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Subject ECONOMICS

Paper No and Title 3: Fundamentals of Microeconomic theory

Module No and Title 7: Revealed preference theory

Module Tag ECO_P3_M7

ECONOMICS Paper 3: Fundamentals of Microeconomic theory

Module 7: Revealed preference theory
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TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Revealed preference theory
4. Assumptions
5. Revealed preference axioms
6. Decomposition of substitution and income effects and derivation of demand
curve
7. Derivation of indifference curve
8. Summary

ECONOMICS Paper 3: Fundamentals of Microeconomic theory

Module 7: Revealed preference theory
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1. Learning Outcomes
After studying this module, you shall be able to

 Know the concept of revealed preference theory.

 Learn how to the consumers revealed their preference for various goods and
services which they consume.
 Derive the demand and indifference curves from consumer’s revealed
preferences.
 Evaluate the income and substitution effect of the consumer.

2. Introduction
Revealed preference theory was propounded by Paul A. Samuelson in 1947 and it was
based on the consumer’s preferences of different goods and services which are available
in the market. He has derived the demand curve of a consumer based on the consumer’s
budgetary constraints and his preferences revealed in the market without involving any
ordinal or cardinal measurement of utility.

Let us study this theory in detail.

3. The Revealed preference theory

Revealed preference theory of consumer behavior is the only theory which has derived
the demand curve of the consumer for a commodity from the revealed preference axioms
i.e. baskets of different goods which a consumer buys at different prices, without using
IC and its restrictive assumptions. Moreover this theory is also capable of establishing the
existence of IC and its convexity. Because of its success, it is also known as the “third
root of the logical theory of demand”.

4. Assumptions

 Rationality: A consumer is always rational i.e. he/she always prefers more of

goods and services to derive maximum utility. Thus he always buys the
commodity which gives him maximum utility first and then he buys the least
utility giving commodity at the end.
ECONOMICS Paper 3: Fundamentals of Microeconomic theory
Module 7: Revealed preference theory
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 Transitivity and consistence of choice: Consumers preferences are always

transitive i.e., if a consumer prefers good X over good Y and the same consumer
prefers good Y over good Z then according to this assumption of transitivity, he
must prefer good X over good Z also.
If, X>Y
If, Y>Z
Therefore, X>Z.
Whereas as per consistence of choice, if a consumer prefers good X to good Y in
one period then he must not prefer good Y to good X in another period or must
not treat both the goods as equal. Symbolically,
If, X>Y in one period
Then, Y > X or Y ≠ X in other period.
 Price inducements: Given the consumer’s choice for a basket of goods, a
consumer can induce to buy a different basket of goods which provide him
sufficient price incentives.

5. Revealed preference Axioms

The basic axiom of the revealed preference theory is that “if a consumer chooses
one basket of goods, given his budgetary constraints and the alternative baskets
of goods of same price, then he reveals his preference. For instance, if there are
two baskets A and B, comprising of two goods X and Y and both are equally
expensive to the consumer, then if a consumer chooses basket A over B then the
consumer is said to reveal his preference for basket A.
He may do so because either he would have a liking for that basket of goods or it
is relatively less expensive than the other. But if the consumer chooses one
basket over the other because it is cheaper than the other then the consumer is not
said to have revealed his preference; he is only said to have revealed his
preference for a basket over the other when the price of both the baskets are same
and he chooses one basket over the other because he likes that basket over the
other. Then only the consumer reveals his preference for one basket over the
other.
This can be shown in the following diagram 1:

ECONOMICS Paper 3: Fundamentals of Microeconomic theory

Module 7: Revealed preference theory
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Fig 1: Revealed preferences

Here in the diagram, the budget line of the consumer is MN where he can choose various
baskets of goods (X and Y) given his income and the prices of X and Y. Now if the
consumer chooses any basket of good for instance if he chooses basket A which
comprises of OX of X and OP of Y then he is said to have revealed his preference for
basket A over any other basket which lies on the same budget line. So here the consumer
has revealed his preference for A over B. Any basket which lies below the budget line
like basket C comprises of cheaper X and Y and the consumer will not revealed his
preference for it. Any basket lying above the budget line would be too expensive for the
consumer to buy therefore he will also not revealed his preference for that basket (like
basket D).

