Getting Started
The Case of the Perverse Demand Curve What is a normal good? What do potatoes and Rolls Royces have in common? Every year, students of economics become confused about the answers to these seemingly innocuous questions. In this column we hope to relieve this confusion through explanation. By now you will be familiar with the 'law of demand', which tells us that the price of a commodity and the quantity demanded are inversely related. I expect you will also have been told about some possible 'exceptions' to this law- It is important to appreciate the significance (or otherwise) of these 'exceptions' since the law of downward-sloping demand is a cornerstone of economics. We should know under what conditions it may fail. In order to enable you to understand why consumers respond to price changes in the way they do, your teacher may have introduced you to concepts such as 'income effects', 'substitution effects', and 'indifference curves'. Even when these concepts have been mastered, many students still get horribly confused when asked to write about 'inferior' and 'Giffen goods'. They find it difficult to distinguish these goods from each other and from 'normal' goods, and when something called a 'status symbol' good is added to the list the confusion becomes intolerable. In examinations, candidates often betray their lack of understanding by describing Rolls Royces, fur coats and expensive perfumes as 'Giffen' goods, because (it is claimed) they have 'perverse' demand curves. Describing these as 'Giffen' goods is wrong, and this mistake would not be made if candidates were clear about the nature of so-called Giffen goods. Although not all inferior goods are Giffen goods, Giffen goods, if they exist at all, (and many economists would say that this is a very big 'if') are all inferior goods; that is, consumers tend to buy more of them as their incomes decrease. Potatoes are usually given as a possible example — but to lump Rolls Royces together with potatoes suggests that people would buy more Rolls Royce cars as their incomes fall! The diagrams on the left should help you to sort out these concepts. Column I contains four demand curves (price/quantity graphs). A and B are 'orthodox' demand curves (they have negative price elasticity and slope downwards from left to right obeying the law of demand). C and D are 'perverse' demand curves (they have positive price elasticity — they slope upwards, violating the law of demand). In drawing the demand curve, we plot quantity demanded against the price of a good, holding other things constant. If instead we plot the quantity demanded against income (again holding other things constant), we get something called an 'Engel curve'. A normal good is one whose consumption increases as income increases — hence a normal good has an Engel curve that slopes upwards from left to right — as in cases A and D in the diagram. Inferior goods, on 1
the other hand, have negative income elasticities of demand and downward-sloping Engel curves (as in cases B and C). Please notice that this is how we define a 'normal' good: it describes how the consumption of a good varies with income. Be wary of using 'normal' in other situations. We therefore have four possibilities: In Case A of the diagram we have 'orthodox-normal goods', with negative price elasticity and positive income elasticity. A fall in price causes an increase in real income, and an increase in price causes a fall in real income; therefore the income and substitution effects of a price change reinforce each other. Most goods and services are of this type. Case B shows 'orthodox-inferior goods', with negative price elasticity and negative income elasticity. Here the income and substitution effects of a price change work in opposite directions (a price fall increases real income which now reduces demand), but because the substitution effect is the stronger, the good still obeys the law of demand. Bread and cheap cuts of meat are likely examples. 'Perverse-inferior goods' (shown in Case C) are commonly termed 'Giffen goods', with positive price elasticity and negative income elasticity. The income and substitution effects of a price change work against each other, and because the income effect is assumed to be the stronger, the demand curve violates the law of demand. Thus in Giffen's alleged example, poor families find that when the price of potatoes rises, they have insufficient remaining income to purchase expensive items such as bacon, so they buy more potatoes instead. Finally, in Case D we have 'perverse-normal goods', with positive price elasticity and positive income elasticity. These goods require us to suspend our belief in the economist's basic assumptions about consumer behaviour and consider the possibility that the utility from consumption of a good may increase with its price; people want them because they are expensive. These 'goods of ostentation' or 'conspicuous consumption' give utility to the consumer by impressing other people. This may prevent our usual analysis in terms of indifference curves or income and substitution effects. More subtle arguments may be valid: consumer ignorance might explain a positive price elasticity if consumers believe that the price of a good reflects its quality. Thus a perfume priced at £5 might sell less well than an identical product priced at £50. Goods of this sort are sometimes called 'Veblen goods', after the economist who analysed aspects of consumer psychology such as these. One reason that this confusion arises is that we don't always distinguish sufficiently carefully between an individual's demand curve and the market demand curve. When we draw indifference curves, and use them to derive a demand curve, it is an individual's demand curve that we derive, for our indifference curves describe the preferences of an individual consumer. We then frequently wave our hands in the air and produce the market demand curve by 'adding up' the demands of individual consumers. This usually works — except where one individual's preferences depend upon overall market conditions. This is what happens in the 'conspicuous consumption' case: the utility obtained from consuming a good derives partly from the knowledge that relatively few others are consuming it. It is this interaction between individuals that distorts the shape of the market demand curve. 'Band-wagon' effects can also produce distortion — although of a different kind. You might like to think about this, or discuss it with your fellow students to see if you can guess what sort of behaviour is described by this label, and what effect it would have on the shape of the market demand curve. Candidates are often asked by A-level Economics examiners to distinguish between 'normal', 'inferior' and 'Giffen' goods. We hope that this short article will enable you to be aware that a lot of confusion is easily avoided by realising that there are in fact four possibilities to be discussed, not just three. You should also be reassured that the vast majority of goods fall in categories A and B, satisfying the 'law of demand'. 2