S.Bhattacharyya E-mail: saikatca@rediffmail.

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The Revealed Preference Theory

The Revealed Preference Theory, an advancement over the earlier cardinal and ordinal theories, establishes all the utility based predictions of the theory of demand, basing solely on the measurable phenomena, rather than on the consumer preference, which is not at all observable. Now what is meant by Revealed Preference? Let us explain the idea first and then subsequently move to the decomposition of price effect into income and substitution effect. In a particular set of commodity price, p 0, a particular commodity bundle q0 is chosen, when another bundle q1 was a feasible alternative to him [That is, p0q0 p0q1; where p0q0 Expenditure for purchasing q0 at price p0 & p0q1 Expenditure for purchasing q1 at price p0]. As under such a situation q0 is chosen, it can be said that q0 is revealed preferred to q1. Before going into details let us have some behavioral assumptions: The consumer spends his entire income. Only one commodity bundle in a price income situation. 3. There exists one and only one price income situation at which each bundle is chosen. 4. The consumers choices are consistent. By this we mean that if a bundle q 0 is chosen when q1 could have been chosen, if in any other price income situation when q1 is chosen q0 must no longer be a feasible alternative. In other words, if q0 is revealed preferred to q1, the latter must never be revealed preferred to the former. This is called the WEAK AXIOM OF REVEALED PREFERENCE. Let at any price vector, p0, commodity set q0 is chosen. M0 = p0q0 is his money income, 0 when q is chosen. In this price income situation (p0, M0) q1 could be an affordable alternative, i.e., p0q0 p0q1. Similarly at another price vector p1, q1 is chosen. Then q0 could not have been chosen. That is, WARP implies p1q1< p1q0. 5. If q0 is revealed to be preferred to q1, which is revealed to be preferred to q2, which is revealed to be preferred to q3,., which is revealed to be preferred to qk, then qk can never be preferred to q0. This is the STRONG AXIOM OF REVEALED PREFERENCE. Figure-1 shows the consumers initial budget line B0, defined by price vector p0 and money income M0. The bundle chosen initially on B0 is q0. B1 is the budget line after a fall in price of commodity-I with M unchanged and q1, the new bundle chosen on B1. The behavioral assumptions do not place any restrictions on the location of q1 on B1. To decompose price effect the consumers money income is reduced until, facing the new prices, he is just able to buy the initial bundle, q0. The consumer confronted with B2 will buy the bundle q2 to the right of q0. Therefore, (q0 to q2) is the substitution effect and (q2 to q1) the income effect of price change.
commodity-II

1. 2.

q0

B1

B0

q2

B2

q1 commodity-I

In figure-1 q2 must lie on B2 (by the assumption-1) and hence there are three possibilities: q 2 can be to the left or the right of, or equal to, q0. q2 cannot be to the left of q0 on B2 because these bundles are inside the consumers initial feasible set and were rejected in favor of q0 (by WARP). q2 cannot equal q0 because the prices at which q0 and q2 are chosen differ (by our 3rd assumption) and, by our 2nd assumption, different bundles are chosen in different price-income situations. Therefore, q2 must contain more q1 than (i.e. be to the right of) q0. Thus the RPT proves that the substitution effect must always be negative. p0, q0 are the initial price vector and consumption bundle, p1 and q1 are the new price vector and consumption bundle. The consumers income is adjusted until at M2 he can just purchase q0 at the new

prices, p1, so that p1.q0 = M2. Faced with price vector p1 and the compensated money income, M2, the consumer chooses q2 and because spends all his money income we have that p 1.q2 = M2. Hence, the compensating change in M ensures that: 1. p1.q0 = M2 = p1.q2 2 Now q is chosen when q0 is still available (i.e. they are both on the same budget plane) so that by WARP, we have 2. p0.q0 < p0.q2 2 Or: q was not purchasable when q0 was bought. Rearranging equation 1 and 2, we have 3. p1.q0 p1.q2 = p1(q0 q2) = 0 4. p0q0 p0.q2 = p0(q0 q2) < 0 Subtracting equation 4 from 3 gives 5. p1( q0 - q2) p0 (q0 q2) = (q0 q2) (p1 p0) > 0 If the price of only one commodity changes others remain the same then equation 5 becomes a strict inequality and proves the substitution effect. We can also derive the Slutsky equation from the behavioral assumptions. Since M2 = p1.q0 & M0 = p0.q0 the compensating reduction in M is

(p1 p0) (q2 q0) < 0

M = M0 M2 = p0.q0 p1.q0 = (p0 p1) q0 = - (p1 p0).q0

In case of a change in the price of a particular commodity j we have 6. M = -pjqj0 The price effect of pj on qj is (qj1 qj0) and this can be partitioned into the substitution (qj2- qj0) and income (qj1 qj2)effects: 7. But using equation. 6 & 7 we have

(qj1 qj0) = (qj2- qj0) + (qj1 qj2) (qj1 qj0)/pj = (qj2- qj0)/pj + (qj1 qj2)/pj

(qj1 qj0)/pj = (qj2- qj0)/pj qj0 (qj1 qj2)/M 8. (qj/pj) M = (qj/pj)pq qj0 (qj/M)p
The above is the Slutsky equation.

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