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even the imaginary Giffen paradox™ [1950, p. 395]. I will argue in this
chapter that the Giffen paradox is important because it is contrary to a
market equilibrium theory of prices and not because it might be seen to be
contrary to any theory of demand. I will discuss both aspects of the sig-
nificance of Giffen goods.
The inability of demand theorists to specify conditions on utility
functions or indifference maps that would preclude Giffen goods without
excluding inferior goods has been a skeleton in our closet which if let out
Marshall modified his theory on two points. The first was that he would create a scandal. In the interests of professional stability and
slightly modified his assertion of the universality of negatively sloping security, the tradition has been to accept almost any ad hoc argument
demand curves and in fact introduced the Giffen paradox as an
which would do the job of eliminating the logical possibility of upward
exception. The second alteration was in his treatment of consumers™
sloping demand curves. All this tradition has existed without ever
surplus: ˜When the total utilities of two commodities which contribute
manifesting a clear understanding as to why they must be eliminated.
to the same purpose are calculated on this plan, we cannot say that the
total utility of the two together is equal to the sum of the total utilities It will be argued here that the exclusion of Giffen goods is an important
of each separately.™ methodological constraint on the development of neoclassical demand
George Stigler [1950, p. 327]
theory because that theory is part of a larger theory based on the ˜going
prices™ that are market-determined. And further, if we are free to ignore
The idea of the Law of Demand was commonly accepted long before Giffen goods, then we are free to ignore the remainder of neoclassical
Marshall mentioned the Giffen paradox. The Giffen paradox has always demand theory as well. Stated another way, Giffen goods and market-
been interpreted as a problem for demand theorists. 1 They were required to determined prices do not go together. It should be recognized that, above
somehow assure us that their theories of consumer behaviour imply the all, neoclassical demand theory was created to explain the quantities
allegedly observed regularity of the absence of Giffen goods “ that is, demanded which in turn are to be used in the explanation of prices.
imply the ˜universal rule™ of negatively inclined demand curves. The basis Contrary to popular views of methodology, it is my view that neoclassical
of this requirement is usually viewed as a matter imposed on us by tradition theory should be expected first to conform to the theoretical job to be done
or casual knowledge rather than as a matter of an interaction of demand (explain prices in this case) more than to the nature of the real world that
theory with the other parts of price theory. If the Law of Demand is the theory intends to explain or describe. This is not to say we should
retained as a matter of tradition it can be callously abandoned. If it is a ignore the ˜realism of the assumptions™ but that the realism is not the
matter of casual knowledge we might wish to be more careful. But if it is a guiding factor in the development of neoclassical theory [Stigler 1950, pp.
matter of dealing with the interaction with other parts of price theory, the 394“6]. If my view is correct it means that there may be more at stake with
Law of Demand may actually be an imperative. Giffen goods than merely trying to get one logical consequence to conform
With little doubt the task facing any demand theorist is to explain the to the nature of the real world.
quantity demanded in the market. For some the task is to go as far as By viewing the Law of Demand as an imperative for demand theorists
explaining the lawness of the Law of Demand. If there were a problem over we may have only two options available to us. One option is to drop all of
the insufficiency of the usual conditions placed on utility functions with neoclassical demand theory and start from scratch. The other option is to
respect to establishing the Law of Demand, one could simply drop all retain as much as possible of neoclassical theory and choose between the
utility analysis, as was suggested long ago by Gustav Cassel. Or one could following: (1) an ad hoc exclusion of the logical possibility of Giffen goods
even declare the neoclassical assumptions about utility analysis to be in demand theory; or (2) an ad hoc dropping of any reference to market-
obviously false, as some of the critics noted in Chapter 1 have done. determined prices in demand theory. The maintenance of neoclassical
© LAWRENCE A. BOLAND
198 Principles of economics Giffen goods vs market-determined prices 199
demand theory with either of these latter choices requires ˜ad hocery™. A the logic of the situation to explain why that theory exists in its present
possible third choice might be suggested, namely, to ˜rehabilitate Giffen form. In short, I will present what I think is the theoretical problem that is
goods™ [e.g. Lipsey and Rosenbluth 1971] without giving up market- solved by neoclassical demand theory. I will again be concerned precisely
determined prices (and hence without giving up most of neoclassical with the allegation of Hicks that the central purpose of demand theory is to
theory). But this possible third option, I will argue, is self-contradictory. provide a rational basis for the Law of Demand [Hicks 1956, p. 59]. The
And furthermore, it may render neoclassical price theory untestable or, issue can be put simply: in economics (or even physics) we usually call any
worse, irrelevant. hypothesis a ˜Law™ only when, if it were false, everything we consider
Any argument over the purposes of any theory in question should be important falls with it. For example, without the ˜Law of Gravity™ there
resolvable merely by consulting the history of that theory. Unfortunately, would be no Newtonian physics; without the Law of Thermodynamics
demand theory has a long history involving too many contributors whose there would be no explanation of engines or refrigerators, and so on. In this
individual aims differed widely. Although economics textbooks may agree case, without the Law of Demand, I will argue, there would be no complete
to a great extent, they still vary widely in some of the details discussed in theory of market-determined prices.
