The denial of Giffen goods and income effects

Reply

RobinHood replied on Mon, Aug 20 2012 2:06 PM

rated by 0 users

Can't he buy an A, then chip in with his neighbors to buy a few B's, with his share being .8 of a B?

Or buy an A, put aside 4m's till next pay, then buy an A and a B and put 3 m's aside for a while?

Or buy an A, borrow an m from a neighbor and buy a B, then next pay...

You get the idea.

Reply

Bogart replied on Mon, Aug 20 2012 2:34 PM

rated by 0 users

There are two assumptions that are not guaranteed to be true after the price of A increases:

1. That the same preference relationship between A and B continues.  The preference relationslhip is for the first pricing situation.  The person may choose differently facing the higher price of A especially when they can purchase both 1 A and 1 B.  Now that they can either purchase 2 As or 1 B they may prefer the B. 

2. Holding m is still not an option.  The person facing higher prices could prefer neither and instead prefer to hold onto the medium of exchange or maybe just purchasing 1 A and holding the rest for an unknown future.  This could be an especially valuable option given that he could not afford the second A under the first pricing scenario.

Reply

Graham Wright replied on Mon, Aug 20 2012 3:14 PM

rated by 0 users

abskebabs:

1. 3m -> A

2. 5m -> B

3. 3m -> A

Shouldn't the m's be on the same value scale as the A's and B's, like this:

1. 9m

2. A & B

3. A & A

4. 8m

5. 7m

6. 6m

7. 5m

8. A

9. B

10. 4m

Reply

Jon Irenicus replied on Mon, Aug 20 2012 5:00 PM

rated by 0 users

If you're analysing it with the Austrian formulation of MUTV, it doesn't really make much sense. I mean it is a real phenomenon, it's just one which isn't "paradoxical" on the Austrian view because preference schedules aren't assumed to hold constant.

Reply

abskebabs replied on Mon, Aug 20 2012 7:55 PM

rated by 0 users

Or buy an A, put aside 4m's till next pay, then buy an A and a B and put 3 m's aside for a while?

Or buy an A, borrow an m from a neighbor and buy a B, then next pay...

You get the idea.

Of course that could happen, I just don't think we need to assume it necessarily would.

There are two assumptions that are not guaranteed to be true after the price of A increases:

1. That the same preference relationship between A and B continues.  The preference relationslhip is for the first pricing situation.  The person may choose differently facing the higher price of A especially when they can purchase both 1 A and 1 B.  Now that they can either purchase 2 As or 1 B they may prefer the B.

2. Holding m is still not an option.  The person facing higher prices could prefer neither and instead prefer to hold onto the medium of exchange or maybe just purchasing 1 A and holding the rest for an unknown future.  This could be an especially valuable option given that he could not afford the second A under the first pricing scenario.

1. Of course preferences are not guaranteed to be constant, but this doesn't change the situation when we're carrying out the common logical procedure of examining the effect of a change keeping valuations ceteris paribus constant. Also, I understand 2A are nt the "units" of the above value scale, but how is it that when the 1st A is preferred to B that the first A and a second A are offered instead of B they would not be preferred if preferences wouldn't change?

2. Of course holding m might be an option. This is why I mentioned cash holding might be an end in itself to be achieved via m. I just haven't represented it above, as I didn't think it necessary just to illustrate a simple example where income/Giffen effects predominate. If you like consider the same example above, but consider just the marginal and submarginal ends to be ranked with plenty of ends involving cash holding above and below them, e.g. m=> nth unit of m for cash holding, etc.

If you're analysing it with the Austrian formulation of MUTV, it doesn't really make much sense. I mean it is a real phenomenon, it's just one which isn't "paradoxical" on the Austrian view because preference schedules aren't assumed to hold constant.

My point is that it is not paradoxical even from an Austrian framework. If we can demonstrate it praxeologically like I have done abovel, then why do we need to pretend we can't? I don't think this is simply a side issue either, Pascal Salin has denied altogether the existence of the income effect in the past, and Rothbard in MES writes in such a way that it seems he thinks it to be a priori impossible (both of which seem ridiculous to me).

Reply

RobinHood replied on Mon, Aug 20 2012 8:24 PM

rated by 0 users

Or buy an A, put aside 4m's till next pay, then buy an A and a B and put 3 m's aside for a while?

Or buy an A, borrow an m from a neighbor and buy a B, then next pay...

