Friday, January 11, 2013

Inferior goods and Giffen Paradox


Chapter 4, Section 6: Inferior goods and Giffen Paradox

The concept inferior goods of economics is translated as "cixuan wupin", something inferiorly chosen, by Hong Kong education authorities, which is wrong! In mainland China it's translated as “didang wupin”, something low end, or "liezhi wupin", something low quality, which are wrong as well! My translation is "pinqiong wupin", which means poverty goods, though indecent yet correct.

What is an inferior good? I don't have a high income, so I drink beer, yet yesterday I won one hundred grand in my horse bet, which is a large amount, then I turn to drink wine. It's quite normal that one drinks beer when he is poor, and once income increased starts to drink wine. If the quantity demanded for a good reduces due to income increase, it's called inferior good. The beer above doesn't have to be low quality, inferiorly chosen, or low end at all. It can be excellent and wonderful, but I'd only drink more when I lose in horse bets, or when I am poor.

That's to say, when the relative price of beer and wine remains unchanged, the increase of my income can change my marginal rate of substitution, and lead to a decrease of the quantity demanded for beer. Logically, any good can be inferior good, and whether it is or not just depends on everyone's different choice.

The phenomenon above and its indubitable logic brings a great problem to economics. During the entire utility analysis, we have only three safe postulates: first, everyone maximizes his utility; second, the postulate of substitution; and third, the convexity postulate. These three are all constraints on behaviors, but since utility and indifference curve are only abstract and unobservable, they cannot give many potentially refutable implications and are not that useful in behavior explanation.

We thus need a postulate stronger enough to solve the difficulty caused by this unreal concept of "utility". We ask: when the sacrifice to obtain some economic good reduces, would one's quantity demanded for the good definitely increase? This is the heart of economics, and intuition seems telling us: of course it would! However, with only the above three postulates, the transition from the change in sacrifice to that in quantity demanded is not justifiable.

Let's take price as the sacrifice. When the price of an economic good reduces, by convexity postulate the quantity demanded for that good must increase, however a same indifference curve must be assumed. When the price of the good reduces, consumers of that good will have a increase in their real income, therefore the utility they maximize would be higher. A reduction in price originally enlarges the quantity demanded for that good, yet the accompanying increase in income or utility can either enlarge or decrease the quantity demanded — the decrease is right caused by "inferior good".

When the price of an inferior good reduces, the reduction itself enlarges the quantity demanded for the good, yet the price reduction leads to an increase in real income, and further to a decrease in the quantity demanded. Combined together, one plus and one minus, the quantity demanded can still increase. However, logically one plus and one minus can lead to a total decrease in the quantity demanded as well. The latter case is right the well-known Giffen paradox.

This was written in the third version (1895) of A. Marshall's Principles of Economics. Sir Robert Giffen (1827-1910) gave Marshall a paradoxical example. Bread is a main type of food, if the price of bread reduces, the purchase power of consumers will increase, they thus eat more meat while less bread. The price of bread reduces, yet the quantity demanded for it decreases. This paradox makes bread called a Giffen goods. Logically, Giffen goods doesn't have to be bread — it can be any goods. In other words, Giffen goods are inferior goods pushed to the extreme: the price reduction of a good leads to an increase in people's real income, and further to the decrease of the quantity demanded for the good. Logically this has nothing wrong.

Giffen goods are familiar to any freshmen that major in economics. They don't know — all economists have weirdly ignored either — that Giffen goods logically exist because we consider only the quantity demanded of each single individual and ignore the competition among them. Logically, Giffen goods cannot be traded on the market, used in back-door dealing, given and taken privately, exchanged in political deal, or allocated according to seniority. In other words, if Giffen goods can ever exist in a real world, that can only be Robinson's one-man world. Robinson's world doesn't have market or any other allocation related problems, yet Robinson has his needs, and need sacrifice as well. Because there is no allocation competition, Giffon goods can exist in this one-man world. However they cannot exist when there is social competition. That's to say, the competition among individuals eliminates Giffen goods. On the other hand, the twentieth-century masters of price theory, like Alchian, Stigler, Coase and etc., all reject the existence of GIffen goods. However, they cannot reject inferior goods. But rejecting one while keeping the other cannot be logically consistent. So I prefer my own handling to let competition eliminate Giffen goods. It will be further explained in Chapter 7, Section 1 of this volume. (That chapter is my own discovery, it rejects Marshall's scissors analysis, plain and clear, and one can easily see Giffen goods don't exist in social competition.)

(Translator: The “paradox” of GIffen goods, as well as inferior goods, originates not from the concept of utility, but from the special treatment of wealth and income. Wealth is nothing special but an economic good as well, and income is just part of one's wealth in a specific form. As an economic good, wealth has its substitution relationship with other economic goods, too, and one can choose whichever combination of wealth, beer and wine, which form a 3-dimensional surface. Once one wins a horse bet, or the price of bread reduces and leads to an increase in real income, as is in the Giffen example, the man just experiences an increase of his wealth. Whether this would lead to the decrease in the quantity demanded for beer or bread, just depends on the man's substitution preference in allocating the extra wealth.)

2 comments:

  1. I am in absolute disagreement with the price of bread falling concept here. Sir Robert Giffen observed contradictory consumption behaviour in times of INFLATION. Where does the idea of falling prices creep in?
    This concept is better explained by using "basket of commodities" and satisfaction of one single want called "hunger". A simple observation seems to have been manipulated in a way to complicate it and change the entire observation of the great economist.

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    1. Hi, Prashant, thanks for the comment. This blog posts personal translation of the Economic Explanations by Steven N. S. Cheung, so your argument may not be able to reach the professor, I am sorry. Yet I can offer my defense here since I was translating the book and had careful reading of the original text.

      Though the falling price of bread here doesn't account for inflation, which is totally a whole new situation, it does be able to happen, for example due to invention of better mixer, stove, and etc. Yet that's not the focal point here. The bread case is a thinking experiment here used to analyze people's reaction under falling price of a commodity good they consume.

      Inflation DOESN'T have to exist, though it may persist through out a great part of human history.

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