Chapter Seven

Revealed Preference

Revealed Preference Analysis

Suppose

we observe the demands (consumption choices) that a consumer makes for different budgets. This reveals information about the consumers preferences. We can use this information to ...

Revealed Preference Analysis

Test the behavioral hypothesis that a consumer chooses the most preferred bundle from those available. Discover the consumers preference relation.

Assumptions on Preferences
Preferences

do not change while the choice data are gathered. are strictly convex. are monotonic. Together, convexity and monotonicity imply that the most preferred affordable bundle is unique.

Assumptions on Preferences
x2

x2*

If preferences are convex and monotonic (i.e. well-behaved) then the most preferred affordable bundle is unique.

x1*

x1

Direct Preference Revelation

Suppose

that the bundle x* is chosen when the bundle y is affordable. Then x* is revealed directly as preferred to y (otherwise y would have been chosen).

Direct Preference Revelation

x2

The chosen bundle x* is revealed directly as preferred to the bundles y and z. x*

y

z
x1

Direct Preference Revelation

That

x is revealed directly as preferred to y will be written as x

p
D

y.

Indirect Preference Revelation

Suppose

x is revealed directly preferred to y, and y is revealed directly preferred to z. Then, by transitivity, x is revealed indirectly as preferred to z. Write this as x z
so x
D

y and y

p
I

p
I

z.

Indirect Preference Revelation

x2

z is not affordable when x* is chosen.

x*
z x1

Indirect Preference Revelation

x2

x* is not affordable when y* is chosen.

x* y*
z x1

Indirect Preference Revelation

x2

z is not affordable when x* is chosen. x* is not affordable when y* is chosen. x* y*

z x1

Indirect Preference Revelation

x2

z is not affordable when x* is chosen. x* is not affordable when y* is chosen. So x* and z cannot be compared x* directly. y* z
x1

Indirect Preference Revelation

x2

z is not affordable when x* is chosen. x* is not affordable when y* is chosen. So x* and z cannot be compared x* directly. But x*x* y* y* D z
x1

Indirect Preference Revelation

x2

z is not affordable when x* is chosen. x* is not affordable when y* is chosen. So x* and z cannot be compared x* directly. But x*x* y* y* D z and y* z
x1

p p
D

Indirect Preference Revelation

x2

z is not affordable when x* is chosen. x* is not affordable when y* is chosen. So x* and z cannot be compared x* directly. But x*x* y* y* D z and y* z
x1 so x*

p
I

p p
D

z.

Two Axioms of Revealed Preference

To

apply revealed preference analysis, choices must satisfy two criteria -- the Weak and the Strong Axioms of Revealed Preference.

The Weak Axiom of Revealed Preference (WARP)

If

the bundle x is revealed directly as preferred to the bundle y then it is never the case that y is revealed directly as preferred to x; i.e.
x
D

not (y

p
D

x).

The Weak Axiom of Revealed Preference (WARP)

Choice

data which violate the WARP are inconsistent with economic rationality. The WARP is a necessary condition for applying economic rationality to explain observed choices.

The Weak Axiom of Revealed Preference (WARP)

What

choice data violate the WARP?

The Weak Axiom of Revealed Preference (WARP)

x2

x x1

The Weak Axiom of Revealed Preference (WARP)

x2

x is chosen when y is available so x y.

x x1

p
D

The Weak Axiom of Revealed Preference (WARP)

x2

x is chosen when y is available so x y.

y is chosen when x is available so y x. y x x1

p
D

p
D

The Weak Axiom of Revealed Preference (WARP)

x2

x is chosen when y is available so x y.

y is chosen when x is available so y x. D These statements are inconsistent with x each other. x1

p
D

Checking if Data Violate the WARP

A

consumer makes the following choices: At prices (p1,p2)=($2,$2) the choice was (x1,x2) = (10,1). At (p1,p2)=($2,$1) the choice was (x1,x2) = (5,5). At (p1,p2)=($1,$2) the choice was (x1,x2) = (5,4). Is the WARP violated by these data?

