Giffen goods and inferior goods

The terms.

• An inferior good is one whose demand falls when the consumer's income rises (and rises when income falls), prices and tastes unchanged; coarse cereals for a consumer above a certain income are an example.
• When the price of a good falls, two effects work on its demand. The substitution effect: the good is now cheaper relative to others, so the consumer buys more of it. The income effect: the fall in price raises her purchasing power, which changes her demand as a rise in income would.
• For a normal good both effects raise demand when its price falls. For an inferior good the income effect works in the opposite direction to the substitution effect.
• A Giffen good is an inferior good whose income effect is stronger than its substitution effect, so that its demand moves in the same direction as its price: the demand curve slopes upward.

(i) All Giffen goods are inferior goods: TRUE. The demand for a good can rise with its price only if the income effect of the price change works against the substitution effect, and outweighs it. The substitution effect of a price rise always lowers demand. For the income effect to push demand the other way, a fall in real income must raise demand for the good, which is exactly what makes a good inferior. A normal good can never be Giffen, because for it both effects lower demand when its price rises. So every Giffen good is necessarily an inferior good.

(ii) All inferior goods are Giffen goods: FALSE. Most inferior goods are not Giffen goods. For most inferior goods the income effect works against the substitution effect but is weaker than it, so the substitution effect wins and demand still falls when price rises; the demand curve still slopes downward and the law of demand holds. Our own example: for a well-paid office worker in Bengaluru, bus travel may be inferior (he switches to cab rides as his income rises), yet if bus fares rise he takes fewer bus trips, not more, because spending on bus fares is a small part of his budget and the income effect is small. A good becomes Giffen only when it is inferior and takes so large a share of the budget that the income effect outweighs the substitution effect, as with a staple food for a very poor household.

Conclusion. Being inferior is a necessary but not a sufficient condition for a good to be Giffen: (i) is true and (ii) is false. Every Giffen good is inferior, but an inferior good is Giffen only in the rare case where its income effect is stronger than its substitution effect.