You get the idea.

Of course that could happen, I just don't think we need to assume it necessarily would.

If we assume people seek their best interests, aka getting the biggest bang for their buck, it is unrealistic to assume anyhting but that they would do exactly that. They will not suddenly freak out and decide to waste their money, as Giffen claims. There is no empirical evidence for it happening [says Wikipedia]. Common sense says it won't.

And just because you can invent a model where they act foolishly, that doesn't mean they actually will follow your model.

I mean, I can make up the following model. Bread cost m units, which is exactly a person's daily income. The price of bread goes up, and my model assumes that he will then stop eating bread, or anything else, and jump out the window. Robin Hood objects that maybe he will soldier along somehow. I reply that "Of course that could happen, I just don't think we need to assume it necessarily would." Have I thus proven that he will, in fact, commit suicide? Is Rothbard now wrong?

Reply

abskebabs replied on Mon, Aug 20 2012 8:37 PM

rated by 0 users

So you're saying that since I am allowing the possibiliity that a loan won't necessarily be taken to pay for A and B, or necessarily defer consumption (which would involve different, discounted valuations), or assume that a good can offer a proportionate satisfaction by joint ownership that I'm the one arbitrarily coming up with a model to prove something could never be the case?

I'm not saying someone necessarily would have the above valuations and thus take the above course of action, I'm just not ruling it out as a possibillity.

Reply

RobinHood replied on Mon, Aug 20 2012 9:04 PM

rated by 0 users

abskebabs my good friend,

The very heart of the discussion is whether your model should be ruled out as a possibility. Rothbard is saying that it flies in the face of an axiom of praxeology, that people use the means they think will best suit their ends. And buying more of something that just got more expensive is, all other things being equal, the worst possible way to pursue ones ends. Once the empirical evidence for a Giffen good is shown not to exist, then we have no reason to postulate it at all.

So the q becomes, what is the basis for a claim that such a model, because it exists on paper, mirrors some reality? It's not like other models where we assume some people like apples more than oranges, where the assumptions do not contradict standard human behavior.

Reply

abskebabs replied on Tue, Aug 21 2012 4:50 AM

rated by 0 users

The very heart of the discussion is whether your model should be ruled out as a possibility. Rothbard is saying that it flies in the face of an axiom of praxeology, that people use the means they think will best suit their ends. And buying more of something that just got more expensive is, all other things being equal, the worst possible way to pursue ones ends. Once the empirical evidence for a Giffen good is shown not to exist, then we have no reason to postulate it at all.

So we don't accept testabillity of praxeological theorems unless we contradict Rothbard? All I have illustrated is how someone could act based on tradeoffs they face. To make it simpler, why not conceive m not as money but a convertible factor of production useful in making either A or B, with the specific, complementary factors already available. Would you still deny the possibility that (2A) might be pursued instead of (A,B) if A suddenly required more of the factor to produce?

Secondly, if someone chooses 2A they precisely are pursuing more valued ends as they are not giving up the 1st A for B. I don't like the terminology "Giffen Good" which implies a characteristic type of good as opposed to just behaviour based on preferences of a good at a particular value ranking, but of course it might make sense that the above type of pattern would not be observed on a large scale as a result of many bids and valuations clearing a market via pricing between marginal pairs, but I think it might definitely be a type of tradeoff you might be able to observe with one-off experiments.

Finally, not that this should matter, but I don't even think all Austrians would have ruled out the existence of income effects and by extension (are you ruling out one or both?). Bohm Bawerk in part of the Positive Theory of Capital uses examples somewhat similar to the above that make me feel he would have perfectly understood the above.

Reply

RobinHood replied on Tue, Aug 21 2012 6:32 AM

rated by 0 users

So we don't accept testability of praxeological theorems unless we contradict Rothbard?

I'm not sure we are talking about the same thing. If I understand you, you are saying that since you can show a model in which someone would prefer 2A when the price of A goes up, as opposed to A and B when the price of A was low, that you have proven the possibility, at least, of a Giffen good.

But I think a refutation of your argument is that of course one can make up all kinds of models. But they have to conform to certain rules. As a trivial example, any model, to be seriously considered as mirroring a possible reality, must have the price of two units of a given good to be not less than the price of one unit. Where do these rules come from? From the study of praxeology, meaning the consequences of the action axiom and the few subsidiary axioms Austrians use.

