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A Semester Paper on Eco 601 : Advanced Microeconomic Theories
Submitted to Central Department of Economics (CEDECON) for the Internal Assessment of Partial Fulfillment of Master of Philosophy (M. Phil 2010) in Economics
Submitted by Bigyan Shrestha Roll No. 21 March, 2010
Table of Contents Introduction Objectives Law of Demand Samuelson’s Revealed Preference Theory 4.1. Fundamental Theorem of Consumption theory 4.2. Critical Appraisal of Revealed Preference Theory 5. Hick’s logical ordering theory of Demand 5.1. Derivation of Law of Demand 5.2. Appraisal of Hicks Logical Ordering Theory 6. Conclusion References 1. 2. 3. 4. 1 1 1 2 3 4 5 7 8 9 11
Demand is the quantity desired per unit of time. Demand for a commodity is consumer’s attitude and reaction towards that commodity. The demand for any commodity is affected by number of factors. The most important factor is price. Law of demand states the inverse relationship between price and quantity demanded. For the normal goods, rationality holds that, lower the price higher the demand for the commodity and higher the price, lower will be demand for the commodity. Over a period of time economists have given varying opinion for analysis of demand and explained consumer’s demand for a product and derives the law of demand analytically. Cardinal marginal utility analysis and an indifference curve analysis use intuitive method for derivation of demand curve and based upon psychological analysis of consumer’s behavior. Samuelson has firstly presented a behavioral approach to analysis of demand theories based upon strong order hypothesis in 1947. Inspired by the Samuelson, Hicks revised his demand theories and presented the logical order theory of demand in his book “Revision of Demand Theories”. Hicks logical order theory of demand is based upon weak order hypothesis. Both the approach assumes consistency as the behavior of consumer neglecting the maximization of satisfaction by consumer as in traditional demand theories.
The objective of this paper is to present the critical analysis of Samuelson’s revealed preference theory and Hick’s logical ordering theory of demand.
3. Law of Demand
Law of demand expresses the functional relationship between price and commodity demanded. According to the law of demand, other things being equal, for the normal goods, if the price of a commodity falls, the quantity demanded of it will rise and if the price of the commodity rises, its quantity demanded will decline.
4. Samuelson’s Revealed Preference Theory of Demand
Marshallian utility theory of demand and Hicks Allen indifference curve theory of demand have applied the introspective method to explain the consumer’s behavior i.e. they provide
psychological explanation of consumer’s demand. Prof. Samuelson has presented the revealed preference theory to explain the consumer’s behavior from his actual preferences of the commodities. His theory is based upon the consumer’s behavior towards preference over the goods. Revealed preference theory is based upon the concept of ordinal utility. The revealed preference theory is regarded as “scientific” explanation of consumer’s behavior as against the psychological explanation provided by Marshallian and Hicks – Allen indifference curve theories of demand. This 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 preference for A over all other alternative combinations which he could have purchased. Actual behavior reveals preference. Choice of the combination A reveals his definite preference for A over all other rejected combinations. Graphically, in figure 1, if consumer chooses combination A out of all other combinations such as B,C,D,E and F which are rejected by him. Samuelson’s revealed preference theory is based upon the strong form of preference hypothesis. i.e. if one combination is selected all other combinations are rejected.
Y P N
C F E D A B G M L Figure 1: Preference Hypothesis X
Revealed preference hypothesis can be utilized to establish the demand theorem. Prof. Samuelson has derived the Marshallian law of demand from his revealed preference hypothesis. Samuelson calls the demand theorem as Fundamental Theorem of Consumption Theory and states that “Any good (simple or composite) that is known always to increase in demand when money income alone rises must definitely shrink in demand when its price alone
rises.” Hence, Samuelson reserves the positive income elasticity of demand to the inverse price – demand principle.
