Question

1. To what extent do the research findings in Jensen and Miller (2008) support the existence of real world Giffen behaviour? Refer to the price elasticity of demand estimates in your answer.

Answer 1

This paper provides the first real-world evidence of Giffen behavior, i.e., upward sloping demand. Subsidizing the prices of dietary staples for extremely poor households in two provinces of China, we find strong evidence of Giffen behavior for rice in Hunan, and weaker evidence for wheat in Gansu. The data provide new insight into the consumption behavior of the poor, who act as though maximizing utility subject to subsistence concerns. We find that their elasticity of demand depends significantly, and nonlinearly, on the severity of their poverty. The “Law of Demand,” which holds that as the price of a good increases, consumers’ demand for that good should decrease, is one of the bedrock principles of microeconomics. Economists have long recognized, however, that the axioms of consumer theory do not guarantee that demand curves must slope downward, and that the Law of Demand, while descriptively valid in many situations, may not apply to very poor consumers facing subsistence concerns. Alfred Marshall first publicized this idea in the 1895 edition of his Principles of Economics:
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. Giffen behavior has long played an important, though controversial, role in economic pedagogy, as well as in the history of economic thought.Finding convincing evidence of such behavior is important, however, for economic theory more broadly. The fact that there has, to date, been no convincing evidence of Giffen behavior stands as a minor embarrassment to economists (John H. Nachbar 1998), one that is reflected in the discussion of the Giffen phenomenon often being presented as a paradox of economic
theory rather than as a real (or even possible) mode of behavior (e.g., Stigler 1947). This lack of evidence has prompted a range of reactions among economists. Some have interpreted it as support for the descriptive validity of the Law of Demand: Perhaps as persuasive a proof [of the “Law of Demand”] as is readily summarized is this: if an economist were to demonstrate its failure in a particular market at a particular time, he would be assured of immortality, professionally speaking, and rapid promotion while still alive. Since most economists would not dislike either reward, we may assume that the total absence of exceptions is not from lack of trying to find them. The conditions under which we would expect Giffen behavior can be demonstrated by elaborating Marshall’s statement.
Imagine an impoverished consumer near a subsistence level of nutrition, whose diet consists of only two foods, a “basic” or staple good (in Marshall’s case, bread) and a “fancy” good (meat). The basic good offers a high level of calories at low cost, while the fancy good is preferred because of its taste but provides few calories per unit currency. A poor consumer will therefore eat a lot of bread in order to get enough calories to meet his basic needs and use whatever money he has left over to purchase meat. Now, if the price of
bread increases, he can no longer afford the original bundle of foods. And if he increases his consumption of meat, he will fall below his required caloric intake. So, he must instead increase his consumption of bread (which is still the cheapest source of calories) and cut back on meat. The Giffen phenomenon illustrates the potential significance of the wealth effects of price changes for extremely poor households. Although the price increase makes the staple less attractive in relative terms, the fact that it makes the consumer so much poorer (in real terms) forces him to consume more bread. Translating this to the language of consumer theory, the conditions under which Giffen behavior is likely to be observed, therefore, include that the good in question be strongly inferior and that expenditure on that good comprise a large portion of the consumer’s budget. In light of these observations, we can state a set of conditions under which Giffen behavior is most likely to be observed:
C1: Households are poor enough that they face subsistence nutrition concerns.
C2: Households consume a very simple diet, including a basic (staple) and a fancy good.
C3: The basic good is the cheapest source of calories available, comprises a large part of the diet/budget, and has no ready substitute.