The Giffen Paradox Explained

This is a fun insight to wrap the mind around. It might not happen very often but it's a nice thought experiment. This is how Giffen goods work: when a good X’s price increases and the only substitute, good Y, is more expensive, people have to purchase more of good X. This should surprise you. Because X’s price is higher, purchases in the same quantity as before the price increase take up a larger share of budgets. Buyers have to purchase more of X and less of Y to round out the total without breaking their budget. Like other price increases, we see a real loss in income. That is, buyers’ budgets are the same as before the price increase but they can buy less satisfaction/utility, so the effect is similar to a decline in income.

Example: Let’s say you are on a tight budget and you can only afford two foods: macaroni and cheese and ramen noodles. You need to buy one or the other every day, and ramen is cheaper than macaroni. You usually eat ramen noodles but you splurge on the more expensive mac and cheese twice per week and this maxes out your food budget. Now say the price of ramen increases, but it is still cheaper than mac and cheese. The law of demand says you will buy less ramen because of this price increase. However, because you are constrained by your budget, you can’t replace ramen with macaroni. The ramen noodle purchases now take up a larger share of your budget than it did before, so you have to buy less macaroni. Since you still need to eat something every day, you have to buy ramen on some or all of the days you previously purchased macaroni. The increased price is what we call a real (inflation-adjusted) decrease in income.