4.1 Fundamental Theorem of Consumption Theory
Let us suppose that consumer spends his entire income on two goods X and Y. His income in terms of good X is OB and in terms of good Y is OA. Price line AB represents the price income situation confronting the consumer. Triangle OAB represents the total combinations of the goods available to the consumer with his available income. If Q is selected, this means that Q is revealed to be preferred to all other available combinations. Point Q will always lie on the Price line.
Y D A Good Y Q
Good X Figure 2: Fundamental Theorem of Consumption Theory
If the price of good X rises, the price of Y remaining unchanged, price line shifts to AC. Point Q is not available to the consumer. To compensate the consumer for higher price of X to get the same combination of goods as before, price line has to be shift to DE. AD represents the amount of compensation. Now, in price income situation DE, the available combinations are Triangle DEO. Consumer can have same level of satisfaction by staying at point Q or can be rationally consistent by moving to other available points in Triangle DOE. Q is preferred over all the available combinations in Triangle ABO hence, consumer may move to combinations available in Triangle ADO. Hence, in that in the price income situation DE the consumer will either choose the original combination Q or any other combination on line QD. In price income situation DE, if the consumer chooses the original combination Q, it means he will be buying the
same amount of goods X and Y as before, and if he chooses any combination above Q on QD, it means that he will be buying less amount of good X and greater amount of Y than before. Thus, even after sufficient extra income has been granted to the consumer to compensate him for the rise in price of good X, he purchases either the same or the smaller quantity of X at higher price. Now, if the extra money granted to him is withdrawn, he will definitely6 buy the smaller amount of X at the higher price, if the income elasticity of demand is positive. The inverse price demand relationship can be shown in case of fall in price also.
4.2 Critical Appraisal of Revealed Preference Theory
• This theory has gained some advantages over the Marshallian Cardinal Utility Theory and Hicks – Allen indifference curve theory of demand. This theory is based upon the behaviouristic approach of the consumer rather than psychological aspect of the consumers behavior. Samuelson remarks “ For just as we do not claim to know by introspection the behavior of utility, many will argue we cannot know the behavior of ration of marginal rate of substitution as an entity independent of any psychological, introspective implications would be, to say the least, ambiguous and would seem an artificial convention in the explanation of price behavior.” Behaviouristic method is more scientific than the introspective method. • This theory gives up the utility maximization postulates of the Marshalian analysis and indifference curve analysis rather consistency postulate has been employed by Samuelson to derive the demand theorem. • • Assumption of continuity has been abandoned. Continuity of indifference curve is quite unrealistic. The theory has been criticized on many grounds. This theory doesn’t admit the possibility of indifference in consumer’s behavior. The rejection of indifference by Samuelson follows from his strong ordering hypothesis and his dictum of preference to be revealed from a single act of choice. It has been pointed out that if preference is to be judged from a large number of observations, and then the possibility of indifference also emerges. • It is criticized on the ground that preference is not revealed at all in the sense of ordinal utility. If, there exist only an apple and an orange, and an orange is picked,
then one can definitely say that an orange is revealed preferred to an apple. In the real world, when it is observed that a consumer purchased an orange, it is impossible to say what good or set of goods or behavioral options were discarded in preference of purchasing an orange. • It has been pointed out that Samuelson’s revealed preference theory is based upon observed consumer’s behavior and on the plane of observations substitution effect cannot be distinguished from income effects. • It cannot derive demand theorem when income effect is negative. Samuelson’s theory cannot account for Giffen’s paradox.
