Giffen's paradox refers to a situation in which the demand for goods is positively related to the price. This happens when the substitution effect of inferior commodity prices is not enough to offset the income effect. The law of demand is very important to economics, because it is simple and has a strong ability to explain behavior, and it restricts the relationship between price and demand. However, the emergence of Giffen goods makes the law of demand problematic.
When the price drops, according to the law of demand, the demand must rise. However, due to the emergence of Giffen products, the demand may also decline. In this way, the price will fall, and we cannot be sure whether the demand will rise or fall. Therefore, the inability to restrain behavior leads to the loss of the ability to explain. Giffin's paradox logically rejected the law of demand, but the law of demand is very important to economics. Therefore, many economists tried every means to save the law.
Giffin's paradox is also called "Giffin's riddle". In economics, the demand theorem means that when other conditions are the same, the price of a commodity rises, and the demand for that commodity decreases. This is a truth that most people know, and it also conforms to the assumption that rational people act. However, during the Great Famine in Ireland in 1845, a strange thing happened. The price of potatoes was rising, but the demand was also increasing. The British economist Giffen has observed this phenomenon which is inconsistent with the demand theorem. This phenomenon is also known as the "Giffen puzzle" in the economic circles, and the goods with this feature are called Giffen goods.
The "Giffin puzzle" has since been solved by economists and is regarded as an exception to the demand theorem. Behind the demand theorem, there are also differences in consumer demand for goods. In economics, when the price of a commodity changes, it will have two impacts on consumers. One is to change the actual income level of consumers, and the other is to change the relative price of commodities. Both changes will change the demand of consumers for a certain commodity.
For all commodities, the substitution effect changes in the opposite direction to the price. In most cases, the effect of income is less than that of substitution effect, and the demand theorem has always been effective. However, in a few specific cases, the income effect of some low-grade commodities is greater than the substitution effect. Just like this, in economics, commodities are divided into normal commodities and low-grade commodities. The demand for normal commodities changes in the same direction as the income level of consumers; The opposite is true for low-end goods. This is not difficult to understand in real life.
Just imagine that the famine in Ireland in 1845 caused a large number of families to fall into poverty. The low-end products such as potatoes, which can only support life and livelihood, will undoubtedly account for a large proportion of the consumption expenditure of most poor families. The rise in the price of potatoes will lead to a significant decline in the real income level of poor families.
In this case, in order to survive, the poorer people have to increase their purchases of low-end commodities in large numbers and give up normal commodities. Compared with low-end commodities such as potatoes, there is no cheaper substitute. Thus, the income effect on potato demand is greater than the substitution effect, As a result, the demand for potatoes increases with the rise of potato prices. A commodity can be called a Giffen commodity only when it meets both the conditions of "being a low-grade product" and "the income effect is greater than the substitution effect".
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