Economic Paradox

Economic Paradox

Economic Paradox

Money Wise; January-2016;


Paradox

A seemingly absurd or contradictory statement or proposition which when investigated may prove to be well founded or true. “I always lie is a paradox because if it is true it must be false”. In the world of Economics there are instances of such paradoxes, absurd but true!

If you get PAY raise, buy caviar not bread

The “elasticity” of demand is its responsiveness to changes in another factor, such as price. British economist Alfred Marshall is generally credited as the first economist to define the concept in 1890, but the German statistician Ernst Engel published a paper five years earlier, showing how changes in income alter the level of demand. The origins of the concept may be disputed, but its importance is not. Elasticity of demand quickly became one of the most widely used tools of economic analysis.

Marshall had been one of the first to formalize the idea that demand fell as prices rose. It took only a small step from this to see how the demand for different products (such as bread and caviar) varied by differing amounts when the price of those products changed.

Marshall saw that when prices changed for necessities such as bread, demand changed very little. Bread is very unresponsive to changes in price because it has few substitutes. On the other hand demand for luxuries might be much more responsive to price—such a product is said to be “price-elastic.” Marshall recognized that among people on average incomes, demand for a luxury such as caviar is much more sensitive to price change than it is among the super-rich, who can afford as much as they like.

Engel’s law Ernst Engel argued that as people grow richer, they increase spending on food by less than their increase in income. Demand for food is “income-inelastic”—an idea that became known as Engel’s law. Engel studied the budgets of 199 households in Belgium and showed that while demand for basic necessities such as food grew less quickly as income rose, demand for luxuries—such as vacations—grew at least as quickly as the increase in income. Economists have identified two types of products or goods. The first normal goods are those where demand rises in line with income. Luxuries are a special type of normal good, known as a superior good, where demand rises proportionately more than the rise in income. The second type of goods—inferior goods—see demand fall as income rises. Some groups of goods, such as food, contain both luxuries and necessities (such as caviar and bread). This means that it may be misleading to judge the impact of increasing income on food as a group. A further complication is that a product is not always normal or inferior—this may change at different levels of income. Given extra income, very poor people might buy more bread, those on high incomes might buy more caviar, but the super-rich might choose to give up caviar and dine on edible gold flakes instead.

designer

Designer clothes are luxury goods that take up a greater proportion of income as a person’s income rises. Necessities such as bread will take a declining proportion of income.

When the price goes up, some people buy more

In 1895, British economist Alfred Marshall demonstrated how supply and demand create the price of goods. After he explained the general rules, such as the greater the demand, the smaller the price, he went on to show how there can be an interesting exception. Marshall suggested that a price rise could, in some circumstances, create a surprising increase in demand. He attributed the discovery of this exception to a well-known Scottish economist and statistician of the time, Sir Robert Giffen. Today, commodities for which demand rises as their prices rise are known as Giffen goods. The original Giffen good was bread, the most important staple of the poorest section of the British population in the 19th century.

The poorest of the working classes spent a large part of their income on bread, a food that was necessary for life but was seen as inferior to the perceived luxury of meat. Marshall said that as the price of bread rose, the poorest people had to spend more of their income on bread to get enough calories to survive—they had to buy bread instead of meat. As a result, if the price of bread increased, so did demand. Inferior and poor

Giffen goods rely on a number of assumptions. First, the commodity has to be an inferior good, that is, a good that people choose to buy less of as their income rises because there is better alternatives—in this case meat in preference to bread. Second, the consumer must spend a large portion of their income on this product, hence the fact that the example refers to the poorest section of society. Finally, there must be no alternatives to the product. In the case of bread, there is no cheaper alternative staple. Given these assumptions, an increase in the price of bread creates two effects. It causes people to buy less bread because the satisfaction it creates per pound of spending falls compared to other goods. This substitution effect would cause bread to follow the general rule of higher price causing lower demand. However, as the price of bread rises, it also reduces the power to spend on other things, and because bread is an inferior good, this lower income will make the demand for bread rise.

What makes the Giffen good so special is that because the poor spend so much of their income on bread, the income effect is so large that It outweighs the substitution effect, and so when the price goes up, some people buy more. Another example of a Giffen good is that of potatoes during the Irish Potato Famine of 1842–53, where rising prices allegedly caused an increase in the demand for potatoes. Elusive evidence

Marshall came under attack from Francis Edgeworth, another British economist, for postulating the existence of a good that contradicts a basic rule of demand, without any hard evidence. In theory, Giffen goods are consistent with consumers’ behavior—the interaction of income and substitution effects—that underlies demand curves. But if Giffen goods exist at all, they are rare: evidence comes from special contexts, and some of the most famous cases are dubious. Yet economists continue to search for them. In a 2007 study Harvard economists Robert Jensen and Nolan Miller presented evidence of Giffen behavior in the demand for rice among poor families in China.

 

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