this chapter. One could probably construct an historical, episodic account The question at issue: Why is the Law of Demand so central to demand
of every version of neoclassical demand theory. However, I think one could theory? The answer, as I shall show, is simply that the Law of Demand is
understand our present theory more clearly if one were to attempt seeing necessary for any neoclassical explanation which claims or assumes that all
each of its details as a timely and rationalizable solution to a particular prices are exclusively determined by market equilibria. In other words, the
theoretical problem involving the aims of the theorist and the obstacles to Law is necessary for the completion of each and every neoclassical
fulfilling those aims. This method, called ˜rational reconstruction™, will be explanation. It will be a sufficient argument that any criticism of the Law
used to present neoclassical demand theory as an outcome of certain of Demand (or of the non-existence of Giffen goods) must be a criticism of
intended consequences of the problem“solution based development of that the entire neoclassical demand theory if it can be shown (1) that the Law of
theory. Criticism and understanding in this context will always be Demand is necessarily true whenever the neoclassical theory of market
˜internal™, having to do with the chosen means of overcoming obstacles prices is true and (2) that together the basic assumptions of neoclassical
rather than be ˜external™ by objecting to the aims of the theorist [see Wong demand theory are sufficient but individually are not necessary for the
1978]. explanation of consumer demand. Moreover, it will be apparent that the
So long as we find neoclassical demand theory interesting, I think the basic assumptions exist in neoclassical demand theory only by virtue of the
job remains to rehabilitate the Hicksian version. If this is to be done in the necessity of the Law of Demand. A corollary is thus that any criticism of
context of market-determined prices then some way must be found to market-determined prices is also a criticism of the necessity of the entire
replace John Hicks™ weak argument against the existence of Giffen goods theory and its use as a basis for understanding the economy.
(which I discussed in Chapter 13). But since this rehabilitation may involve
some ˜ad hocery™, I will again offer a brief digression on ˜good™ and ˜bad™
Walrasian stability and Marshallian stability
ad hocery. So as not to keep the reader in suspense, I can give the following
hint: ˜good™ ad hocery exposes skeletons whereas ˜bad™ ad hocery hides I begin now by showing why I think the Law of Demand is a necessity
them either by closing the closet door or by moving to another house (i.e. whenever we wish to explain prices as being determined in the market. The
to another set of intended consequences). basic focus of neoclassical price theory is to explain why the price of any
good is what it is and not what it is not. The neoclassical reason given is
that the price of any good is a market equilibrium price, which is to say, if
A RATIONAL RECONSTRUCTION OF NEOCLASSICAL
for any reason the price were higher than it is now it would fall back to the
DEMAND THEORY
equilibrium level (and rise when it is lower). This raises certain questions
In this section I present my rational reconstruction of neoclassical demand which are essentially about specifying requirements for a successful
theory. The overall purpose is to understand the methodological and ˜equilibrium explanation™. The first requirement is simply a set of reasons
theoretical constraints on any attempt to develop or repair neoclassical why the price must fall when it is higher (and rise when it is lower) than the
demand theory. My rational reconstruction of demand theory will lay out ˜equilibrium level™.
© LAWRENCE A. BOLAND
200 Principles of economics Giffen goods vs market-determined prices 201
higher price) and
ED
P
P S
(2) Any time the going price is greater than the equilibrium price there
will exist a situation where supply exceeds demand (and when the
P price is less there will be excess demand).