Checking if Data Violate the WARP

Choices Prices ($2, $2) ($2, $1) ($1, $2) (10, 1) $22 $21 $12 (5, 5) $20 $15 $15 (5, 4) $18 $14 $13

Checking if Data Violate the WARP

Choices Prices ($2, $2) ($2, $1) ($1, $2) (10, 1) $22 $21 $12 (5, 5) $20 $15 $15 (5, 4) $18 $14 $13

Red numbers are costs of chosen bundles.

Checking if Data Violate the WARP

Choices Prices ($2, $2) ($2, $1) ($1, $2) (10, 1) $22 $21 $12 (5, 5) $20 $15 $15 (5, 4) $18 $14 $13

Circles surround affordable bundles that were not chosen.

Checking if Data Violate the WARP

Choices Prices ($2, $2) ($2, $1) ($1, $2) (10, 1) $22 $21 $12 (5, 5) $20 $15 $15 (5, 4) $18 $14 $13

Circles surround affordable bundles that were not chosen.

Checking if Data Violate the WARP

Choices Prices ($2, $2) ($2, $1) ($1, $2) (10, 1) $22 $21 $12 (5, 5) $20 $15 $15 (5, 4) $18 $14 $13

Circles surround affordable bundles that were not chosen.

Checking if Data Violate the WARP

Ch o i c e s (10,1) (5,5) Prices ($2,$2) ($2,$1) ($1,$2) $22 $21 $12 $20 $15 $15 (5,4) $18 $14 $13

(10, 1) (5, 5) (5, 4) (10,1) (5, 5) (5 ,4) D D D D

Checking if Data Violate the WARP

Ch o i c e s (10,1) (5,5) Prices ($2,$2) ($2,$1) ($1,$2) $22 $21 $12 $20 $15 $15 (5,4) $18 $14 $13

(10, 1) (5, 5) (5, 4) (10,1) (5, 5) (5 ,4) D D D D

Checking if Data Violate the WARP

(10,1) is directly revealed preferred to (5,4), but (5,4) is directly revealed preferred to (10,1), so the WARP is violated by the data.
(10, 1) (5, 5) (5, 4) (10,1) (5, 5) (5 ,4) D D D D

Checking if Data Violate the WARP

x2 (5,4)

(10,1)

p
D

p
D

(10,1)
(5,4)

x1

The Strong Axiom of Revealed Preference (SARP)

If

the bundle x is revealed (directly or indirectly) as preferred to the bundle y and x y, then it is never the case that the y is revealed (directly or indirectly) as preferred to x; i.e. x y or x y
D

not ( y

x or y

p
I

p
I

x ).

The Strong Axiom of Revealed Preference

What

choice data would satisfy the WARP but violate the SARP?

The Strong Axiom of Revealed Preference

Consider

the following data:

A: (p1,p2,p3) = (1,3,10) & (x1,x2,x3) = (3,1,4) B: (p1,p2,p3) = (4,3,6) & (x1,x2,x3) = (2,5,3)

C: (p1,p2,p3) = (1,1,5) & (x1,x2,x3) = (4,4,3)

The Strong Axiom of Revealed Preference

A: ($1,$3,$10) (3,1,4).
Choice Prices A B C A $46 $39 $24 B $47 $41 $22 C $46 $46 $23

B: ($4,$3,$6) (2,5,3).
C: ($1,$1,$5) (4,4,3).

