Assignment on
Revealed Preference Theory
Submitted by:
Ruchi Singh
MFM 2009-11
National Institute of Fashion Technology, Mumbai
Contents
1 Revealed preference theory................................................................2
2 The Weak Axiom of Revealed Preference...........................................5
3 The Strong Axiom of Revealed Preference.........................................5
4 The Generalized Axiom of Revealed Preference.................................6
5 Criticism...............................................................................................6
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1 Revealed preference theory
Revealed preference theory, pioneered by American economist Paul Samuelson,
is a method by which it is possible to discern the best possible option on the basis
of consumer behavior. Essentially, this means that the preferences of consumers
can be revealed by their purchasing habits. Revealed preference theory came
about because the theories of consumer demand were based on a diminishing
marginal rate of substitution (MRS). This diminishing MRS is based on the
assumption that consumers make consumption decisions based on their intent to
maximize their utility. While utility maximization was not a controversial
assumption, the underlying utility functions could not be measured with great
certainty. Revealed preference theory was a means to reconcile demand theory
by creating a means to define utility functions by observing behavior.
Economists explain and predict human behavior in terms of agents’ preferences.
Some people buy insurance because they prefer a certain amount of security over
the goods that they could have bought for the premium; others enroll at
university because they prefer the degree to the salaries they could have earned
in that time; yet others take out a loan because they prefer a steady stream of
consumption to a tight budget now and wealth at retirement. When economists
explain a person’s action, they attribute to her preferences that rationalize her
action—i.e. that make it rational for her to have chosen this action. When
economists predict a person’s action, they determine the choice the person
would rationally take, given her preferences and environmental conditions.
The problem with explanations and predictions of this sort is that the preferences
employed in them raise empirical scruples. Preferences are subjective mental
states that are not directly observable; hence the question arises whether they
are compatible with good scientific practice. The principle most often endorsed by
economists today to overcome these scruples is that of methodological
behaviorism: preferences must be inferred exclusively from observed behavior,
and introspection is generally not admissible. The most prominent methodology
that economists use to attribute preferences according to this principle is the
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revealed preference concept. It claims that the satisfaction of certain axioms over
an agent’s choices is equivalent to the existence of a preference ordering that
rationalizes these choices. From this purported equivalence, economists derive
some important results. The claims are as follows: that one can infer, first, the
preference ordering from the observed choices if the choice axioms are satisfied,
and second, the irrationality of the preference ordering if the choice axioms are
violated. If both of these claims were true, revealed preference theory would
indeed be a very powerful tool.
If a person chooses a certain bundle of goods (ex. 2 apples, 3 bananas) while
another bundle of goods is affordable (ex. 3 apples, 2 bananas), then we say that
the first bundle is revealed preferred to the second. It is then assumed that the
first bundle of goods is always preferred to the second. This means that if the
consumer ever purchases the second bundle of goods then it is assumed that the
first bundle is unaffordable. This implies that preferences are transitive. In other
words if we have bundles A, B, C, ...., Z, and A is revealed preferred to B which is
revealed preferred to C and so on then it is concluded that A is revealed preferred
to C through Z. With this theory economists can chart indifference curves which
adhere to already developed models of consumer theory.
The three relevant axioms of revealed preference theory are the WARP axiom
(‘weak axiom of revealed preferences’), the GARP axiom (‘generalized axiom of
revealed preferences’) and the SARP axiom (‘strong axiom of revealed
preferences’). The axiomatic constraints over a preference relation are known
from preference theory. Typical examples of these constraints include reflexivity,
transitivity, anti symmetry and completeness. Revealed preference theory shows
that the choice axioms are necessary and sufficient conditions for the existence of
a potential preference relation that satisfies certain preference axioms and
rationalizes the given choice data. These relations are represented in the
following table.
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Choice axioms Preference axioms
WARP Completeness, Antisymmetry
GARP Transitivity, Completeness
SARP Transitivity, Completeness, Antisymmetry
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2 The Weak Axiom of Revealed Preference
The Weak Axiom of Revealed Preference (WARP) is a characteristic on the choice
behavior of an economic agent. For example, if an individual chooses A and never
B when faced with a choice of both alternatives, they should never choose B
when faced with a choice of A,B and some additional options. More formally, if A
is ever chosen when B is available, then there can be no optimal set containing
both alternatives for which B is chosen and A is not.
This characteristic can be stated as a characteristic of Walrasian demand functions
as seen in the following example. Let pa be the price of apples and pb be the price
of bananas, and let the amount of money available be m=5. If p a =1 and pb=1, and
if the bundle (2,3) is chosen, it is said that that the bundle (2,3) is revealed
preferred to (3,2), as the latter bundle could have been chosen as well at the
given prices. More formally, assume a consumer has a demand function x such
that they choose bundles x(p,w) and x(p',w') when faced with price-wealth
situations (p,w) and (p',w') respectively. If p·x(p',w') ≤ w then the consumer
chooses x(p,w) even when x(p',w') was available under prices p at wealth w, so
x(p,w) must be preferred to x(p',w').
“Weak Axiom of Revealed Preference” WARP
– If A ¤ B then never B ¤ A
– If consumer chooses bundle A once when B also affordable, then
consumer will always choose A instead of B, regardless of relative prices
3 The Strong Axiom of Revealed Preference
“Strong Axiom of Revealed Preference” SARP
– If A ¤ B & B ¤ C then never C ¤ A
• Formal definition of a utility maximiser
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4 The Generalized Axiom of Revealed Preference
– “Generalised Axiom of Revealed Preference” GARP
– If A ¤ B & B ¤ C then pC * A ¥ pC * C
• If A ¤ B & B ¤ C then A more expensive than set C at prices when C
declined in favour of B
5 Criticism
If, in a theoretical model, there exist only an apple and an orange, and that an
orange is picked, then one can definitely say that an orange is preferred over an
apple. In a real world, when it is observed that a consumer purchased an orange,
it is impossible to say what good or set of goods or behavioral options were
discarded in preference of purchasing an orange. In this sense, preference is not
revealed at all in the sense of ordinal utility. One of the critics of the revealed
preference theory states that "Instead of replacing 'metaphysical' terms such as
'desire' and 'purpose'" they "used it to legitimize them by giving them operational
definitions." Thus in psychology, as in economics, the initial, quite radical
operationalist ideas eventually came to serve as little more than a "reassurance
fetish" (Koch 1992, 275) for mainstream methodological practice."
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