P e
e
Walrasian stability then involves these two behavioural assumptions about
the nature of the real world, neither of which is necessary or sufficient for
S
D the question2 but it can be argued that they are together sufficient. They
ED D
hang together. One can only criticize their sufficiency, 3 which is always
easy, much easier than criticizing their necessity. 4 What, then, are the
Qe Qe Q
Q
implicit assumptions that underlie the presumed sufficiency of these
(a) (d)
behavioural assumptions, (1) and (2)?
P
P The first behavioural assumption is seldom suspect, it is merely
ED D
S
accepted either as a direct behavioural assumption or as a definition of
competition which is assumed to exist. The second can be rationalized, that
P
P e is, we can give a rational argument for why, when the going price is greater
e
than the equilibrium price, there will exist an excess supply. To understand
this second behavioural assumption we need to examine the logic of the
S
ED D situation. Consider the following question. If our assumptions are true then
what logically possible states of the world are thereby claimed not to
represent the real world? To answer this question I note that there are six
Qe Qe Q
Q
possible situations that might be found in the world, that is, six
(e)
(b)
combinations of demand and supply curves, as shown in Figure 14.1. 5
In a Walrasian world the behavioural assumption (1) will work to
P ED promote equilibrium only if the assumption (2) is true, that is, only if the
P S D
D S world is not like situations (d), (e) or (f) of Figure 14.1. Thus assumption
(2) implicitly asserts that the world is like (a), (b) or (c). Now without
support assumption (2) becomes a mere ad hoc empirical assumption about
P
P e
e
the real world. To avoid the ad hocery, we must be able to explain why the
relative slopes of the demand and supply curves are as indicated in (a), (b)
or (c) and not like (d), (e) or (f). This might require a joint explanation of
ED
demand and supply. Such a joint explanation is precluded by the ideology
behind much of neoclassical theory, viz. laissez-faire individualism where
Qe Qe Q
Q all individuals, whether buyers or sellers, must be independent.
(f)
(c)
Particularly, demand must be independent of supply. Without our
Figure 14.1 Intersecting slopes in alternative markets
providing a joint explanation, assumption (2) is simply an ad hoc attempt
to save the equilibrium theory of prices. And furthermore, without a joint
The reasons usually given broadly define what is traditionally called
explanation, there is no way to distinguish worlds (a) and (d), or (c) and (f),
˜Walrasian stability™. Specifically, it is claimed that the world is such that:
without violating the independence of buyers™ and sellers™ decision-
(1) Any time the quantity supplied exceeds demand, there is at least one making. In these cases, demand and supply are both negatively or both
person, a seller who will offer to sell at a lower price to achieve his or positively sloped and, to distinguish (a) from (d) or (c) from (f), one has to
specify which curve is steeper.6
her own goals (and when demand exceeds supply, a buyer will offer a
© LAWRENCE A. BOLAND
202 Principles of economics Giffen goods vs market-determined prices 203
Fortunately, there could be another way to avoid this ad hocery. Implicit the Law of Demand can be given independently of an explanation for the
in the neoclassical theory of the competitive firm there is an additional Law of Supply, then ad hocery can be avoided and prices be explained as
equilibrium theory, namely, Marshall™s theory of quantity adjustment market-determined without the risk of condoning a methodologically
which is formally the same as that described so far for prices. In the dangerous interaction between any buyer and any seller, as such interaction
might undermine the virtues of a competitive price system. 8
Walrasian view of stability we have one price and two different quantities,
the quantity demanded and the quantity supplied. In Marshall™s theory of It may be distasteful for recently trained economists to admit that there
the firm we find one quantity (the supply) and two prices, the offering price is a lot of silly philosophy underlying ordinary neoclassical economics, but
(which is the price at which all demanders would be maximizing their I think such is the case. It is seldom recognized because our textbooks try
utility with their contribution to the market demand) and the asking price to socialize us into believing that our theories are merely descriptions of the
(which is merely the marginal cost of the quantity being supplied by the real world and those theories were actually derived from observations of
firm). Thus, it can be shown that the real world, or worse, it is all a game of logic and language, of a priori
assumptions and all that. To some extent all theories are descriptions but
(1¢) Any time the quantity bought and sold in the market, Q, is greater
only to the extent that they are empirical. Of course, anyone can make an
than the equilibrium quantity, Qe, the quantity will fall (when less,
empirical statement without deriving it from the real world; for example,
the quantity will rise).
