Question
Prof. samuelson theory of revealed preference is described as behaviorist ordinadist. “Describe this preferences hypothesis stating the account of both strong ordering and weak a view of the preference relation. Explain the flows associated with the preference theory.
Revealed preference is an economic theory regarding an individual’s consumption patterns, which asserts that the best way to measure consumer preferences is to observe their purchasing behavior. Revealed preference theory works on the assumption that consumers are rational. In other words, they will have considered a set of alternatives before making a purchasing decision that is best for them. Thus, given that a consumer chooses one option out of the set, this option must be the preferred option
Samuelson’s revealed preference theory has preference hypothesis as a basis of his theory of demand.
According to this hypothesis, when a consumer is observed to choose a combination A out of various alternative combinations open to him, then he ‘reveals’, his preference for A over all other alternative combinations which he could have purchased.
In other words, when a consumer chooses a combination A, it means he considers all other alternative combinations which he could have purchased to be inferior to A. That is, he rejects all other alternative combinations open to him in favour of the chosen combination A. Thus, according to Samuelson, choice reveals preference. Choice of the combination A reveals his definite preference for A over all other rejected combinations.
From the hypothesis of ‘choice reveals preference’ we can obtain definite information about the preferences of a consumer from the observations of his behaviour in the market. By comparing preferences of a consumer revealed in different price-income situations we can obtain certain information about his preference scale.
Let us graphically explain the preference hypothesis. Given the prices of two commodities X and Y and the income of the consumer, price line PL is drawn in Fig. below. The price line PL represents a given price-income situation. Given the price-income situation as represented by PL, the consumer can buy or choose any combination lying within or on the triangle OPL.
In other words, all combinations lying on the line PL such as A, B, C and lying below the line PL such as D, E, F and G are alternative combinations open to him, from among which he has to choose any combination. If our consumer chooses combination A out of all those open to him in the given price-income situation, it means he reveals his preference for A over all other combinations such as B, C, D, E and F which are rejected by him. As is evident from Fig, in his observed chosen combination A, the consumer is buying OM quantity of commodity X and ON quantity of commodity Y.
It can be inferred from this choice of the consumer that he prefers A to other baskets of goods lying on the budget line AB or within the budget space. Thus, with the given price- income situation PL, when the consumer chooses A it is inferred that all other combinations of goods lying within the triangle OPL or on the line PL which he can afford to buy are revealed to be inferior to his chosen combinations A.
Besides, we can infer more from consumer’s observed choice. As it is assumed that a rational consumer prefers more of both the goods to less of them or prefers more of at least one good, the amount of the other good remaining the same, we can infer that all combinations lying in the rectangular shaded area drawn above and to the right of chosen combination A are superior to A.
The flows associated with the preference theory.
Revealed preference theory, initiated by Samuelson (1938, 1948), provides a structural approach to analyze demand behavior. Its main underlying principle is that a consumer’s observed choices provide information about her underlying preferences. If a consumer is observed to have chosen a certain consumption bundle x,3 while another bundle y was also available (e.g. because it was less expensive), then she reveals her preference for x over y. Equivalently, we say that x is revealed preferred over y. In this manner, choices say something about the underlying preferences of the consumer.
Samuelson (1938) introduced the weak axiom of revealed preference (WARP), which provides attest of the simplest form of the utility maximization hypothesis: if a bundle x is revealed preferred over a bundle y, then at some other instance, y should not be revealed preferred over x. WARP requires the revealed preference relation to be asymmetric.
Houthakker (1950) generalized WARP by introducing the strong axiom of revealed preference (SARP) which states that the revealed preference relation is acyclic. Interestingly, he also showed that this gives the strongest test for the consistency of choice behavior under the utility maximization hypothesis.
Strengths of the preference theory
(i) It does not involve any psychological introspective information about the behaviour of the consumer. Rather, it presents a behaviouristic analysis based on observed consumer behaviour in the market. This approach has helped, according to Samuelson, to divest the theory of demand of the “last vestiges” of the psychological analysis.
Thus the revealed preference hypothesis is more realistic, objective and scientific than the earlier demand theorems.
(ii) It avoids the “continuity” assumption of the utility and indifference curve approaches. An indifference curve is a continuous curve on which the consumer can have any combination of the two goods. Samuelson believes that there is discontinuity because the consumer can have only one combination.
(iii) The Hicksian demand analysis is based on the assumption that the consumer always behaves rationally to maximise his satisfaction from a given income. Samuelson’s demand theorem is superior because it completely dispenses with the assumption that the consumer always maximises his satisfaction, and makes no use of the dubious hypothesis like the Law of Diminishing Marginal Utility of the Marshallian analysis or the Law of Diminishing Marginal Rate of Substitution of the Hicksian approach.
(iv) In the first stage of Samuelson’s demand theorem the ‘over compensation effect’ is more realistic as an explanation of consumer behaviour than the Hicksian substitution effect. It permits the consumer to shift to a higher price-income situation in case of rise in the price of X and vice versa. It is an improvement over Hicks “compensating variation”.
(v) Similarly, the second stage of the Samuelsonian Theorem explains the Hicksian income effect in a much simpler way. Hicks himself admits the superiority of Samuelson’s theory when he writes that as a clear alternative to the indifference technique its presentation is the newest and important contribution of Samuelson to the theory of demand.
They appeal to many economists because they rely on actual or observed behaviour in markets (economic theory gives credence to data obtained from observing people make real choices in real markets).
Many economists readily accept values produced by these methods as being useful for environmental policy making.
Weakness of preference theory
Inability to estimate non-use values, and Dependence of estimated values on technical assumptions made on the relationship between the non-market good/service to be valued and the surrogate market good.
In addition, market imperfections and policy failures can distort the estimated monetary value of the non-market ecosytem services.
Economic theories have observable and unobservable components, and one can say that an observable data set is consistent with the theory if there exists some specification of the unobservables that is consistent with the theory. The statement that observables are consistent if there exists unobservables that are consistent with the theory is the “as if” or “revealed preference” formulation of the theory. However, the revealed preference formulation of a theory may not be useful as an empirical test of the theory.
Some economists say that revealed preference theory makes too many assumptions. For instance, how can we be sure that consumer’s preferences remain constant over time? Isn’t it possible that an action at a specific point in time reveals part of a consumer’s preference scale just at that time? For example, if just an orange and an apple were available for purchase, and the consumer chooses an apple, then we can definitely say that the apple is revealed preferred to the orange.
There is no proof to back up the assumption that a preference remains unchanged from one point in time to another. In the real world, there are lots of alternative choices. It is impossible to determine what product or set of products or behavioral options were turned down in preference to buying an apple
