such as price and income elasticity,
income effect, substitution effect and indifference curve analysis come into play in
explaining the metrics of Giffen's paradox. However, I have deliberately refrained from
including them in this article so that the reader gets a clear understanding of this
economic concept without getting confused by the numerical contraptions.
10

REQUISITES FOR GIFFEN GOOD
There are three necessary preconditions for this situation to arise:
the good in question must be an inferior good,
there must be a lack of close substitute goods, and,
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 I
0
, the optimum mix of purchases for this individual is
point A.
11


10
Supra note 4.
11
http://en.wikipedia.org/wiki/Giffen_good#cite_note-0.
Income Effect: Giffens Paradox


13
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 X
a
to X
b
while the income effect lowers the quantity demanded from X
b
to X
c
. The
net effect is a reduction in quantity demanded from X
a
to X
c
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.
12

EFFECT OF GIFFEN GOOD
If a good is inferior, a drop in income (represented by a price increase)
increases the quantity of the good that is demanded. The substitution effect is negative
for any good that experiences a price increase. A giffen good faces an upward sloping
demand curve because the income effect dominates the
substitution effect, meaning that quantity demanded
increases as price rises. However, a good cannot have an
upward sloping demand curve forever, because eventually
the consumer will run out of money. Remember that
giffen goods have to be inferior goods, which implies that
the consumer purchasing them has little money to begin
with. At some point, the rising price of the giffen good
takes over the consumers entire budget, and a price increase will actually lower the
amount of the good the consumer is able to buy. This means that at high enough prices,
we will see the traditional downward sloping demand curve.
Lets go through an example of a giffen good, using potatoes and steak as the
choice set of the consumer. Imagine the consumer has a budget of $30, and the cost of a
potato begins at $0.50 and the price of a steak is $10.00. Also consider that the consumer
needs to buy meals for 10 days. With the original budget and prices, the consumer may

12
Ibid.
Income Effect: Giffens Paradox


14
choose to consume 2 steaks, at $20, and 20 potatoes for $10 over this time frame to use
up their entire budget. This is a satisfactory amount because they will have on average 2
potatoes a day, and 2 steaks over the period.
Now imagine a price increase of potatoes to $1 each. The consumer could
still buy 2 steaks, but could now only buy 10 potatoes. This might leave them hungry, so
it is possible they will buy less steak, and more potatoes in order to get their calories.
This means that 20 potatoes will still be purchased, but now only 1 steak is purchased.
If the price of a potato increased again, say to $1.25, then the consumer would
only be able to get 16 potatoes for $20, which may not be enough calories to survive.
They will decrease their steak consumption by one, and use that money to buy more
potatoes in order to get the necessary energy. In this example, potato consumption would
rise to 24 ($30/$1.25) and steak consumption would drop to zero. This shows how
consumption of a good would rise with a price increase (thus an upward sloping demand
curve).
At this point, the consumers entire budget is taken up by the giffen good, so
any price increase now will result in a decrease of the amount of good the consumer is
able to buy. Thus, we will have our typical downward sloping demand curve.
13













13
http://www.freeeconhelp.com/2012/01/what-is-giffen-good-example-with-graphs.html.
Income Effect: Giffens Paradox


15
CONCLUSION
In general terms, Giffens goods are those that people consume more as price
rises. In common ways, if price of a commodity goes up, quantity demanded goes down
or vice versa. Giffens goods are exceptions to this. Giffens goods price elasticity is
positive. When the price goes up for them, the quantity demanded also goes up and vice
versa. Prof Giffen himself has given the example of the staple foods whose demand is
driven by poverty. When the price of bread increases, poor people curtail their expenses
on costlier foods like meat, etc. and purchase more of bread. So, increase of price brings
increase of demand which is contrary to the normal situation. Thus, this particular
phenomenon is known as Giffens paradox.
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 is Giffen originally envisioned a specific situation faced by
individuals in a state of poverty. Modern consumer behaviour 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.
Some types of premium goods (such as expensive French wines, or celebrity-
endorsed perfumes) are sometimes claimed to be Giffen goods. It is claimed that
lowering the price of these high status goods can decrease demand because they are no
longer perceived as exclusive or high status products. However, the perceived nature of
such high status goods changes significantly with a substantial price drop. This
disqualifies them from being considered as Giffen goods, because the Giffen goods
analysis assumes that only the consumer's income or the relative price level changes, not
the nature of the good itself. However the theoretical distinction between the two types of
analysis remains clear; which one of them should be applied to any actual case is an
empirical matter.

Income Effect: Giffens Paradox


16
BIBLIOGRAPHY
Books referred
Satija Kalpana, Textbook on Economics for Law Students, Universal
publication.
Arora Surbhi, Textbook on Economics for Law Students, Universal publication.

Sites Referred
http://www2.econ.iastate.edu/classes/econ101/hallam/Income_Substitution.pdf.
http://courses.byui.edu/ECON_150/ECON_150_Old_Site/Lesson_05.htm.
http://www.buzzle.com/articles/giffen-good-example.html.
http://en.wikipedia.org/wiki/Giffen_good#cite_note-0.
http://ib-economics.blogspot.in.
http://www.assignmenthelp.net/assignment_help/microeconomics-demand.php.
http://www.freeeconhelp.com/2012/01/what-is-giffen-good-example-with-
graphs.html