The argument is, therefore, whether one of the rules imposed on any model is that when the price of something goes up, then the demand for it must not go up. So that the arena in which the controversy takes place is not the arena where models are built, but the arena where the rules imposed on all models are decided upon.

As for considering m a factor of production, that is a bit different than money, because the change in the makeup of A may change it's properties and usefulness. For example, more vitamin D in milk makes it healthier. But changes in the cost of A do not change A's intrinsic usefulness, but only increases what will have to given up to get A in exchange. And the argument is that having to give up more just to get the same amount of A will not make A more desirable, but less.

As for the rest of your post, I admit that I do  not understand it. I have not read the Positive Theory of Capital, so I cannot reply to that either.

Reply

abskebabs replied on Sat, Aug 25 2012 11:50 AM

rated by 0 users

I've had a think about this and I think a better way to vividly illustrate what I am getting at would actually be with pursuing an analogy considering production.

The reasons are two-fold. First (as Rothbard himself correctly emphasises in MES), money can be thought of as the most convertible good in existence for the conduct of action within a market economy. Where we might place it on a value scale against all the ends we might utilise it to purchase other items with concerns the valuen placed on keeping a sum of it for cash-holding as an end. Hence, a nice way to illustrate the effects of rising "costs" would be to consider the decisions of how to allocate a convertible capital/consumer good. Secondly, since money itself is quite a distinguishing and complicating factor of the analysis subject to its own variations in purchasing power based on expectations and actions based on them, I think a better way to isolate what I am getting at with regard to a "pure income effect" would be to utilise an example not explicitly considering money. This would mean the phenomena is more universal than just for indirect exchange economies, and this would make sense given that necolassical value and price theory is itself pretty much "money-less" in an essential sense.

So let us explicitly consider a simple example. lets say we have a convertible good, e.g. cups of water to use a scenario very similar to the type Menger originally used to illustrate marginal utillity in his Principles. We first of all recognise the elemntary but important point that it is not means that are ultimately valued but ends. This of course is the same for indirect means; capital goods whose value is iindirectly imputed from lower order goods from their ultimate ends.

Hence say we have 3 cups of water. One is needed for each of the following purposes ranked in descending order of importance: drinking to keep oneself alive for one day, keeping one's household pet alive, watering your plant for the day. Now, going via this traditional example we may say a cup of water has been lost, and of course one must decide where to apply the remaining cups. The essential aspect of the decision however is a choice among ends however; which one to forsake and which one to keep. The marginal end forsaken out of the 3 if forced to keep just 2 by the acting individual, and the value of this purpose imputes the value of any of the cups of water.

Now, let us modify the example only slightly. Say that you fall ill, such that actually at least 2 cups would be required to sustain and keep yourself alive for the day. You still have 3 cups of water, and the requirements for the other purposes have not changed. This example of course does not employ a situation in which the same number of units of water for each purpose, but this in no way detracts from our abillity to analytically realise the resultant consequences, once we focus our attention on the choice scenario regarding the ultimate determinats of valuation; the ends (if you want a good example of how the Austrian framework is flexible enough to deal with such scenarios, and avoid the traps caused by the diminishing marginal utillity forumulations used by mathematical economists, see Mises HA, p.128). We resolve the consequences in this situation by focusing on the possible tradeoffs among ends. After ensuring the possibility of the most highly ranked end it is no longer possible to realiseb both the second most valuable and third most valuable end, hence the latter is the the one forsaken. I hope this is abundantly obvious. Furthermore, the end for whom the requirements have increased is not the one that suffers a diminishing in its realisation as a result of a "price" change, half of the effect considered above.

We need only slightly alter the scenario to forsee the possibillity of not only a restriction in the decided realisation of an alternative end as a result of a rise in the requirements to realise one end, but an actual increase in the "demand" for the realisation of the more "costly" end. Hence we might consider a scenario where let's say we have the cups of water (with the actor still posessing only 3 of them) represented by w able to produce goods A and B that help realise a set of ends E1-E3. Lets say the rankings of the ends and the requirements for the achievement of each one may be as follows:

1. 1w -> A -> E1.

2. 2w -> B -> E2

3. 1w -> A -> E3.

