Thursday, December 18, 2008

Steve Levitt clarifies Giffen goods

Giffen goods are those products whose demand, contrary to normal goods, increases with price - an upward sloping demand curve. Steve Levitt has an excellent post clarifying the recent claims that rice in rural China (peasants buy more of rice as its price rises) and prostitutes (types of customers preferring more expensive prostitutes) are examples of Giffen goods, may be off the mark.

Levitt writes, "When we talk about the demand curve for a good, what we mean is how the quantity consumed for that exact same good changes with the price of that good while holding everything else constant (such as the consumer’s income, the price of other goods, etc) and vice-versa."

In case of prostitutes, cheaper and more expensive prostitutes are two types of "goods", serving two different categories of consumers. Therefore the customer who purchases the high-price prostitute would demand just as much or more of her services if she were willing to do all the same things but at half the price.

Rice is the staple diet in rural China, whereas meat is a luxury diet, and people prefer to substitute rice with more meat (substitution effect) as they become richer. However, as the prices of commodities rice (or inflation takes hold), peasants face reduced real incomes (income effect of a price change) which turns them away from consuming luxury food items like meat and towards consuming basic staple like rice. For staples like rice, the substitution effect and the income effect push in opposite directions, and when the income effect is bigger than the substitution effect (the relative rise in price of rice is smaller than that of meat or the difference between the prices of the two products are too high), higher rice prices lead the peasants to feel so poor that they end up consuming more rice.


jasonchen said...

I think you missed the point about prostitutes. They're saying some rich men, like the former Gov. of New York, aren't making economically rational decisions. Instead, they value a woman BASED on how much she charges, rather than solely on her looks. Anyone who's seen pictures of Pizer's woman would agree; she's hot, but not significantly more attractive that what's available for much less money.

The fact she is unavaible to middle class consumers makes her more desirable to those people. If that woman lowered her rate, her customers would change as those that demand the high-priced prostute would no longer buy.

It isn't a Giffin good in the since that rice is, but it is a good for some consumers, that defies the tradional utility curve.

The same could be said about high-end but completely unpratical and unreliable cars and all sorts of foolish stuff that the rich buy.

chris sivewright said...

If the price of a cheap prostitute falls then we realsie we can consume the same as before and have money left to buy the services of a more expensive prostitute. We thus buy more of the expensive prostitute. When we buy more of the expensive prostitute we then need even less of the cheap prostitute and the price of a prostitute falls we buy less.

Thus cheap prostitutes are a Giffen good.

If you agree with that analysis then the same would apply to many other products eg margarine.

Price of margarine falls, buy the same, use the surplus to buy butter. we now have more butter and the same margaraine thus we can reduce consumption of margarine and thus...margarine is a Giffen good....