CHAPTER 7
Revealed Preference
Copyright © 2019 Hal R. Varian
Revealed Preference Analysis
Suppose we observe the demands (consumption choices) that a consumer
makes for different budgets. This reveals information about the consumer’s
preferences. We can use this information to . . .
• test the behavioral hypothesis that a consumer chooses the most
preferred bundle from those available.
• discover the consumer’s preference relation.
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Assumptions on Preferences – 1
Preferences
• do not change while the choice data are gathered.
• are strictly convex.
• are monotonic.
Together, convexity and monotonicity imply that the most preferred affordable
bundle is unique.
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Assumptions on Preferences – 2
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Direct Preference Revelation – 1
Suppose that the bundle x* is chosen when the bundle y is affordable. Then x*
is directly revealed preferred (DRP) to y (otherwise y would have been
chosen).
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Direct Preference Revelation – 2
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Direct Preference Revelation – 3
That x is revealed directly as preferred to y will be written as x > y.
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Indirect Preference Revelation – 1
Suppose x is directly revealed preferred to y, and y directly revealed preferred
to z. Then, by transitivity, x is indirectly revealed preferred (IRP) to z. In
symbols,
If x > y and y > z, then x > z.
Or equivalently, if x DRP y and y DRP z, then x IRP z.
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Indirect Preference Revelation – 2
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Indirect Preference Revelation – 3
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Indirect Preference Revelation – 4
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Two Axioms of Revealed Preference
To apply revealed preference analysis, choices must satisfy two criteria—the
Weak and the Strong Axioms of Revealed Preference.
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The Weak Axiom of Revealed Preference (WARP) – 1
If the bundle x is revealed directly as preferred to the bundle y then it is never
the case that y is revealed directly as preferred to x;
i.e., if x DRP y, then y CANNOT BE DRP x.
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The Weak Axiom of Revealed Preference (WARP) – 2
A person that makes choices in violation of the WARP is inconsistent with
economic rationality.
The WARP is a necessary condition for applying economic rationality to
explain observed choices.
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A Violation of WARP
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Checking if Data Violate the WARP – 1
A consumer makes the following choices:
• At prices the choice was
• At prices the choice was
• At prices the choice was
Is the WARP violated by these data?
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Checking if Data Violate the WARP – 2
the choice was This choice cost the consumer
• Could be afforded?
So, (5, 5) was affordable while (10, 1) was chosen. (10, 1) DRP (5, 5).
• Could be afforded?
So, (5, 4) was affordable while (10, 1) was chosen. (10, 1) DRP (5, 4).
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Checking if Data Violate the WARP – 3
• At the choice was This choice cost the consumer
• Could be afforded?
So, (10,1) was unaffordable while (5,5) was chosen.
• Could be afforded?
So, (5, 4) was affordable while (5,5) was chosen. (5,5) DRP (5, 4).
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Checking if Data Violate the WARP – 4
• At the choice was This choice cost the consumer
• Could Be afforded?
was unaffordable while (5,4) was chosen.
• Could Be afforded?
was affordable while (5,4) was chosen. (5,4) DRP (10,1).
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Checking if Data Violate the WARP – 5
In summary,
• (10, 1) DRP (5, 5)
• (10, 1) DRP (5, 4)
• (5, 5) DRP (5, 4)
• (5, 4) DRP (10, 1)
But, the WARP states that it cannot be that both (10, 1) DRP (5, 4) and
(5, 4) DRP (10, 1).
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The Strong Axiom of Revealed Preference (SARP) – 1
If the bundle x is revealed preferred (directly or indirectly) to the bundle y and
x y, then it is never the case that the y is revealed preferred (directly or
indirectly) to x.
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The Strong Axiom of Revealed Preference (SARP) – 2
That the observed choice data satisfy the SARP is both a necessary and
sufficient condition for there to be a well-behaved preference relation that
“rationalizes” the data.
In other words, if the SARP is not violated, the behavior is considered rational.
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Recovering Indifference Curves
Suppose we have the choice data satisfy the SARP.
Then we can discover approximately where are the consumer’s indifference
curves.
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Index Numbers – 1
Over time, many prices change. Are consumers better or worse off “overall” as
a consequence?
Index numbers give approximate answers to such questions.
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Index Numbers – 2
Two basic types of indices:
• price indices
• quantity indices
Each index compares expenditures in a base period and in a current period
by taking the ratio of expenditures.
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Quantity Index Numbers – 1
A quantity index is a price-weighted average of quantities demanded; i.e.,
(p1, p2) can be base period prices (p1b, p2b) or current period prices (p1t, p2t).
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Quantity Index Numbers – 2
If then we have the Laspeyres quantity index:
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Quantity Index Numbers – 3
If then we have the Paasche quantity index:
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Quantity Index Numbers – 4
How can quantity indices be used to make statements about changes in
welfare?
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Quantity Index Numbers – 5
If then
so consumers overall were better off in the base period than they are now in
the current period.
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Price Index Numbers – 1
A price index is a quantity-weighted average of prices; i.e., (x1, x2) can be the
base period bundle (x1b, x2b) or else the current period bundle (x1t, x2t).
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Price Index Numbers – 2
If then we have the Laspeyres price index:
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Price Index Numbers – 3
If then we have the Paasche price index:
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Price Index Numbers – 4
How can price indices be used to make statements about changes in welfare?
Define the expenditure ratio
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Price Index Numbers – 5
If , then
so consumers overall are better off in the current period.
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Price Index Numbers – 6
But, if then
so consumers overall were better off in the base period.
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