The Strong Axiom of Revealed Preference

Choices A Prices A B C B C

$46 $47 $46 $39 $41 $46 $24 $22 $23

The Strong Axiom of Revealed Preference

Choices A Prices A B C B C

$46 $47 $46 $39 $41 $46 $24 $22 $23

In situation A, bundle A is directly revealed preferred to bundle C; A C.

p
D

The Strong Axiom of Revealed Preference

Choices A Prices A B C B C

$46 $47 $46 $39 $41 $46 $24 $22 $23

In situation B, bundle B is directly revealed preferred to bundle A; B A.

p
D

The Strong Axiom of Revealed Preference

Choices A Prices A B C B C

$46 $47 $46 $39 $41 $46 $24 $22 $23

In situation C, bundle C is directly revealed preferred to bundle B; C B.

p
D

The Strong Axiom of Revealed Preference

Choices A Prices A B C B C

A A B C D

C D

$46 $47 $46 $39 $41 $46 $24 $22 $23

The Strong Axiom of Revealed Preference

Choices A Prices A B C B C

A A B C D

C D

$46 $47 $46 $39 $41 $46 $24 $22 $23

The data do not violate the WARP.

The Strong Axiom of Revealed Preference

We have that A
D

C D

C, B

A and C

so, by transitivity,
A
I

B, B

C and C

The data do not violate the WARP but ...

p
D I

A B D D

A.

The Strong Axiom of Revealed Preference

We have that A
D

C D

C, B

A and C

so, by transitivity,
A
I

B, B

C and C

The data do not violate the WARP but ...

p
D I

A B D

I
D

A.

The Strong Axiom of Revealed Preference

B

with A

The data do not violate the WARP but ...

p
I

p
D

A is inconsistent B.
A B C

C D

I
D

I
D

The Strong Axiom of Revealed Preference

A

with C

The data do not violate the WARP but ...

p
I

p
D

C is inconsistent A.
A B C

C D

I
D

I
D

The Strong Axiom of Revealed Preference

C

with B

The data do not violate the WARP but ...

p
I

p
D

B is inconsistent C.
A B C

C D

I
D

I
D

The Strong Axiom of Revealed Preference

A B C D

The data do not violate the WARP but there are 3 violations of the SARP.

A B C D

I
D

The Strong Axiom of Revealed Preference

That

the observed choice data satisfy the SARP is a condition necessary and sufficient for there to be a wellbehaved preference relation that rationalizes the data. So our 3 data cannot be rationalized by a well-behaved preference relation.

Recovering Indifference Curves

Suppose

we have the choice data satisfy the SARP. Then we can discover approximately where are the consumers indifference curves. How?

Recovering Indifference Curves

Suppose

we observe: A: (p1,p2) = ($1,$1) & (x1,x2) = (15,15) B: (p1,p2) = ($2,$1) & (x1,x2) = (10,20) C: (p1,p2) = ($1,$2) & (x1,x2) = (20,10) D: (p1,p2) = ($2,$5) & (x1,x2) = (30,12) E: (p1,p2) = ($5,$2) & (x1,x2) = (12,30). Where lies the indifference curve containing the bundle A = (15,15)?

Recovering Indifference Curves

The

table showing direct preference revelations is:

Recovering Indifference Curves

A A B C D E D D D D D D B D C D D E

Direct revelations only; the WARP is not violated by the data.

Recovering Indifference Curves

Indirect

preference revelations add no extra information, so the table showing both direct and indirect preference revelations is the same as the table showing only the direct preference revelations:

Recovering Indifference Curves

A A B C D E D D D D D D B D C D D E

Both direct and indirect revelations; neither WARP nor SARP are violated by the data.

Recovering Indifference Curves

Since

the choices satisfy the SARP, there is a well-behaved preference relation that rationalizes the choices.

Recovering Indifference Curves

x2
E B A

A: (p1,p2)=(1,1); (x1,x2)=(15,15) B: (p1,p2)=(2,1); (x1,x2)=(10,20) C: (p1,p2)=(1,2); (x1,x2)=(20,10) D: (p1,p2)=(2,5); (x1,x2)=(30,12) E: (p1,p2)=(5,2); (x1,x2)=(12,30). C

x1

Recovering Indifference Curves

x2
E B A

A: (p1,p2)=(1,1); (x1,x2)=(15,15) B: (p1,p2)=(2,1); (x1,x2)=(10,20) C: (p1,p2)=(1,2); (x1,x2)=(20,10) D: (p1,p2)=(2,5); (x1,x2)=(30,12) E: (p1,p2)=(5,2); (x1,x2)=(12,30). C

Begin with bundles revealed to be less preferred than bundle A.

x1

Recovering Indifference Curves

x2

A: (p1,p2)=(1,1); (x1,x2)=(15,15).

