How can we explain this odd result? The testimony suggested an explanation: consumers are so much better off with the lower price of potatoes that they buy more of other foods, and thus less of the inferior good, potatoes. Can we put this explanation to the test? Turning it around, the explanation says that, if people could buy potatoes at the lower price, but somehow they were no better off, then they would buy more potatoes, not less. (If it is being better off that reverses the law of demand, then we should see the law of demand back in full force if they were no better off).
With a lower price and the same money income, people are better off, in this example. But if the lower price were offset by a lower income, they would be no better off. There is a certain reduction of income that would leave the person neither better off nor worse of than before, even though the price is lower. That reduction in income is called the "compensating income variation" for the price drop. This is shown in Figure 5. To figure out the compensating income variation in the diagram, we just move the budget line N (for the new, low price) down to N', which just touches indifference curve I. Since the consumer is back on indifference curve I, she is no better off nor worse off than before -- in terms of her own preferences.
With budget line N', we see that the consumer will buy quantity C of potatoes -- more potatoes at the lower price. What we see is that the cut in price has increased the quantity demanded from A to C, but the increase in the purchasing power of income has cut the consumption of potatoes all the way from C back to B. So the testimony holds up -- it seems that a Giffen good could be a reality in terms of preference theory.
(I told you this application was nastily complex! If you feel pretty lost, try printing out these two pages, getting colored pencils, and underlining the corresponding concepts with the same colors -- red for prices, blue for quantities demanded, and so on. Works pretty well for me!)
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