The Power of Nonparametric Tests of Preference Maximization

Author(s): Stephen G. Bronars

Source: Econometrica, Vol. 55, No. 3 (May, 1987), pp. 693-698
Published by: The Econometric Society
Stable URL: http://www.jstor.org/stable/1913608
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 Econometrica, Vol. 55, No. 3 (May, 1987), 693-698

THE POWER OF NONPARAMETRIC TESTS OF

PREFERENCE MAXIMIZATION'

BY STEPHEN G. BRONARS

1. NONPARAMETRIC TESTS OF PREFERENCE MAXIMIZATION

IN A RECENT PAPERin this journal, Varian (1982) presented algorithms which test a
finite body of data for consistency with the Generalized Axiom of Revealed Preference
(GARP). Despite the fact that he used broadly defined aggregate data, Varian was unable
to uncover any violations of GARP over the period 1947-1978. Varian attributes the
inability of his test to reject preference maximization to the postwar aggregate data which
he uses:2
Most existing sets of aggregate consumption data are post-war data, and this period
has been characterized by small changes in relative prices and large changes in income.
Hence each year has been revealed preferred to the previous years in the sense that it has
been typically possible in a given year to purchase the consumption bundles of each of
the previous years. Hence no "revealed preference" cycles can occur and the data are
consistent with the maximization hypothesis.
In each year the "representative consumer" has been typically able to purchase the observed
consumptionbundles of previous years, but since consumption bundles are potentially the
outcome of preference maximizing decisions, this is not a meaningful criticism of postwar
aggregate data for tests of preference maximization. Varian is incorrect in asserting that
relative price changes are unimportant in postwar aggregate data, for the budget sets of
the "representative consumer" frequently intersect in the positive orthant. Varian finds
that the observed consumption bundles do not provide much of an improvement on the
"classical" bounds for true cost of living indexes, but this does not imply that tests of
preference maximization using aggregate data have low power. Any budget set intersec-
tions, whether or not they improve the "classical" bounds for cost of living indexes,
increase the power of tests of preference maximization. A data set contains no useful
information about preference maximization only if budget sets do not intersect (the
"representativeconsumer" is able to purchase all feasible consumption bundles of previous
years).
This point is made clearly in Figures 1 and 2, which contain budget sets for years I,
II, and III. The budget sets are identical across figures, but consumer 1 in Figure 1 chooses
A, B, and C, while consumer 2 in Figure 2 chooses D, E, and F. Since budget line III
does not intersect with the other two budget sets, it provides no useful information about
preference maximization in either figure: GARP cannot be violated by any possible choice
in year III. A violation of GARP only occurs if a consumer chooses consumption along
GH in year I and along HI in year II, which is possible for either consumer. The fact
that consumer 2 was "typically possible in a given year to purchase the consumption
bundles of each of the previous years" is dependent on consumer 2's choice of bundles
across years, and does not diminish the power of this test relative to Figure 1 (consumer
1 is unable to afford year I's consumption bundle in year II).

l I would like to thank the editor and referees for comments which have improved the paper's
exposition. Michael Baye, Donald Deere, Chris Fawson, Martyn Houtman, John Lott, and Bob Reed
provided insightful comments. James Van Beek and Julie Holleman provided excellent research
assistance. Any remaining errors are my responsibility.
2 See Varian (1982, p. 965). The problem to which Varian refers is price collinearity; since nominal
prices tend to be highly correlated across commodities, relative prices are characterized by "small"
changes. This note argues that even these "small" changes are enough to detect violations of GARP
against certain alternatives.
693

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694 STEPHEN G. BRONARS

C2

J
Year I
G A C

B
Year III
Year II
I K C1
FIGURE 1.

The observed consumption bundles in Figure 2 reveal more information about the set
of consumption bundles "not revealed worse" than year I's consumption bundle (in
Varian's notation), since E is revealed preferred to D, but neither A is revealed preferred
to B, nor is B revealed preferred to A. Varian discusses why the set of consumption
bundles in Figure 2 provide tighter approximate bounds for the true costs of living index
for year I compared to the observed choices in Figure 1. Improvements in cost of living
bounds depend on observed consumption choices; the power of the test of preference
maximization depends on the way in which these consumption choices are made.
The power of this test (the probability of rejecting the null hypothesis) is zero when
the null hypothesis is true, given the absence of an error term in the theory of preference
maximization upon which GARP is based. One would like to know the entire power

C2

YearI
F

E
D Year III
Year II
C1

FIGURE2.
3 See Varian (1985) for a discussion of tests of preference maximization with measurement error.