by conjecture or by accident. Moreover, not all empirical statements are
This follows directly from the neoclassical theory of the firm. For example, true. The Law of Demand has always been a fiction (abstraction, non-
if the offering price is greater than the asking price, the firm will increase description, generalization, etc.) to the extent that we present it as an
its output to increase its profit. 7 To form a sufficient argument for a so- inductively proven empirical truth instead of a possible empirical challenge
called Marshallian stability of the equilibrium quantities, the real world to our understanding of prices.
must be such that In spite of the long history of believing in the empirical fact of the Law
of Demand, I think it should be obvious that the necessity of the Law of
(2¢) Any time Q>Q the asking price must be greater than the offering
e Demand for an explanation of equilibrium prices is the outcome of
price (and when Q<Qe, the asking price must be less).
avoiding either ad hocery or undesirable ideological implications of our
This assertion about the nature of the real world is similar to the one made theory, or both. But my argument intends to go further by showing that
to define Walrasian stability, and needs likewise to be rationally supported neoclassical demand theory can be rationally reconstructed only if we see
or to be acceptably ad hoc. To assure Marshallian stability, another that theory as an attempt to rationalize the Law of Demand.
empirical assumption is thus required, namely, one that would now assure There is only one fundamental behavioural assumption made about the
that the market situation in the real world not be like (a), (c) or (e) of process of consumption, namely, that consumers are maximizing utility (or,
Figure 14.1 and that the real world is like (b), (d) or (f). Now it turns out which amounts to the same thing, choosing the ˜best™ bundle). The rest of
that by itself this Marshallian assertion about the nature of the real world the assumptions are made in an attempt to facilitate the conjunction of the
would require an argument involving the joint behaviour of demand and maximization assumption and the Law of Demand. To facilitate the
supply prices similar to the previous discussion. Note also that there is maximization assumption we use assumptions which limit the shape of the
something else in common between the two market equilibrium theories: assumed utility function or preference ordering (e.g. greed, diminishing
they both exclude the possibility of the world being like situation (e) of MRS, transitivity, continuity, etc.). But as discussed in Chapter 13, these
Figure 14.1 and both allow situation (b). If we could independently argue assumptions are usually insufficient to rule out the logical possibility of
why the world is like (b) and is not like (a), (c), (d), (e) or (f), we then Giffen goods “ that is, the demand curves could be upward sloping without
could avoid the ad hocery of asserting Walrasian stability or its counterpart violating the axioms of consumer theory. Several additional assumptions
in terms of quantity, Marshallian stability. Such is the task of our have been attempted. All seem to be unsatisfactory for one reason or
independent theories of demand and of supply. Situation (b) is merely a another.
joint statement of the Law of Demand and an analogous Law of Supply, As was seen in Chapter 13, the most effective way to rule out Giffen
which says that as the price rises the quantity demanded must always be goods is to rule out ˜inferior goods™. Of course, this is unsatisfactory
falling and the quantity supplied must always be rising. If an explanation of because it does too much. It is a case which Martin Hollis and Edward Nell
© LAWRENCE A. BOLAND
204 Principles of economics Giffen goods vs market-determined prices 205
[1975, p. 61] describe as solving a New York City slum problem by the quantity demanded is the aggregate effect of all the individual
redefining the city boundaries. Another ad hoc method considered has been consumers™ rational attempts to maximize their (independent) personal
to require the satisfaction of the Axiom of Revealed Preference which, as I utility.
have shown in Chapter 13, does not rule out entirely Giffen goods although It is a sufficient argument that if all individual demand curves are
it does limit them somewhat. Unfortunately, the limits placed on the slope negatively sloped their aggregation, the market demand curve, will also be
of the demand curve are insufficient to assure that the market demand negatively sloped. If one could show that rational maximization necessarily
curve intersects the market supply curve as shown in case (b) of Figure leads to negatively sloped individual demand curves, then the central task
14.1 and thereby leaves open the question of market stability. Thus it might of demand theory would be fulfilled. Unfortunately, that has not yet been
seem that we must choose between ad hoc eliminations of inferior goods or shown by anyone. But, the question might be asked, is it necessary for all
ad hoc assertions that markets are stable. individuals to have negatively sloped demand curves? The obvious
response would be to say ˜No™ [see Lloyd 1967, p. 24; De Alessi 1968, pp.
