ch7 Revealedpreferences

Chapter 7
Revealed
Preference
1
Revealed Preference Analysis
◆  Supposewe observe the demands
(consumption choices) that a
consumer makes for different
budgets. This reveals information
about the consumer’s preferences.
We can use this information to ...
2
Revealed Preference Analysis
– Test the behavioral hypothesis that
a consumer chooses the most
preferred bundle from those
available.
– Discover the consumer’s
preference relation.
3
Assumptions on Preferences
◆  Preferences
– do not change while the choice
data are gathered.
– are strictly convex.
– are monotonic.
◆  Together, strict convexity and
monotonicity imply that the most
preferred affordable bundle is
unique.
4
Assumptions on Preferences
x2
If preferences are strictly
convex and monotonic (i.e.
well-behaved) then the most
x 2* preferred affordable bundle
is unique.
x 1* x1
5
Direct Preference Revelation
◆  Supposethat the bundle x* is chosen

when the bundle y is affordable.
Then we say x* is directly revealed
preferred to y (otherwise y would
have been chosen).
6
x2
The chosen bundle x* is
directly revealed preferred
to the bundles y and z.
x*
z
y
x1
7
◆  That
x is directly revealed preferred
to y will be written as
≺"
x y.
D
8
Indirect Preference Revelation
◆  Suppose x is directly revealed
preferred to y, and y is directly
revealed preferred to z. Then we say
x is indirectly revealed preferred to z.
Write this as ≺"
x z
I
≺" ≺" ≺"
so x y and y z x z.
D D I
9
x2
z is not affordable when x* is chosen.
x*
x1
10
x2
x* is not affordable when y* is chosen.
x*
y*
z
x1
11
x2
x*
y*
z
x1
12
x2
So x* and z cannot be compared
x* directly.
y*
z
x1
13
x2
x* directly. ≺"
y* But x*x* y*
D
z
x1
14
x2
x* directly. ≺"
y* But x*x* y*
D
z and y*
≺"
z
D
x1
15
x2
x* directly. ≺"
y* But x*x* y*
D
z and y*
≺"
z
D ≺"
so x* z.
x1 I
16
Two Axioms of Revealed
Preference
◆  To apply revealed preference
analysis, choices must satisfy two
criteria -- the Weak and the Strong
Axioms of Revealed Preference.
17
The Weak Axiom of Revealed
Preference (WARP)
◆  If
the bundle x is directly revealed
preferred to the bundle y then it is
never the case that y is directly
revealed preferred to x; i.e.
≺" ≺"
x y not (y x).
D D
18
Preference (WARP)
◆  Choice data which violate the WARP
are inconsistent with economic
rationality.
◆  In particular, the WARP is a necessary
condition for economic rationality.
◆  In other words: if consumers choose
the best affordable bundle (i.e.
rationality holds), then WARP must be
satisfied.
19
Preference (WARP)
◆  What choice data violate the WARP?
20
Preference (WARP)
x2
y
x
x1
21
Preference (WARP)
x2
x is chosen when y is available
≺"
so x y.
D
y
x
x1
22
Preference (WARP)
x2
≺"
so x y.
D
y is chosen when x is available
≺"
so y x.
D
y
x
x1
23
Preference (WARP)
x2
≺"
so x y.
D
y is chosen when x is available
≺"
so y x.
D These statements are
y
x inconsistent with
WARP.
x1
24
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?
25
Choices
(10, 1) (5, 5) (5, 4)
Prices
($2, $2) $22 $20 $18
($2, $1) $21 $15 $14
($1, $2) $12 $15 $13
26
Choices
(10, 1) (5, 5) (5, 4)
Prices
($2, $2) $22 $20 $18
($2, $1) $21 $15 $14
($1, $2) $12 $15 $13
Red numbers are costs of chosen bundles.