A x1

Recovering Indifference Curves

x2

A: (p1,p2)=(1,1); (x1,x2)=(15,15).

A x1

Recovering Indifference Curves

x2
A is directly revealed preferred to any bundle in

A: (p1,p2)=(1,1); (x1,x2)=(15,15).

A x1

Recovering Indifference Curves

x2
E B A C

A: (p1,p2)=(1,1); (x1,x2)=(15,15) B: (p1,p2)=(2,1); (x1,x2)=(10,20).

x1

Recovering Indifference Curves

x2

A: (p1,p2)=(1,1); (x1,x2)=(15,15) B: (p1,p2)=(2,1); (x1,x2)=(10,20). B A x1

Recovering Indifference Curves

x2
A is directly revealed preferred to B and B A x1

Recovering Indifference Curves

x2
B is directly revealed preferred to all bundles in B

x1

Recovering Indifference Curves

x2
so, by transitivity, A is indirectly revealed preferred to all bundles in

x1

Recovering Indifference Curves

x2
so A is now revealed preferred to all bundles in the union. B A

x1

Recovering Indifference Curves

x2
E B A C A: (p1,p2)=(1,1); (x1,x2)=(15,15)

C: (p1,p2)=(1,2); (x1,x2)=(20,10).

x1

Recovering Indifference Curves

x2
A: (p1,p2)=(1,1); (x1,x2)=(15,15)

C: (p1,p2)=(1,2); (x1,x2)=(20,10).

C x1

Recovering Indifference Curves

x2
A is directly revealed preferred to C and ...

C x1

Recovering Indifference Curves

x2
C is directly revealed preferred to all bundles in

C x1

Recovering Indifference Curves

x2
so, by transitivity, A is indirectly revealed preferred to all bundles in

C x1

Recovering Indifference Curves

x2
so A is now revealed preferred to all bundles in the union. B A C x1

Recovering Indifference Curves

x2
so A is now revealed preferred to all bundles in the union. Therefore the indifference curve containing A must lie B everywhere else above A this shaded set. C x1

Recovering Indifference Curves

Now,

what about the bundles revealed as more preferred than A?

Recovering Indifference Curves

x2
E B A A

A: (p1,p2)=(1,1); (x1,x2)=(15,15) B: (p1,p2)=(2,1); (x1,x2)=(10,20) C: (p1,p2)=(1,2); (x1,x2)=(20,10) D: (p1,p2)=(2,5); (x1,x2)=(30,12) E: (p1,p2)=(5,2); (x1,x2)=(12,30). C

x1

Recovering Indifference Curves

x2
A: (p1,p2)=(1,1); (x1,x2)=(15,15)

D: (p1,p2)=(2,5); (x1,x2)=(30,12). A

x1

Recovering Indifference Curves

x2
D is directly revealed preferred to A.

x1

Recovering Indifference Curves

x2
D is directly revealed preferred to A. Well-behaved preferences are

convex
A

x1

Recovering Indifference Curves

x2
D is directly revealed preferred to A. Well-behaved preferences are convex so all bundles on the line between A and D are A preferred to A also. D

x1

Recovering Indifference Curves

x2
D is directly revealed preferred to A. Well-behaved preferences are convex so all bundles on the line between A and D are A preferred to A also. D As well, ... x1

