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

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. We will write a custom essay sample on Differentiate between Inferior goods and Giffen goods in the context of income effect and substitution effect or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page 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 products price relative to the consumers 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 markets 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 Giffens 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 consumers 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 The good must be an inferior good in order for the budget shortage on the part of consumers to cause an increase in consumption. In other words, the good must be inferior for the income effect to increase its consumption due to substitution away from costly and superior alternatives. Close substitutes must be absent but not-so-close substitutes must exist Finally, the cost difference with substitutes must be sufficiently substantial that even with the increase in price, it is still attractive as an inferior good. In other words, the substitution effect created by an increase in its relative price should be too small to counter the income effect created by the increased costs. Alternative explanations for apparent Giffen goods Just because the quantity demanded for a good increases with increases in its price does not imply that the good is a Giffen good. To qualify as a Giffen good, the quantity demanded must increase despite the fact that the substitution effect works against it: in other words, the value that buyers place on the good does not increase. Substitution and Income Effect: These two terms are very familiar to anybody who has taken an intermediate course in macroeconomics. With the recent articles regarding volunteerism and labor statistics, I thought that it was very timely to write on these two very important concepts. Let’s start with a thought experiment: if you were to receive a 10% increase in your hourly wage, would you increase, decrease, or maintain your hours worked? Believe it or not, any answer is correct, despite many assumptions regarding the positive slope of labor supply curves. The reason that any answer is correct lies in an understanding of substitution and income effects. The substitution effect is the change in consumption patterns due to a change in the relative prices of goods. For example, if private universities increase their tuition by 10% and public universities increase their tuition by only 2%, then it is very likely that we would see a shift in attendance from private to public universities (at least amongst students accepted to both). The same can be said across brands, goods, and even categories of goods. Examples would be the relative price of Pepsi vs. Coke, Red Meat vs. Poultry and Clothes vs. Entertainment. The income effect is the change in consumption patterns due to the change in purchasing power. This can occur from income increases, price changes, or even currency fluctuations. Since income is not a good in and of it (it can only be exchanged for goods and services, a point which has been debated recently by neuroeconomists), price decreases increase one’s purchasing power. For example, a decrease in the price of all cars allows you to buy either a cheaper car or a better car for the same price, thus increasing your utility. Goods typically fall into one of two categories: normal and inferior. These categorizations relate consumption of a good with a particular individual’s income. Normal goods increase in consumption as income increase while inferior goods decrease as income increases. Also, some goods can be normal or inferior only on certain ranges of an income spectrum. For example, education is a normal good: as one’s income increases (family income), demand for education increases. As one’s income increases, hot dog consumption, however, typically decreases. References