Revealed Preference Theory and Determination

of Demand

Revealed Preference Theory Overview:

Revealed preference theory, introduced by
economist Paul Samuelson in 1938, posits that
consumer behavior is the best indicator of their
preferences when income and prices remain
constant. It suggests that observing what
consumers choose among available options
reveals their true preferences.
Consumer Rationality:
The theory assumes that consumers are rational
decision-makers who evaluate alternatives
before making a purchase. In the context of the
Revealed Preference Theory, consumer
rationality is a fundamental assumption. The
theory posits that consumers are rational
decision-makers who carefully consider their
options before making a purchase. Rationality in
this theory implies that consumers aim to
maximize their utility or satisfaction given their
budget constraints and the prices of goods and
services.
According to the theory, when consumers make
choices among different goods and services
while keeping their income and prices constant,
these choices reflect their preferences.
Consumers are assumed to have consistent
preferences, meaning that they will always
choose the option that provides them with the
highest level of satisfaction within their budget
constraints.
Demand in Revealed Preference Theory is
determined by observing consumer choices
under various price and income constraints. The
theory suggests that by analyzing what
consumers actually purchase, we can derive
their demand for different goods and services.
When prices change or income levels fluctuate,
consumers adjust their purchasing decisions
accordingly based on their preferences.
The demand curve for a consumer can be
derived by plotting the quantity of a good or
service that the consumer purchases at different
price levels. This curve represents the
consumer’s willingness to pay for each unit of
the good or service at varying prices. As prices
decrease, the quantity demanded typically
increases, reflecting the law of demand.
2) Preference Observation:
By analyzing consumer choices under various
price and budget constraints, a schedule can be
created to identify preferred items. In the
context of the Revealed Preference Theory,
preference observation is a fundamental concept
that underpins the determination of consumer
preferences. The theory posits that consumer
behavior, when income and prices are held
constant, provides the best indicator of their
preferences. By observing the choices
consumers make among available alternatives,
economists can infer their underlying
preferences. This observation is crucial in
understanding how consumers prioritize and
select goods and services based on their utility
and budget constraints.
In Revealed Preference Theory, demand is
determined by analyzing consumer behavior and
choices in response to varying prices and
income levels. The theory assumes that
consumers are rational decision-makers who
aim to maximize their utility within budget
constraints. As prices change, consumers adjust
their purchasing decisions to optimize their
satisfaction.
The demand curve for a consumer can be
derived by examining their preferred
consumption bundles at different price levels.
By plotting these bundles on a graph with
quantity on the x-axis and price on the y-axis,
we can observe how changes in price impact the
quantity demanded by the consumer. The
demand curve slopes downwards from left to
right, indicating an inverse relationship between
price and quantity demanded as shown below.

At lower prices, consumers tend to purchase

more of a good or service due to increased
affordability, leading to higher quantities
demanded. Conversely, as prices rise,
consumers may reduce their purchases or switch
to alternative goods that offer better value for
money. The demand curve illustrates this
relationship between price and quantity
demanded, providing valuable insights into
consumer behavior and market dynamics.
3)Utility vs. Behavior:
Unlike traditional utility-based theories,
revealed preference theory focuses on
observable behavior rather than quantifying
utility. In traditional economics, the concept of
utility played a central role in understanding
consumer behavior. Utility refers to the
satisfaction or pleasure that consumers derive
from consuming goods and services. However,
quantifying utility in precise terms proved to be
challenging and subjective. As a result,
economists sought alternative ways to analyze
consumer preferences.

Revealed Preference Theory emerged as a

groundbreaking approach that shifted the focus
from utility to observable behavior. Instead of
relying on hypothetical utility values, this theory
suggests that consumer preferences can be best
understood by observing their actual choices in
the market. When consumers make purchasing
decisions, they reveal their preferences through
their actions.
The key idea behind Revealed Preference
Theory is that consumers are rational decision-
makers who carefully evaluate available options
before making a choice. By examining what
consumers choose when faced with different
price and budget constraints, economists can
infer their underlying preferences without
having to quantify utility directly.
In the context of Revealed Preference Theory,
demand can be determined by analyzing how
consumers respond to changes in prices and
incomes. When prices change, consumers adjust
their purchasing decisions based on their
preferences and budget constraints. The law of
demand states that as the price of a good
decreases, the quantity demanded increases,
holding other factors constant
Determining Demand through Revealed
Preference:
Price Effect: When the price of a good
decreases, consumers tend to buy more of that
good due to increased affordability.

Income Effect: Changes in real income resulting

from price changes influence consumer demand.

Demand Curve Derivation: By plotting price

and quantity combinations based on consumer
choices at different price levels, a demand curve
can be derived.
Steps to Derive a Consumer’s Demand Curve:
Identify the original price-income line where the
consumer reveals preferences at a specific point
(e.g., R) and buys a certain quantity of the good
(e.g., OA).
If the price of the good falls, creating a new
price-income line, the consumer may purchase a
larger quantity (e.g., OB) at point T.
.
Conclusion: Revealed preference theory offers
valuable insights into consumer behavior by
emphasizing observable choices as indicators of
preferences. By understanding how consumers
make decisions under varying constraints,
economists can derive demand curves to analyze
market dynamics effectively.