5. Hick’s logical ordering theory of Demand
Prof. Hicks in his book “A revision of Demand Theory”, embhaises econometric approach to theory of demand. He himself remarks that theory is strongly influenced by Samuelson’s revealed preference theory and states “It was a defect, a serious defect that the economic reference was not made more explicit, the ideal theory of demand for econometric purposes is still not precisely that which had been reached at the point just described. …In Samuelsson the whole form of the theory is allowed to be dictated by reference to econometrics, Great and beautiful simplifications follow. But I am not convinced that even in Samuelson the econometric reference is quite as it should be, sot that the present work, deeply influenced by Samuelson as it is, will not follow him at all exactly. In technique we shall keep quite close to him, but our methodology will be more explicitly econometric even than his.” Hicks assumes preference hypothesis as a principle which governs the behavior of such a consumer. The assumption of behavior according to a scale of preferences is known as preference hypothesis. Hicks negatively criticized the strong ordering hypothesis presented by Samuelson and adopted the weak ordering hypothesis. Weak ordering hypothesis recognizes the relation of indifference. If the consumer’s scale of preferences is weakly ordered then his choice of a particular position A does not show or reveal that A is preferred to any rejected position within or on the triangle, all that is shown is that there is no rejected position which is preferred to A. It is perfectly possible that some rejected
position may be indifferent to A; the choice of A instead of that rejected position is then a matter of chance. For derivation of postulates of demand theory, Hicks make one more hypothesis that the consumer will always prefer a larger amount of money to a smaller amount of money, provided that the amount of good X at his disposal is unchanged’. The above two hypothesis provides the explanation of consumers’ behavior on selection of commodities as shown below:
Y a C
a Commodity X
Figure 3: Hick’s weak order hypothesis In fig 3, commodity X is measured among X axis and money income is measured in Y axis. If consumer selects the combination of good X and income at point L from all the available combinations in triangle aOa, we can say under weak ordering hypothesis that B is not preferred to A this doesn’t show that A is preferred to B as in strong order hypothesis. On the additional hypothesis made, L is preferred to B, since L contains more amount of money than B, amount of X being the same in both the positions. If A and B are indifferent from transitivity, it follows that L is preferred to A. But L was available when A was selected. Therefore, though L can be indifferent to A, it cannot be preferred to A. Hence, under weak order hypothesis it cannot be said that whether chosen combination L is preferred over the other combinations lying in the line aa. Following Samuelson, Hicks also assumes consistency behavior on the part of the ideal consumer whose scale of preferences remains unchanged when prices of goods and his
income vary. Hicks call this consistency test as the Direct Consistency test. Direct consistency test is the economic expression of the two term consistency condition of the theory of the logic of order. It tests whether the consumer is consistently choosing the combinations of commodities.
5.1 Derivation of Law of Demand
From the logic of weak ordering along with the additional hypothesis of preference of larger amount of money to a smaller amount of money and the theory of direct consistency test, all major propositions of the theory of consumer’s demand are deduced. For a single commodity using the above hypothesis demand law of demand is derived as follow:
Y a,b c A
B z Q
a Commodity X
Figure 4 : Derivation of law of demand In figure 4, commodity X is measured on the X axis and money income on Y axis. With initial income level, price income line is aa. Let us suppose that consumer chose the point A on aa. If price of good X falls, the new price income line will be bb. Now consumer will chose the point on line bb. From consistency theory that any position on bb is preferred to A i.e. consumption of goods can be lower, higher or equal to the good X previously consumed by the consumer before fall in price. Hence, Hicks says “this is all we learn from consistency theory when it is applied to these two positions. It is perfectly consistent for there to be a rise or fall or no change in the consumption of X between A and B.” Now, if fall in price of good X is accompanied by an appropriate reduction in consumer’s income, then it can be shown from the consistency theory that the amount demanded of
good X must rise or remain the same; it cannot fall. As shown in figure 3, in reduced income price line, all the combinations lying in cz are inconsistent to A and combinations lying in c’z are consistent to A. Hence any combinations in c’z show that consumption of good X will rise. This shows the effect of change in price only removing the effect of change in relative income. Hence, it is substitution effect of the change in demand. It follows therefore from the consistency theory that due to substitution effect of the fall in price of good X, the consumption of X must rise or remain the same, it cannot diminish. The movement from A on aa to B on bb as a result of the change in price represents the price effect. In order to separate out the substitution effect, income is reduced by compensating variation. The rest of the effect of the change in price is the income effect. In which direction the income effect of the fall in price works cannot be proved with the aid of consistency theory. Our knowledge about income effect is based upon observation. So for normal goods, income effect is positive and more goods of X are demanded than before fall in price. For giffen goods, income effect is negative which pulls down the demand for good X on fall in price. The combined effect of the substitution and income effect determines the point B on the line bb, which may represent the lower, higher or same amount of commodity X as at the point A. Hence, Hicks logical ordering theory can also explain giffen paradox.