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 NONPARAMETRIC TESTS 695

function, for any arbitrary alternative hypothesis. Since any type of irrational behavior is
an admissable alternative hypothesis, some restrictions must be placed on the alternatives
to preference maximization in order to make power calculations.
In this note I adopt Becker's (1962) notion of irrational behavior. The representative
consumer is assumed to choose consumption bundles randomly from his budget hyper-
plane. In Becker's example the consumer chose consumption from a uniform distribution
across all bundles in the budget hyperplane.4 For example, in Figure 1 a violation of
GARP occurs if agents choose bundles along GH and HI, which occurs with the following
probability:
Power = Pr (Violating GARP) = (11GH 1* 11HI 1 /(11GK 11* I!JI1)
where lidI denotes the length of the budget line denoted by d. Since 11HK1 IHI and
IIJH1 11GH1, this probability is bounded between 0 and .25, given only one budget set
intersection.' The power of this test can increase substantially as the number of budget
set intersections increases.6 In general, the probability of rejecting the null hypothesis
increases with the number of budget set intersections in the data, although for more than
two commodities, and with multiple budget set intersections, no simple formula for the
power of this test can be obtained (even for the uniform distribution case). This suggests
that a fruitful approach to obtaining the approximate power of this test is to perform a
Monte-Carlo type study. Consumption data sets based on random choice behavior, given
the constraints implied by actual post-war U.S. price and total expenditure data, are
generated and Varian's algorithm is used to check the random data for consistency with
GARP.

2. CALCULATING THE APPROXIMATE POWER OF VARIAN'S NONPARAMETRIC

TEST USING RANDOM CONSUMPTION DATA

The first step in calculating the approximate power of Varian's test is to construct
algorithms that generate random consumption data which exhaust the budget set in each
year. Given N commodities, in each year we seek N random variables, SI,, . . ., S,, that
sum to one and represent budget shares of each commodity in year t. Algorithm 1 generates
budget shares in such a way as to induce a uniform distribution of consumption choices
across the budget hyperplane, following Becker's example.7 The generated budget shares
in year t are multiplied by either aggregate or per capita total expenditure in t and divided
by the actual price of the corresponding commodity in t, to obtain the random consumption
quantities for year t.
Algorithm 2 draws N i.i.d. uniform random variables in each year, Z1, . . ., Zn, and Si,
is determined by the following equation:
N

4Becker (1962) showed that tests of individual preference maximization have low power against
the alternative of individual random behavior, when aggregate data are used (if individual randomness
is independent across agents). Houtman and Maks (1985) verify this by generating random individual
data, aggregating the data, and finding that the aggregate data are rarely inconsistent with GARP.
This paper concerns another issue: are there enough budget set intersections in the data for a powerful
test of GARP even if one had individual consumption data?
5The power is highest when GH -I JHIIand HI - HK or the two budget sets are "nearly"
1I II II II 11,
parallel. The power is lowest when 11GH II/IIJH11and 11HI / HK 11are nearly zero. This occurs when
the budget sets intersect at close to a 90? angle.
6 Two sets of mutually exclusive budget set intersections could result in a power of the test as high
as .4375. Each budget set intersection would result in a rejection probability of at most .25. The
probability of a rejection due to either budget set intersection equals at most .25 + .25 - (.25)2 =.4375,
given independence. Using similar arguments the power of a test given three mutually exclusive pairs
of intersections is at most .25 +.25 +.25 - 3(.25)2- (.25)3 .547.
7A copy of this algorithm is available from the author.

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696 STEPHEN G. BRONARS

Since this algorithm imposes an expected budget share of 1/ N, algorithm 3 determines

Si, by:
N \
Sit-=K.ZZ / E KJj
JZj
j=l

where Ki is the mean budget share of good i in the actual data across all years. Algorithm
3 mimics the actual consumption data in the sense that mean budget shares in the simulated
and actual data are equal.
In all of these algorithms I imposed independence of choices over time. The approximate
power of the test given each alternative hypothesis (algorithm for generating consumption
choices) is the fraction of data sets in which violations of GARP occurred.
Following Varian, I use aggregate U.S. consumption data by nine categories, over the
period 1947-1978, for the nonparametric test of preference maximization.8 My analysis
differs from Varian's in that I use both aggregate and per capita consumption data in
testing for violations of GARP. Working with per capita rather than aggregate data
significantly alters the nature and frequency of budget set intersections in the sample period.
Using Varian's algorithms for the nonparametric tests of GARP, I verified that neither
the actual aggregate or the actual per capita consumption data violated GARP over this
sample period. Using aggregate data, budget hyperplanes in 7 of the 32 years did not
intersect (in the positive orthant) with any other budget hyperplanes. For the purposes of
nonparametric tests of GARP, one can view the years 1947-1961 and 1968-1977 as two
separate subsamples. Using per capita data, the budget hyperplane in each year intersected
(in the positive orthant) with budget hyperplanes from at least two other years.
Using each of the algorithms described above, I generated 200 ranuom consumption
time series, using actual prices and both per capita and aggregate total expenditure
measures. For each of the six sets of 200 time series (32 years in each series), I calculated
the percentage of times that GARP was rejected. These results are reported in Table I.
Table I indicates that U.S. per capita consumption data provide a surprisingly powerful
test of preference maximization against the alternative hypothesis of random behavior by
the "representative consumer." Rejection probabilities exceed 90 per cent for all three per
capita versions of the tests, but are considerably lower for aggregate versions of the tests.
The pattern of rejection probabilities presented in Table I is consistent with the notion
that in aggregate versions of the tests, most budget set intersections in post-war U.S. data
are similar to those in Figure 3. Algorithms 2 and 3 make it unlikely that a consumer
randomly chooses a bundle near a corner solution, and since violations of GARP can
only be detected if consumers choose a bundle between points A and B in Figure 3, the
test has low power against this alternative. Algorithm 1 results in a considerably higher
probability of rejecting preference maximization because it induces a much higher probabil-
ity of observing consumption bundles in the neighborhood of a corner solution.9
The third and fifth columns of Table I report the mean number of violations of GARP
across time series (conditional on the occurrence of at least one violation of GARP). For
example, using algorithm 1 and aggregate total expenditure, 67.5 per cent of the time
series had at least one violation of GARP, and among these series, the average number
of violations per series was 3.58. The use of per capita data substantially increases the

