revealed preference theory

revealed preference theory
Name	Revealed preference theory
Field	Microeconomics
Founded by	Paul Samuelson
Year	1938
Related theories	Consumer choice theory, Utility maximization, Indifference curve

revealed preference theory. It is a foundational concept in microeconomics that infers a consumer's preferences from their observed purchasing behavior, rather than relying on stated or hypothetical utility. Developed by Paul Samuelson in 1938, it provided a behaviorist alternative to the ordinal utility approach of earlier thinkers like Francis Edgeworth and Vilfredo Pareto. The theory posits that choices reveal underlying preferences, allowing economists to construct demand functions without directly measuring subjective satisfaction.

Overview and historical context

The theory emerged as a direct response to the perceived weaknesses in the neoclassical economics of the late 1930s, which relied heavily on unobservable utility functions. Paul Samuelson, building on earlier work by economists at the London School of Economics, sought to ground consumer theory in observable, empirical data. This shift aligned with the broader logical positivism movement in philosophy, emphasizing verifiable statements. Key antecedents include the work of Irving Fisher and the revealed preference ideas implicit in Ragnar Frisch's consumption analysis, but Samuelson's formulation was the first rigorous, axiomatic treatment.

Theoretical foundations

The core principle is that if a consumer chooses a specific bundle of goods when another affordable bundle is available, the chosen bundle is "revealed preferred" to the alternative. This is formalized using basic set theory and logic, connecting directly to the budget constraint faced by consumers in markets. The theory is fundamentally linked to the concept of utility maximization, demonstrating that consistent choice behavior implies the existence of a underlying, well-behaved utility function. This provided a bridge between the psychological assumptions of Jeremy Bentham and the mathematical formalism of John Hicks.

Weak and strong axioms of revealed preference

Samuelson initially proposed the **Weak Axiom of Revealed Preference (WARP)**, which states that if bundle A is chosen over bundle B when both are affordable, then B can never be chosen over A when A is also affordable. This ensures consistency in choices across different budget situations. Later, Hendrik Houthakker introduced the more stringent **Strong Axiom of Revealed Preference (SARP)**, which extends consistency to indirect comparisons across multiple bundles, preventing logical cycles in preference. These axioms are necessary and sufficient conditions for generating demand curves that satisfy the Slutsky equation and exhibit negative semidefiniteness.

Applications in economics

The theory is central to empirical demand analysis, allowing economists to test consumer theory using data from sources like the Consumer Expenditure Survey. It underpins the construction of price indices such as the Consumer Price Index by agencies like the Bureau of Labor Statistics. In welfare economics, it is used for cost-benefit analysis of public projects, as seen in evaluations by the World Bank. The framework is also essential in international trade theory for analyzing patterns like those described in the Heckscher–Ohlin model, and in studying labor supply decisions within models from the National Bureau of Economic Research.

Criticisms and limitations

A major critique, advanced by economists like Amartya Sen, targets its "internal consistency" requirement, arguing it ignores the role of bounded rationality and social norms documented by researchers at the Santa Fe Institute. The theory struggles with aggregation problems when moving from individual to market demand, a issue highlighted in the work of Hugo Sonnenschein. It cannot easily handle choices involving risk and uncertainty, domains better addressed by prospect theory from Daniel Kahneman and Amos Tversky. Furthermore, experimental evidence from the University of Chicago and the Massachusetts Institute of Technology often shows violations of its axioms in controlled settings.

Extensions and related concepts

Generalized Axioms of Revealed Preference (GARP) extend the framework to allow for indifference and are used in nonparametric demand analysis. Stochastic revealed preference models, developed by scholars like Daniel McFadden, incorporate random elements to account for decision noise. The theory is a cornerstone of experimental economics, influencing the design of experiments at the California Institute of Technology. It is fundamentally connected to Afriat's theorem, which provides a computational method for recovering utility functions. Related concepts include the integrability problem in demand systems and the modern theory of choice under risk associated with the von Neumann–Morgenstern utility theorem.

Category:Consumer theory Category:Microeconomics Category:Economic theories