6. Decomposition of substitution and income effect and derivation of

demand curve

The price effect and its decomposition into substitution and income effect can also be
shown by the revealed preference theory apart from the indifference curve theory. For
this lets us assume the budget line as M1N1 on which a consumer chooses bundle A,
comprising of AX1 of Y and OX1 of X. Since all the bundles on this budget line are
equally expensive to the consumer but the consumer has revealed his preference for A
over all other bundles lying on this budget line.
Now if the price of X would fall then the budget line will pivot to M1N3 and the
consumer shifts to point C. This movement of the consumer from point A to C is known
as the price effect. This price effect can now be split into substitution and income effect
in the following figure 2:

ECONOMICS Paper 3: Fundamentals of Microeconomic theory

Module 7: Revealed preference theory
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Fig 2: Decomposition of Income and substitution effects

This can be done by drawing a budget line M2N2 through point A. note that we are doing
the separation based on the Slutskian method. Since the new budget line M2N2 passes
through point A so I means that the combination of X and Y are still available to the
consumer. Now the consumer response to the change in the price of X could be taken as
the bundle which he chooses on this M2N2 budget line.
As it has been seen in the above diagram that the consumer will not choose any bundle
lying between M2 A, as all these bundles are inferior to him. He would only choose either
A or any bundle lying on the segment A N2 and precisely between point A and H.
Now if he would choose basket A, then the substitution effect would be zero and if he
chooses basket B then the substitution effect would be X1X2 and the income effect would
be X2X3.
Since here the substitution effect is positive thus it implies that when the price of X falls,
the demand for X increases, hence the demand curve could be derived from this.

7. Derivation of Indifference curve

As has been explained above that the revealed preference theory is capable of deriving
the proofs for the existence of indifference curve and its convexity, it does so using the
consumer behavior i.e. a consumer’s choice for various goods at various prices. This
derivation of the IC is shown in the diagram 3.

ECONOMICS Paper 3: Fundamentals of Microeconomic theory

Module 7: Revealed preference theory
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Fig 3: Derivation of indifference curve

For this let us assume that the consumer reveals his preference for basket A over the other
on the budget line MN. Moreover all the bundles lying below the budget line are inferior
to him and thus not preferred by him as they all are cheaper than A. This is represented as
the triangle MON which is marked as inferior zone.
Let us now consider the area above the budget line. This area is divided into three
segments namely, JAM, JAK and KAN. The area JAK is the preferred one because any
point on JA represents a higher quantity of Y, with the same quantity of X. Similarly any
point on AK is preferred as it shows a higher quantity of X, with the same quantity of Y;
and area above AK and to the right of AJ represents a basket comprising of more of both
the goods X and Y. Therefore, any point on the line AJ, AK and between them is
preferred over point A. Hence in the diagram this area is marked as the preferred zone.
The areas JAM and KAN are the ignorance zone as any point in these areas represents
more of one good and less of the other good as compared to point A. And the consumer’s
preferences are very difficult to be known in these areas.

Thus it is clear from the above discussion that the consumer’s indifference curve will
pass through point A, JAM and KAN to retain its convexity.
The course of indifference curve in the ignorance zones can be found out by ranking
consumer’s choices in these areas. For this let us assume a budget line MN which shifted
to PT when the price of X falls and price of Y increases. Now the consumer will either
choose B or any bundle on BT segment of this new budget line but since because of the
assumption of consistency the consumer cannot choose any point on BP as they all are
inferior to him. Now if he chooses B, then any other point on or below PT is inferior B.
Thus, any bundle in the area NBT is revealed inferior to B. Hence, the
triangle NBT which is a part of the ignorance zone, KAN, is clipped off because the
consumer's ranking of this area is now known.
ECONOMICS Paper 3: Fundamentals of Microeconomic theory
Module 7: Revealed preference theory
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This procedure can be repeated for as many points as we wish to repeat in order to find
out the best point and thus the ignorance area can be reduced bit by bit. For instance point
C and D. Moreover the same procedure can be done for the upper ignorance zone, JAM,
to find points in relation to A in the following figure 4.

Fig 4: Derivation of indifference curve

Now if we join all these points, D, A, B, C then we get the offer curve FF’ in the
following figure 5:

ECONOMICS Paper 3: Fundamentals of Microeconomic theory

Module 7: Revealed preference theory
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Fig 5: offer curve

According to Samuelson the position of the offer curve would be the probable position of
Indifference curve. He has given the following points in support of this argument.
 The IC cannot be a straight line like MN because when the consumer chooses
point A, then it reflects that all other points on MN are inferior to A and hence the
consumer cannot be indifferent to point A and to all other points lying on MN.
 All the points below the budget line MN are revealed inferior to A therefore the
IC cannot intersects the budget line not it could be concave (as shown in the
diagram as CC’).
 Since all the points on or above the budget line MN are revealed superior to A, IC
cannot pass through the preferred zone JAK. Therefore, the position of the IC
would be somewhere between the ignorance zone which pass through A and
shown as FF’ in the above diagram 5.

ECONOMICS Paper 3: Fundamentals of Microeconomic theory

Module 7: Revealed preference theory
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8. Summary
The revealed preference theory given by Samuelson is though easy and simple but it has
its own complexities. As we have seen the consumer can reveals his preferences by
choosing one basket of goods over the others and thus there is no need of finding out the
price effect using the IC approach. This approach is equally capable of finding out the
demand curve and the IC of the consumer based on his behavior. Hence, this theory was
adopted by various economists for doing the further research.

ECONOMICS Paper 3: Fundamentals of Microeconomic theory

Module 7: Revealed preference theory