Giffen goods as exceptions to the law of demand

The law of demand. Holding other things equal, the demand for a good and its price are negatively related: when the price rises the quantity demanded falls, and when the price falls the quantity demanded rises. The other things are the consumer's income, the prices of other goods and her preferences, which are taken as given when the demand curve is drawn. The demand curve therefore normally slopes downward.

Why demand normally falls when price rises. A change in a good's own price works on demand through two effects:

• Substitution effect. When the good becomes dearer relative to other goods, the consumer shifts towards the others to keep the same level of satisfaction, so she buys less of it.
• Income effect. A higher price lowers her purchasing power, which acts like a fall in income.

For a normal good, whose demand moves in the same direction as income, the fall in purchasing power also cuts demand. Both effects then push the same way, and the law of demand holds.

What a Giffen good is. An inferior good is one whose demand falls when income rises and rises when income falls. For such a good the two effects of a price change work in opposite directions. After a price rise the substitution effect still lowers demand, but the fall in purchasing power raises demand for the inferior good. The net result depends on which effect is stronger:

• if the substitution effect is stronger, demand still falls as price rises;
• if the income effect is stronger, demand rises with price. A good of this kind is a Giffen good.

So a Giffen good needs both conditions together: (i) it is inferior for the consumer, and (ii) its income effect outweighs its substitution effect.

Why it is an exception. For a Giffen good, quantity demanded rises when its own price rises, even though income, other prices and preferences are unchanged. The negative relation the law of demand describes is reversed, and the demand curve slopes upward over that range. This must be kept apart from cases where more is bought at a higher price because income or tastes changed: those are shifts of the demand curve, not exceptions to the law. The Giffen case is a movement along the consumer's own demand curve, caused by the price alone.

Example: bajra in a very poor household. Our own illustrative figures. A household spends ₹500 a week on food: 15 kg of bajra at ₹20 a kg (₹300) and 2.5 kg of vegetables and dal at ₹80 a kg (₹200). The price of bajra rises to ₹25. The household is now so much poorer in real terms that it can no longer afford its earlier mix and still get enough to eat, so it cuts the costlier foods to 1.25 kg (₹100) and buys 16 kg of bajra (₹400). Total spending is still ₹500, but bajra demand has gone up from 15 kg to 16 kg as its price rose: the income effect has outweighed the substitution effect.

Not every inferior good is a Giffen good. For most inferior goods the substitution effect is the stronger, so demand still falls when price rises and the law of demand holds. Also, a good can be normal for a consumer at some levels of income and inferior at others; Giffen behaviour can therefore arise only for consumers at whose income the good is inferior.

Conclusion. A Giffen good is an inferior good whose income effect is stronger than its substitution effect, so its demand rises when its price rises, other things equal. Its demand curve slopes upward, which is why it is a true exception to the law of demand.