BCom 1st Year Revealed Preference Theory Notes Study Material
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BCom 1st Year Revealed Preference Theory Notes Study Material
Introduction to Revealed Preference Theory
Utility as well as indifference curve analysis presents a psychological explanation of consumer demand based on introspective method. An attempt is made to know the psychological reaction of the consumer to hypothetical changes in price and income. So both are regarded as psychological theories.
A different approach to consumer demand theory was introduced by P. A. Samuelson which is based solely on observations of how consumers react to changes in prices and income. It is called the revealed preference theory.
Explanation of the Revealed Preference Theory
The term “revealed preference’ was introduced into economics by Samuelson in 1938. It was further explained by him in 1948. This theory is considered a major break-through in the theory of demand. It is so because it has made possible the establishment of the “law of demand” directly from observed behaviour. Tapas Majumdar describes the revealed preference theory as behaviouristic ordinalist because it employs a behaviouristic method and uses the concept of ordinal utility. The theory is based on the following assumptions:
(i) Rationality: The consumer is assumed to behave rationally in the sense that he prefers the bundle of goods that includes more quantities of the commodity. Like the utility analysis as also the indifference curve analysis, the consumer is not assumed to maximise satisfaction from his purchases.
(ii) Consistency: Consistency in behaviour means that if the consumer chooses a bundle A in a situation in which basket B was also available to him he will not choose B in any other situation in which A is also available.
(iii) Transitivity: If some combinations of goods A is preferred to another combination B, and B is preferred to C then, by transitivity, A is preferred to C. Symbolically,
If A>B and B > C, then A>C
Violation of transitivity is an indication of irrationality.
(iv) Strong Ordering: Samuelson’s theory is based on strong orderina preferences. Ordering means listing of preferences such that the most prefer appears at the top of the list, the next most preferred second, and so on. strong ordering of preferences, the consumer’s choice of a combination of good reveals his definite preference for that over all other alternatives open to him Strong ordering rules out the possibility of indifference on the part of th consumer between alternative combinations.
Choice for A may be due to one of the following two reasons:
(a) Combination A is cheaper than all other bundles.
(b) The consumer prefers A to all other combinations.
We know that Ais not cheaper since the prices of X and Y are given in the market. So if the consumer chooses A out of all those.open to him in the given price-income situation, it means that he reveals his preferences for A over all combinations such as B, C, D, …. which are rejected by him. Thus A is the most preferred position. There is no attempt to go into the process by which choice is transformed into preference. It rests on the assumption “Choice reveals preference”.
The revealed preference theory can be defined as:
“If a consumer buys some collection of goods A, rather than the available collections B, C, D, etc., and it turns out that none of the latte is more expensive than A, we say that A has been revealed preferred to others or that the others have been revealed to be inferior to A.”
This theory explains the theory of consumer demand on the bas concepts which do not require the consumer to supply any information himself. If his tastes do not change, observation of his market behaviour supply all the requisite data.
This analysis was designed almost entirely by Samuelson, while finishing touches were provided by Houthakkar.
Income and Substitution Effects of a Change in Relative Prices: The Demand Theorem
If revealed preference theory is to be as useful as the indifference curve analysis, it must be able to explain an income effect and a substitution effect of a price change.
In fig. these two effects have been shown. In the initial situation the budget line is MN and the consumer chooses point A. Now assume that the price of X falls, while the price of Y and the money income of the consumer remain changed. In this new situation the budget line shifts to MN2. The consumer now chooses the combination B and wishes to buy OX2 of X.
Thus the fall in the price of X results in an increase in the consumption of X from OX1 to OX2-an increase of X1X2. This increase is the result of income effect and substitution effect. In order to know these effects separately, the money income of M the consumer is so reduced that the M fall in the price of X results in no increase in his real income.
In this situation the new budget line M1N1 runs parallel to the budget line MN2 and passes through A. The consumer does not return to his old position A but chooses C instead. The movement from A to C is the substitution effect due to which the consumer purchases X1X3 additional units of X. The movement from C to B is the income effect which results in the purchase of X3X2 additional limits of X. Thus
Price Effect = Substitution Effect + Income Effect
X1X2 = X1X3 + X3X2
This method of dividing the price effect-known as the cost-difference method is a less fundamental way of doing it than the one found in the indifference curve analysis. Yet it is an important division for two reasons. First, it provides the justification for the downward sloping demand curve. Second, it is based on a purely mathematical calculation which we can make even though we have no information about the indifference map of the consumer. It is an analytical device based on observation of the consumer behaviour and thus it is a scientific theory of consumer demand.
In his A Revision of Demand Theory, J. R. Hicks uses the compensating variation in income method in place of what he called the cost-difference variation in income. In the compensating variation in income method the analysis used is revealed preference rather than indifference curves. It is shown in Fig.
In the figure the consumer’s initial position is at A on the budget line MN. As a result of the fall in the price of X, the budget line shifts to MN1 on which he chooses B. His money income remains constant at OM.
Revealed preference analysis, based on strong ordering of preferences, cannot do this because it is possible that points like A and C be such points between which the consumer is indifferent. Choice is only that which is observable; indifference cannot be observed. So we cannot observe C.
Evaluation
The revealed preference theory is a behaviourist theory.
So it is superior to both utility analysis and indifference curve analysis. Being based on observation, it is not subject to mistakes. But it is unable to explain behaviour of the consumer like the utility analysis, so it does not go very deep into the analysis.
Another feature of this theory is that it is free from the doubtful assumption of utility maximisation. It is also free from the unreal assumption of continuity.
The chief weakness of this theory is that it rules out the possibility of indifference. Indifference plays an important role in welfare economics.
Which theory is better and more satisfactory cannot be answered without knowing the philosophy and thinking of an individual.
Yet it cannot be denied that the behavioural theory has received wide acceptance and has become very popular now as it has been able to reduce unnecessary assumptions. (BCom 1st Year Revealed Preference Theory Notes Study Material)
BCom 1st Year Revealed Preference Theory Notes Study Material