8The nine consumption categories include Motor Vehicles, Furniture, Other Durables, Food,
Clothing, Fuel, Housing, Transportation, and Other Services. The price of each good is given by the
GNP deflator for each commodity. One abstracts from savings decisions by assuming that total
disposable income in each period equals total expNenditureson these 9 commodities.
9 As N gets large, the probability that Zi_j= Zj is "close to" one approaches zero. With 9
commodities it is relatively rare that a consumer would be devoting a "large" share of his income
to just one or two commodities, given algorithms 2 or 3. A uniform distribution of choices implies
that this choice "near" a corner solution is just as likely as equal budget shares across commodities.

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 NONPARAMETRIC TESTS 697

TABLE I
PROBABILITY OF REJECTING GARP AND AVERAGE NUMBER OF VIOLATIONS PER TIME SERIES

Aggregate Version Per Capita Version

Algorithm Probability Avg. Violations Probability Avg. Violations

1 .675 3.58 .985 14.52

2 .305 2.80 .910 6.34
3 .220 2.18 .915 6.19

C2

Year I

Year II

A~~~~~
B C.

FIGURE 3.
average number of violations of GARP relative to aggregate data. The variation in real
per capita total expenditure and relative prices over the period 1947-1978 has been sufficient
to provide a powerful test of preference maximization against the alternative of random
behavior, although aggregate versions of the tests appear much less powerful than per
capita versions of the tests against this alternative.

III. CONCLUSION

This note outlines a simple and inexpensive method for calculating the approximate
power of a nonparametric test of preference maximization for a simple alternative
hypothesis. Before one estimates a system of demand equations, it is important and
instructive to first examine whether or not the data are consistent with GARP, as Varian
has noted. Before one accepts the results of a nonparametric test of preference maximization
based on a set of observed consumption data, it is important and instructive to examine
the nature and frequency of budget set intersections. The power calculations in this note
suggest that Varian's test of preference maximization using per capita data is quite powerful
against the alternative of random behavior, but tests using aggregate data appear much
less powerful. One should be wary of tests that have low power against the rather naive
alternative of random behavior, for failure to reject the null hypothesis may convey little
useful information.
As always, one must be cautious in drawing conclusions about a "representative
consumer" based on observed aggregate or per capita data. As Becker (1962) noted,
random behavior by individuals may still result in aggregate or per capita consumption
data that are consistent with revealed preference theory. The results presented here indicate
that U.S. post-war consumption data are inconsistent with an irrational "representative

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698 STEPHEN G. BRONARS

consumer," but i.i.d. randomness in behavior across individuals would be difficult to detect
with aggregate or per capita data. This is a limitation of the use of aggregate rather than
individual data, and not a criticism of nonparametric tests in general.

Department of Economics, University of California-Santa Barbara, Santa Barbara, CA

93106, U.S.A.

received November, 1985; final revision received July, 1986.

AManuscript

REFERENCES
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HOUTMAN,M., AND J. A. H. MAKS (1985): "The Consistency of Aggregate Random Data with the
Hypotheses of Cost Minimization and Utility Maximization," Paper presented at 1985 World
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gen, The Netherlands.
LANDSBURG,S. E. (1981): "Taste Change in the United Kingdom, 1900-1955," Journal of Political
Economy, 89, 92-104.
VARIAN, H. (1982): "The Nonparametric Approach to Demand Analysis," Econometrica,50,945-973.
(1985): "Non-parametric Analysis of Optimizing Behavior With Measurement Error,"Journal
of Econometrics,30, 445-458.

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