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What Do Prostitutes and Rice Have in Common?

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If you believe what you read, then the answer to that question is that they are both examples of one of economics’ most elusive objects: Giffen goods. But don’t always believe what you read.

A Giffen good is a product or service for which demand rises with price. In other words, if you hold everything else constant, but the good gets more expensive, the quantity consumed will increase.

In an excellent series of guest posts to this blog earlier this year, economist Robert Jensen described his personal quest to prove that rice is a Giffen good for peasants in China.

On The Economist magazine’s Free Exchange blog, the same claim is made about prostitutes:

Less attractive and even cheaper prostitutes may still be available, but for a variety of very good reasons, the customer will not desire the cheapest option, suggesting prostitution services can be classified as a Giffen good.

Are prostitutes Giffen goods? Absolutely not. And understanding why provides a useful economic lesson.

The comparison made on The Economist‘s blog is between two different types of prostitutes. As the blogger indicates, the cheaper prostitutes are less attractive and otherwise undesirable for a “variety of good reasons.”

The client who buys the services of these two types of prostitutes is buying two very different products. It is the case in every industry that high-quality products sell for more than low-quality products. Not everyone buys the cheapest car made, but that doesn’t mean that cars are Giffen goods. Not every restaurant meal is consumed at Taco Bell, that doesn’t mean that meals in restaurants are Giffen goods.

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). A moment’s reflection makes it obvious that 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. Similarly, the customer who chooses the low-price prostitute would also consume more of her services if her price were halved. If this is the case, the demand for prostitutes indeed slopes downward, just like the demand for virtually every other good known to mankind.

So how is it that rice in rural China might violate this rule? How could it be that when the price of rice rises, people actually consume more of it? Two factors are critical.

First, rice makes up a large share of the total expenditures of these Chinese peasants. Second, if they were richer, these peasants would prefer to eat less rice and more of other things, like meat; it is just that they are too poor right now to afford much meat and they have to eat something. When rice becomes more expensive, one effect of the higher price is to make the peasants want to consume less of it (just as johns do with prostitutes who raise their prices).

In economic parlance this is known as the substitution effect. But when the price of rice rises, it also has the effect of making the peasants poorer. Their incomes haven’t changed, but the main thing they buy with their money costs more, meaning that they have to cut back their consumption of something to stay within their budgets. This pushes the peasants away from consuming luxury goods like meat, and toward consuming basic goods like rice. This is known to economists as the income effect of a price change.

For staples like rice, the substitution effect and the income effect push in opposite directions. If the income effect is bigger than the substitution effect, higher rice prices lead the peasants to feel so poor that they end up consuming more rice.

So the answer to the question posed in the title of this blog post (what do prostitutes and rice have in common?) is definitely not that both are Giffen goods.

As a reward to those among you who were loyal enough readers to slog through the economics of the last paragraph, I offer a Freakonomics contest: the commenter who provides the best answer to the question of what prostitutes and rice have in common within the first 24 hours of this post will win their choice of Freakonomics schwag.

Addendum: The winners are announced here.