Question

In studying the consumption of very poor families in China, Robert Jensen and Nolan Miller found that in both Hunan and Gansu, "Giffen behavior is most likely to be found among a range of households that are poor (but not too poor or too rich)." a. What do Jensen and Miller mean by "Giffen behavior"? b. Why would the poorest of the poor be less likely than people with slightly higher incomes to exhibit this behavior? c. Why must a good make up a very large portion of consumers' budgets to be a Giffen good?

Short answer

Giffen behavior refers to an economic situation where an increase in the price of a good leads to an increase in its demand, mostly associated with inferior goods. This behavior is less likely to be exhibited by the poorest people as severe budget constraints lead them to cheaper substitutes. A good must make up a large portion of consumers' budgets to be a Giffen good because only then can the income effect outweigh the substitution effect when prices rise, causing an increase in demand for the good.

Step-by-step solution

Explain Giffen behavior

Giffen behavior, or Giffen goods, refers to a concept in economics where an increase in the price of a good leads to an increase in demand for that particular good. It is a paradoxical situation that violates the law of demand. This happens particularly with inferior goods, products that are more in demand as customer's income decreases.

Explain behavior of poorest of the poor

The poorest of the poor are less likely to exhibit Giffen behavior due to their severe budget constraints. Given their low income, they are likely to opt for cheaper substitutes available in the market, rather than continuing to demand a good whose price has increased. Therefore, the demand for a Giffen good, in this case, falls rather than increasing as Giffen behavior suggests.

Explain the importance of the budget portion for a Giffen good

A good must represent a significant portion of consumers' budgets to qualify as a Giffen good because only then will the income effect outweigh the substitution effect when the price increases. This means that if the price of such a good increases and it forms a significant part of the consumer's budget, they have to cut back on the consumption of other goods, causing a rise in the demand for the Giffen good.

Key concepts

Law of Demand

The law of demand is a fundamental concept in economics which states that, all else being equal, an increase in the price of a good will typically lead to a decrease in the quantity demanded of that good. This relationship occurs because higher prices make an item less attractive to consumers, who may choose to buy less or look for alternatives. Conversely, when prices fall, people are usually more inclined to purchase more of an item. This principle is easy to see in everyday life. For example:

• If the cost of concert tickets increases, fewer people may decide to attend.
• Alternatively, if prices are reduced during a sale, more consumers may take advantage and purchase the on-sale products.

Though widely applicable, the law of demand has exceptions. One such exception is exemplified by Giffen goods, which do not adhere to this rule, as their demand goes up when their price increases. Understanding this paradox requires exploring concepts like inferior goods and the income effect.

Inferior Goods

Inferior goods are a category of products for which demand increases as the income of consumers falls, reversing the typical pattern seen with most goods. This is because, with lower income, consumers cannot afford more expensive alternatives, making cheaper, basic substitutes more appealing. A classic example of inferior goods includes essential items such as generic brand foods or public transit services. As a person's income decreases:

• They might opt for these less expensive groceries instead of premium brands.
• More people may choose to rely on public transport rather than owning a car.

In the context of Giffen behavior, the role of inferior goods is crucial. When the price of a prominent inferior good increases and it constitutes a large part of someone’s budget, the individual might forego other luxuries, leading to an odd increase in demand for that inferior good despite the price boost. This perceived anomaly is driven by the income effect.

Income Effect

The income effect describes how a change in the price of a good affects the purchasing power of an individual's income, thereby influencing the quantity demanded. When a price increase occurs, a consumer effectively has less disposable income, as more money is required to buy the same amount of goods, assuming there are no changes in income. For instance:

• If the price of bread rises significantly, people may feel poorer because they need more money for bread and, thus, buy less overall.
• However, if bread is a staple good in their diet, they might reduce consumption of other less essential items.

In cases of Giffen goods, this income effect can dominate the usual substitution effect, leading to increased demand despite higher prices. This particular scenario can mostly occur where the good takes up a significant share of the consumer's budget, forcing more significant adjustments in their purchasing habits.