Recovering Indifference Curves

x2
all bundles containing the same amount of commodity 2 and more of commodity 1 than D are preferred to D and therefore are preferred to A A also. D

x1

Recovering Indifference Curves

x2
bundles revealed to be strictly preferred to A

A D x1

Recovering Indifference Curves

x2
E B A A

A: (p1,p2)=(1,1); (x1,x2)=(15,15) B: (p1,p2)=(2,1); (x1,x2)=(10,20) C: (p1,p2)=(1,2); (x1,x2)=(20,10) D: (p1,p2)=(2,5); (x1,x2)=(30,12) E: (p1,p2)=(5,2); (x1,x2)=(12,30). C

x1

Recovering Indifference Curves

x2
E A: (p1,p2)=(1,1); (x1,x2)=(15,15)

E: (p1,p2)=(5,2); (x1,x2)=(12,30).
A x1

Recovering Indifference Curves

x2
E

E is directly revealed preferred to A.

A x1

Recovering Indifference Curves

x2
E

E is directly revealed preferred to A. Well-behaved preferences are

convex
A x1

Recovering Indifference Curves

x2
E

E is directly revealed preferred to A. Well-behaved preferences are convex so all bundles on the line between A and E are preferred to A also.

x1

Recovering Indifference Curves

x2
E

E is directly revealed preferred to A. Well-behaved preferences are convex so all bundles on the line between A and E are preferred to A also. As well, ...
x1

Recovering Indifference Curves

x2
E all bundles containing the same amount of commodity 1 and more of commodity 2 than E are preferred to E and therefore are preferred to A also. A x1

Recovering Indifference Curves

x2
E

More bundles revealed to be strictly preferred to A

A x1

Recovering Indifference Curves

x2
E B A Bundles revealed earlier as preferred to A C

D x1

Recovering Indifference Curves

x2
E B

All bundles revealed to be preferred to A A

C D x1

Recovering Indifference Curves

Now

we have upper and lower bounds on where the indifference curve containing bundle A may lie.

Recovering Indifference Curves

x2 All bundles revealed to be preferred to A A

x1 All bundles revealed to be less preferred to A

Recovering Indifference Curves

x2 All bundles revealed to be preferred to A A

x1 All bundles revealed to be less preferred to A

Recovering Indifference Curves

x2 The region in which the indifference curve containing bundle A must lie. A

x1

Index Numbers
Over

time, many prices change. Are consumers better or worse off overall as a consequence? Index numbers give approximate answers to such questions.

Index Numbers
Two

basic types of indices price indices, and quantity indices Each index compares expenditures in a base period and in a current period by taking the ratio of expenditures.

Quantity Index Numbers

A

quantity index is a price-weighted average of quantities demanded; i.e.

t t p1x1 p2x 2 Iq b b p1x1 p2x 2

(p1,p2)

can be base period prices (p1b,p2b) or current period prices (p1t,p2t).

Quantity Index Numbers

If

(p1,p2) = (p1b,p2b) then we have the Laspeyres quantity index;

b t b t p1 x1 p 2 x 2 Lq b b b b p1 x1 p 2 x 2

Quantity Index Numbers

If

(p1,p2) = (p1t,p2t) then we have the Paasche quantity index;

t t t t p1x1 p 2x 2 Pq t b t b p1x1 p 2x 2

Quantity Index Numbers

How

can quantity indices be used to make statements about changes in welfare?

Quantity Index Numbers

If

b t b t p1 x1 p2 x 2 Lq 1 b b b b p1 x1 p2 x 2

then

b t b t b b b b p1 x1 p2 x 2 p1 x1 p2 x 2

so consumers overall were better off in the base period than they are now in the current period.

Quantity Index Numbers

If

t t t t p1x1 p 2x 2 Pq 1 t p1xb pt xb 1 2 2

then

t t t t t b t b p1x1 p2x 2 p1x1 p2x 2

so consumers overall are better off in the current period than in the base period.