290“1]. For example, one or two demanders could easily have upward
The imperatives of demand theory
sloping demand curves, yet in the aggregation the negative slope of all the
Now I would like to present neoclassical demand theory in a slightly other demanders could cancel out the positive slope. Unfortunately, that
different way to show why it is important to avoid this choice problem. The reasonable response leads to problems over the independence of the
central question of neoclassical demand theory is: Why is the quantity demanders themselves.
demanded at the going price what it is? And why would that quantity Let me try to explain. Say there are N demanders whose respective
demanded fall if the price rose? To be neoclassical it is required that the demands at the going price are d1, d2, d3 ... dm, dm+1 ... dN“1, dN. And say
theory of demand not only assume maximizing behaviour but that it be that the first m demanders, who respectively demand d 1 through d m, each
consistent with laissez-faire individualism, that is, with the philosophy that have negatively sloped demand curves and that demanders of d m+1 through
everyone should make independent rational decisions in the market “ or as, dN“1 have upward sloped demand curves such that a slight change in price
Voltaire said in Candide, we should till our own gardens. As noted above, would leave the aggregate demand of the N“1 demanders unchanged (the
this leads us to argue that, to assure Marshallian and Walrasian stability, positive and negative slopes just cancel out). If this market is to be both
the real world would have to be like (b) of Figure 14.1 since that would Marshallian and Walrasian stable and preserve the independence of
allow us to explain demand and supply independently. That is, if we have suppliers and demanders, then the Nth demander™s behaviour is no longer
separate arguments for why demand curves are always negatively sloped independent of the other N“1 demanders. This is because to avoid an
and for why supply curves are always upwardly sloped, then we would embarrassing contradiction of the philosophically desirable independence
never have to consider a violation of the independence of the decision- between suppliers and demanders, the Nth demander™s demand curve must
be negatively sloped.9 It clearly would be best if all individuals™ demand
makers. Without the ˜always™ we could never rationally reconstruct
demand theory. curves could be shown to be negatively sloped as a consequence of the
This then is the task facing any neoclassical demand theorist: to give logic of their individual situations, namely, as a result of their rational
reasons why the Law of Demand is true without assuming anything which maximization and the nature of their situational constraints.
would have us violate the rationality or the independence prescribed by
laissez-faire individualism. However, there is a slight complication. The
AD HOCERY VS TESTABILITY
arguments about stability are relevant for market demand curves, and
neoclassical demand theory is about the behaviour of the individual I now turn to some general questions of methodology that are raised in this
consumer. Thus we have an added problem facing the demand theorist. The consideration of Giffen goods. What is the difference between (1)
reasons given for the slope of the market demand curve must be seen as a straightforwardly ruling out Giffen goods as Cassel [1918] or Moore
consequence of the individuals™ demand curves. On the surface this would [1929] might, and (2) setting out a group of assumptions (with, or within,
seem to allow much more latitude for maintaining independence of the theory) which if taken together logically exclude Giffen goods as Hicks
consumers™ decisions, but that latitude would be at the expense of the [1956] tried to do? Is this merely the difference between ˜good™ and ˜bad™
strength of our arguments for the Law of Demand. Specifically we say that ad hocery?
© LAWRENCE A. BOLAND
206 Principles of economics Giffen goods vs market-determined prices 207
It must be realized that to a certain extent both options are ad hoc. Every or theory not only increase the amount of information needed to test the
assumption is ad hoc in one sense. If an assumption is formally a strictly model (since we would now also need to know the ˜applicability™ of the
universal proposition (e.g. ˜all swans are white™) it cannot be empirically model), they also insulate the model from empirical criticisms. If our
demonstrated to be true even if it is true. Hence, assuming it to be true objective in constructing a model or theory is to understand the subject in
without such a demonstration of its truth can be viewed as being ad hoc. It question (e.g. consumer behaviour) then, as most followers of Samuelson™s
is ad hoc merely because it may be necessary or sufficient for the theory in methodology realize, our understanding must deny the existence of

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