Proposed by Scottish economist Sir Robert Giffen (1837-1910) from his observations of the purchasing habits of the Victorian poor, Giffen paradox states that demand for a commodity increases as its price rises.
Giffen paradox is explained by the fact that if the poor rely heavily on basic commodities like bread or potatoes, when prices are low they might still have some disposable income for purchases of other items.
As bread or corn prices rise, these other purchases are no longer possible, thereby forcing the poor to concentrate all their purchasing power on the bread or corn. It should not be confused with products bought as status symbols or for CONSPICUOUS CONSUMPTION.
R Giffen, Economic Inquiries and Studies (London, 1904)
Giffen goods are the inferior goods that are tied in the mind of individuals to hard times.These inferior goods are known as Giffen goods named after Sir Robert Giffen. Marshall introduced the Giffen’s paradox as an exception to the law of demand in the third edition of his book Principles of Economics (I895) as, ‘ There are however some exceptions. For instance, 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. But such cases are rare; when they are met with they must be treated separately (p. 208).’
Explanation of the Diagram:
Most students find it very frustrating to illustrate the case of a Giffen good using indifference curves and budget lines because rarely does a diagram come out right the first time. There are two goods, X and Y, and we want to show that X is a Giffen good, i.e., a decrease in its price would cause its consumption to fall. The Substitution Effect occurs when with fall in price, the quantity increases; with adjusting income in such a way that the real purchasing power of the consumer remains the same as before.It is called as ‘Compensatory variation in income’.It isolates substitution effect. In the above diagram, AB price line depicts the compensated budget line.AB price line is tangent to the IC1 at point e’1.When Income effect is positive and very strong then there is exception to the law of demand;that is the case of Giffen goods.
For advanced students, the reason why this would work can be given. Recall the Slutsky equation.( Refer: Decomposition of Price Effect: Giffen Goods by Dr Rekha Mahadeshwar Break Up) where the income effect (which is responsible for the perverse effect) is proportional to the budget share of the good. By locating e1 very close to the horizontal axis, we make this share large and, hence, increase the likelihood that the good would come out Giffen.