Price Index Numbers

A

price index is a quantity-weighted average of prices; i.e. t t p1x1 p2x 2 Ip b b p1 x1 p2 x 2 (x1,x2) can be the base period bundle (x1b,x2b) or else the current period bundle (x1t,x2t).

Price Index Numbers

If

(x1,x2) = (x1b,x2b) then we have the Laspeyres price index;

t b t b p1x1 p 2x 2 Lp b b b b p1 x1 p 2 x 2

Price Index Numbers

If

(x1,x2) = (x1t,x2t) then we have the Paasche price index;

t t t t p1x1 p 2x 2 Pp b t b t p1 x1 p 2 x 2

Price Index Numbers

How

can price indices be used to make statements about changes in welfare? Define the expenditure ratio t t t t p1x1 p 2x 2 M b b b b p1 x1 p 2 x 2

Price Index Numbers

If

Lp

b b b b p1 x1 p 2 x 2

t p1xb pt xb 1 2 2

t t t t p1x1 p 2x 2 M b b b b p1 x1 p 2 x 2
t t t t p1x1 p2x 2

then t b t b p1x1 p2x 2

so consumers overall are better off in the current period.

Price Index Numbers

But,

if

t t t t p1x1 p 2x 2 Pp b t b t p1 x1 p 2 x 2

t t t t p1x1 p 2x 2 M b b b b p1 x1 p 2 x 2

then
b t b t p1 x1 p2 x 2

b b b b p1 x1 p2 x 2

so consumers overall were better off in the base period.

Full Indexation?
Changes

in price indices are sometimes used to adjust wage rates or transfer payments. This is called indexation. Full indexation occurs when the wages or payments are increased at the same rate as the price index being used to measure the aggregate inflation rate.

Full Indexation?
Since

prices do not all increase at the same rate, relative prices change along with the general price level. A common proposal is to index fully Social Security payments, with the intention of preserving for the elderly the purchasing power of these payments.

Full Indexation?
The

usual price index proposed for indexation is the Paasche quantity index (the Consumers Price Index). What will be the consequence?

Full Indexation?
t t t t p1x1 p 2x 2 Pq t b t b p1x1 p 2x 2

Notice that this index uses current period prices to weight both base and current period consumptions.

Full Indexation?
x2
Base period budget constraint Base period choice x2b

x1b

x1

Full Indexation?
x2
Base period budget constraint Base period choice x2b

Current period budget constraint before indexation x1b x1

Full Indexation?
x2
Base period budget constraint Base period choice x2b Current period budget constraint after full indexation

x1b

x1

Full Indexation?
x2
Base period budget constraint Base period choice x2b Current period budget constraint after indexation

Current period choice after indexation

x1b x1

Full Indexation?
x2
Base period budget constraint Base period choice x2b x2
t

Current period budget constraint after indexation

Current period choice after indexation

x1b x1t x1

Full Indexation?
x2
(x1t,x2t) is revealed preferred to (x1b,x2b) so full indexation makes the recipient strictly better off if relative prices change between the base and current periods.

x2b x2t x1b

x1t

x1

Full Indexation?
So

how large is this bias in the US CPI? A table of recent estimates of the bias is given in the Journal of Economic Perspectives, Volume 10, No. 4, p. 160 (1996). Some of this list of point and interval estimates are as follows:

Full Indexation?
Author Adv. Commission to Study the CPI (1995) Congressional Budget Office (1995) Alan Greenspan (1995) Shapiro & Wilcox (1996) Point Est. 1.0% Int. Est. 0.7 - 2.0% 0.2 - 0.8% 0.5 - 1.5% 1.0% 0.6 - 1.5%

Full Indexation?
So

suppose a social security recipient gained by 1% per year for 20 years. Q: How large would the bias have become at the end of the period?

Full Indexation?
So

suppose a social security recipient gained by 1% per year for 20 years. Q: How large would the bias have become at the end of the period? 20 1 0120 1 22 so after A: (1 0 01) 20 years social security payments would be about 22% too large.