“It was Marshall who first drew attention to the fact that the so-called universal law of demand is unfortunately subject to a possible exception, namely, Giffen’s paradox, the case where, to express it in modern language, the negative-income effect of a price change is so large in absolute terms as to cancel out the negative substitution effect of that change. The fact that Sir Robert Giffen never actually stated Giffen’s paradox … is of considerable significance: Marshall was looking, as it were, for Giffen’s paradox and, therefore, was determined to find it. He realized that for practical purposes, we must define individual demand curves as subject to a ceteris paribus clause that includes tastes, expectations about future prices, the money incomes of consumers, and all prices other than the one under consideration. So defined, however, it was not possible to argue that there is in fact one ‘universal’ law of demand.I hope readers can see the significance of this passage.
Marshall also flirted, as Friedman has shown (see Blaug, 1980, pp. 351–3, 369), with a constant-real-income interpretation of demand curves in which the prices of all closely related goods are varied inversely to the price of the good in question (in practical terms, we divide money income by a Laspeyres price index) so as to ‘compensate’ the consumer for any change in real income caused by the price change. Such a constant-real-income or compensated demand curve must indeed be negatively inclined under the very conditions implied in its construction, and hence, Friedman argued, we ought to choose this interpretation as the more preferable one because it alone has an unambiguously testable implication. Alas, a compensated demand curve is never observed, whereas we do at least observe one point on the constant-money-income demand curve. The constant-real-income formulation of demand curves is thus an evasion of issues: the income effect of a price change is as integral a part of real-world consumer behavior as is the substitution effect and to leave it out is to adjust the world to fit our theories rather than the other way round. (Blaug 1996: 140–141).
There is indeed some confusion about the law of demand: does it require, in its ceteris paribus assumption, that (1) only money income remain constant, or (2) does it assume that real income must remain constant?
Some formulations of the law of demand seem to require that real income must remain constant.
But how is this an even remotely realistic assumption? All price changes must change real income, and it is not possible for a price change to occur in the real world without changing real income. We have a law that is formulated in a way that is grossly unrealistic, if not logically incoherent.
Of course, if one wants to define the ceteris paribus assumption as only referring to money income and not real income, we have a different law.
So advocates of the law of demand must define carefully what they mean by the ceteris paribus qualification.
Blaug, Mark 1996. Economic Theory in Retrospect (5th edn.). Cambridge University Press, Cambridge.