The Science of Demand (26) - Unofficial Translation of Steven Cheung's 经济解释 - 科学说需求

Section 6.  Inferior Goods and the Giffen Paradox

What are inferior goods? I normally drink beer given that I do not earn much. Luckily I won $100,000 at the races yesterday. With increased income, I switch to drinking wine instead. Having beer when less well-off and wine when better-off is human nature of certain people. Inferior goods are so called since the quantity demanded of them drops with increased income. Note that the aforementioned beer is not substandard, second choice, nor low-class. Yet no matter how highly exquisite beer may be, I would only drink more of it after losing at the races or when I am poor.

With the relative prices of beer and wine unchanged, any change in my income can bring about changes in intention to substitute at the margin. I may therefore drink less beer when my income rises. Logically, any kind of good can be inferior good, and whether it is or not depends on individual choices.

The above common phenomenon and its correct logic lead to a significant problem in economics. In the whole utility analysis we only have three failsafe postulates: the first one being every individual maximizes utility number under constraints; the second one the postulate of substitution; the third one the convexity postulate. All these three postulates restrain behavior, but since utility and indifference curves are abstract and non-observable, not many refutable implications can be derived, therefore their applications in explaining behavior are only limited.

What we really need is a more rigid postulate in restraining behavior so as to overcome the problem triggered by unreal utility. We have to ask: if the option forgone in obtaining an economic good is less, will the quantity demanded of that good necessarily increase? This is the focus of economics, and its intuitive answer is: certainly! However, if we were to apply the aforementioned three postulates, we can never arrive at this inexorable law between the change in option forgone and the change in quantity demanded.

Let’s replace option forgone with price. According to the convexity postulate, when the price of an economic good falls, its quantity demanded must increase. But this assumes that we stay on the same indifference curve with utility number unchanged. When the price of a good falls, the real income of a consumer in effect increases, hence his utility number increases, too. The fall in price itself will lead to an increase in the quantity demanded of that good, though the increase in income or utility number may cause the quantity demanded to go up or down – the latter being the effect of “inferior good”.

When the price of an inferior good falls, the fall itself will cause an increase in the quantity demanded of that good. But the fall in price leads to an increase in real income, hence reducing the quantity demanded of that inferior good. When the two are combined, one for and one against, the resultant quantity demanded may still increase. However, logically, this one for and one against may also lead to a fall in quantity demanded. The latter is the renowned Giffen paradox.

It was written by Marshall in the third edition of his masterpiece (1895). A Sir Robert Giffen (1827 – 1910) proposed the following paradox example to Marshall. Bread is a primary food. If the price of bread drops significantly, the purchasing power of consumers will increase, resulting in their consumption of more meat and less bread. The price of bread has decreased, yet its quantity demanded also decreases. The bread in this paradox is called Giffen good. Logically, Giffen good is not limited to bread – any kind of good can possibly be Giffen good. In other words, Giffen good is inferior good to the extreme: the fall in price of a good leads to an increase in real income, resulting in reduced quantity demanded of that good. This is logically correct.

All freshmen in economics are familiar with Giffen good. What they do not know – and surprisingly being overlooked by all economists as well – is that Giffen good can only logically exist because we view purely from the perspective of individual demand while ignoring competition among individuals. Logically, Giffen goods cannot be transacted in the market. And under a system with no market, such goods will not be used in back-door transactions, underhand transfers, political deals, or be allocated according to seniority. In other words, if Giffen goods were to exist in the real world, they could only logically exist in Crusoe’s one-man economy. Crusoe’s economy had neither market nor any of the allocation problems in a social system, though Crusoe still had his demand and options to forgo. Giffen goods could logically exist in a one-man economy with no competition among different individuals. Yet Giffen goods can never exist in a society with competition. In other words, human competition has eliminated Giffen goods. By contrast, twentieth century’s gurus of the price theory like Alchian, Stigler, Coase, etc., chose to arbitrarily veto the existence of Giffen goods. Their problem, however, is that they could not veto the existence of inferior goods. It is illogical to veto one but not the other. That is why I still prefer my approach of competition eliminating Giffen goods. I will provide further explanation in Point 5, Section 1, Chapter VII. (In that original chapter of mine, Marshall’s scissor analysis is plainly rejected, thus making it clear that Giffen goods would not exist in a competitive society.)