Appraisal of Hicks Logical Ordering Theory
J.R Hicks in his Revision of Demand Theory based on weak logical ordering goes deeper into the foundations of demand theory and derives in a more closely reasoned manner law of demand from a few simple and self evident propositions of “logic of order”. He doesn’t follow Samuelson’s behaviouristic approach to study consumer’s behavior but instead adopts the technique of weak logical ordering on the part of consumer to establish the theorems of demand.
Professor Fritz Machlup remarks “The methodological position underlying Hicks approach is eminently sound. He is free from positivist behaviouristic restrictions on the study of consumer’s behavior and he also avoids contentions about the supposedly empirical assumptions regarding rational action. Instead he starts from a fundamental postulate, the preference hypothesis.
Hicks abandon the use of indifference curve and corrects some of the mistakes of IC curve, continuity and maximizing behavior on part of the consumer. Hicks like Samuelson relies on consistency in the behavior of the consumer which is a more realistic assumption.
This theory is capable of being easily applied in case of more than two goods. The theory provides for the decomposition of price effect into income effect and substitution effect as in case of indifference curve analysis with more simple and realistic assumptions of consumer behavior.
The theory can analytically explain the giffen paradox and inferior goods.
The behavioral approach to demand theory presented by Samuelson and logical ordering theory presented by Hicks is more scientific and practical than the traditional theories of demand based upon cardinal and ordinal measurability of utility ( Marshallian approach and Indifference curve approach). Samuelson presents strong ordering hypothesis and consistency theory as the base for his derivation of demand theory. While Hicks came up with the weak ordering hypothesis and consistency as his base for analysis of demand. These theories gave up the unrealistic assumption of continuity of indifference curve and maximization of satisfaction by consumer. Though the Samuelson’s theory is more scientific than the previous theories, it is criticized on many grounds. The hypothesis of strong ordering, non provision for giffen goods, and not capable of segregating price effect into substitution and income effect. Hicks inspired by the work of Samuelson revised his demand theories and came up with weak ordering hypothesis. He presented his theory of demand to make econometric reference more explicit. He based his theory on weak ordering hypothesis and consistency theory. His theory is more practicable and based upon simple and more realistic assumptions. Hicks has corrected the mistakes of the indifference curve analysis. Hicks demand theory can well explain the income effect and substitution effect of demand. It is also capable of explaining giffen paradox.
Hence, Samuelson’s revealed preference theory of demand based on strong ordering hypothesis provides for the scientific and behaviourial approach in explaining demand.Hicks logical order theory of demand based on weak order hypothesis provide is capable of explaining many aspects of demand theories based upon realistic and simple hypothesis.
REFERENCES Ahuja, H.L (2001). Advanced Economic Theory New Delhi: S. Chand & Company Pvt. Ltd. Hal R. Varian, (2005). Revealed Preference. (http://people.ischool.berkeley.edu/~hal/Papers/2005/revpref.pdf) Hicks, John (2001 reprint), Revision of Demand Theories, Oxford University Press (New York) http://en.wikipedia.org/wiki/Revealed_Preference_Theory Autor, David (fall 2004), Lecture: Revealed Preference and Consumer’s welfare (http://ocw.mit.edu/NR/rdonlyres/Economics/14-03Fall-2004/F0C2D271-386D-46E48A28-F1177FB62EA6/0/lecture8.pdf)
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