Now if the requirements to realise the production of good A somehow change for the individual (one conceivable reason for such a change might be a change undergone by a complementary capital good required for A's realisation), from 1w to 1.5w our actor is faced with a tradeoff between ends. First and foremost, it becomes abundantly clear that ends E1 and E2 cannot both be realised together. Faced with the choice between them E2 is forsaken. Yet due to the discontinuous nature of the tradeoffs and means-end relations this leaves the opportunity of applying the remainder 1.5w to another purpose. If as above, the next most valued end that can be realised with them also involves the production of A, then considering as Mises abundantly demonstrated, action involves the exchange of conceivable states of affairs a scenario in which E1 and E3 can both be realised, would be willingly exchanged for one where only E1 could be realised.

Now this example helps illustrate some important points. First, we see that the income effect, and the resultant consequence through which a "Giffen good effect" can be observed is by no means at all characteristic only of the conditions of a market economy, but actually a general part of value theory. Secondly, having derived and accounted for this possibility in valuational terms, as praxeologists we can also succeed over neoclassicals in thus explaining why the income effect may generally occur as a result of chainging prices in a market economy (so that rising/falling prices of goods can cause demand reductions/increases in other goods), we can also effectively account for why the observation of the second part of this effect (causing the label of Giffen Good) is so rarely observed.

The reasons are due to the fact that money itself is the most divisible and convertible good on the market, thus due to the very large number of other consumption possibilities made available by the extra funds remaining after abstaining from end like E2, it is much more likely ceteris paribus that they would be used to purchase more of alternative items as opposed to more of A. Furthermore, money allows for the division and joint ownership and contracts of use of other goods, loans etc. and all sorts of in betweens as you pointed out that might make the observation of the second part of this effect unlikely.

But this is no reason to deny the possible existence of such tradeoffs valuationally, as well as their more general significance.

Reply

RobinHood replied on Sat, Aug 25 2012 3:37 PM

rated by 0 users

First, to make sure we are on the same page, the scenario you laid out is certainly possible.

But let's look at wikipedia's definition of a Giffen good:

In economics and consumer theory, a Giffen good is one which people paradoxically consume more of as the price rises, violating the law of demand.

But that did not happen in your example. Where is the increased consumption of anything?

Reply

abskebabs replied on Sat, Aug 25 2012 4:09 PM

rated by 0 users

First, to make sure we are on the same page, the scenario you laid out is certainly possible.

But let's look at wikipedia's definition of a Giffen good:

In economics and consumer theory, a Giffen good is one which people paradoxically consume more of as the price rises, violating the law of demand.

But that did not happen in your example. Where is the increased consumption of anything?

I used 3 examples in the post above to demonstrate different aspects of my point. What I think would be helpful to first of all realise is that "consumption" in a market economy is utilising money, the commonly accepted medium of exchange as a means at a certain exchange ratio to obtain another good which can then actually be consumed. The price or exchange ratio is analogous in the sense I have pointed out above to production requirements leaving aside the variabillity and other facts associated with money's purchasing power and people's expectations and uncertainty regarding the future.

The first example was just a simple Mengerian one to demonstrate the roots of the marginal utillity theorem and was used to demonstrate the equivalence of the underlying principle used to realise the resulting consequences in the 2 examples that followed it. The second example involved no increased consumption of the good undergoing an increase in the requirements for it to be produced (analogous to a price increase), but involved a drop in the demand for a different good (illustrating the income effect). The third example (the one with the w's listed) on the other hand did involve an increase in the production of A as well as a drop in the production of the alternative good B, inspite of the requirements to produce each A going up (equivalent in terms of a means-end relation to the price of A going up on a market in terms of the money used as a means to obtain it). hence this could be considered directly analogous to an increased consumption of it inspite of  price rise. If you read what caveats I stated at the end of my last post, you will see why I think from a through Austrian perspective we can not only understand the basis of the income effect and "Giffen goods" effect, but also explain why the latter is so rarely observed and suggest where it might be observed more often (as a valuational phenomena, more likely outside of the context of developed market exchange).

Finally, perhaps I have not stated this emphatically enough: I utterly reject that anything can be a superior, inferior, normal or Giffen good, since this terminology very misleadingly assuades that these are inherent properties of these goods instead of describing effects of how people may treat these goods based on their particular subjective evaluations. I have only used the term "Giffen Good" since I have no other commonly accepted terminology to describe what I have been trying to show, and this is also why I have used the phrasing Giffen Goods effect as opposed to Giffen good at times.