27
Choices
(10, 1) (5, 5) (5, 4)
Prices
($2, $2) $22 $20 $18
($2, $1) $21 $15 $14
($1, $2) $12 $15 $13
Circles surround affordable bundles that

were not chosen. 28
Choices
(10, 1) (5, 5) (5, 4)
Prices
($2, $2) $22 $20 $18
($2, $1) $21 $15 $14
($1, $2) $12 $15 $13

were not chosen. 29
Choices
(10, 1) (5, 5) (5, 4)
Prices
($2, $2) $22 $20 $18
($2, $1) $21 $15 $14
($1, $2) $12 $15 $13

were not chosen. 30
Ch o i c e s
(10,1) (5,5) (5,4) (10, 1) (5, 5) (5, 4)
Prices
($2,$2) $22 $20 $18 (10,1) D D
($2,$1) $21 $15 $14 (5, 5) D
($1,$2) $12 $15 $13 (5 ,4) D
31
Ch o i c e s
(10,1) (5,5) (5,4) (10, 1) (5, 5) (5, 4)
Prices
($2,$2) $22 $20 $18 (10,1) D D
($2,$1) $21 $15 $14 (5, 5) D
($1,$2) $12 $15 $13 (5 ,4) D
32
(10,1) is directly (10, 1) (5, 5) (5, 4)

revealed preferred
to (5,4), but (5,4) is (10,1) D D
directly revealed
preferred to (10,1), (5, 5) D
so the WARP is
violated by the data. (5 ,4) D
33
x2
≺"
(5,4) (10,1)
D
≺"
(10,1) (5,4)
D
x1
34
The Strong Axiom of Revealed
Preference (SARP)
◆  If
the bundle x is (directly or
indirectly) revealed preferred to the
bundle y and x ≠ y, then it is never
the case that the y is (directly or
indirectly) revealed preferred to x; i.e.
≺" ≺"
x y or x y
D I
≺" ≺"
not ( y x or y x ).
D I
35
Preference
◆  What
choice data would satisfy the
WARP but violate the SARP?
36
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)
37
Preference
A: ($1,$3,$10)
Choice
(3,1,4). A B C
Prices
B: ($4,$3,$6) A $46 $47 $46

(2,5,3).
B $39 $41 $46
C: ($1,$1,$5) C $24 $22 $23

(4,4,3).
38
Preference
Choices
A B C
Prices
A $46 $47 $46
B $39 $41 $46
C $24 $22 $23
39
Preference
Choices In situation A,
A B C
Prices bundle A is
directly revealed
A $46 $47 $46
preferred to
bundle C;
B $39 $41 $46 ≺"
A C.
D
C $24 $22 $23
40
Preference
Choices In situation B,
A B C
Prices bundle B is
directly revealed
A $46 $47 $46
preferred to
bundle A;
B $39 $41 $46 ≺"
B A.
D
C $24 $22 $23
41
Preference
Choices In situation C,
A B C
Prices bundle C is
directly revealed
A $46 $47 $46
preferred to
bundle B;
B $39 $41 $46 ≺"
C B.
D
C $24 $22 $23
42
Preference
Choices
A B C A B C
Prices
A $46 $47 $46 A D
B $39 $41 $46 B D
C $24 $22 $23 C D
43
Preference
Choices
A B C A B C
Prices
A $46 $47 $46 A D
B $39 $41 $46 B D
C $24 $22 $23 C D
The data do not violate the WARP.

44
Preference
We have that A B C
≺" ≺" ≺"
A C, B A and C B A D
D D D
so, B D
≺" ≺" ≺"
A B, B C and C A. C D
I I I
The data do not violate the WARP but ...

45
Preference
We have that A B C
≺" ≺" ≺"
A C, B A and C B A I D
D D D
so, B D I
≺" ≺" ≺"
A B, B C and C A. C I D
I I I

46
Preference
≺"
B A is inconsistent A B C
D
≺"
with A B. A I D
I
B D I
C I D

47
Preference
≺"
A C is inconsistent A B C
D
≺"
with C A. A I D
I
B D I
C I D

48
Preference
≺"
C B is inconsistent A B C
D
≺"
with B C. A I D
I
B D I
C I D

49
Preference
A B C
The data do not violate
the WARP but there are A I D
3 violations of the SARP.
B D I
C I D
50
Preference
◆  That the observed choice data satisfy
the SARP is a condition necessary
and sufficient for there to be a well-
behaved preference relation that
“rationalizes” the data.
◆  So our 3 data cannot be rationalized
by a well-behaved preference
relation.
51
Recovering Indifference Curves
◆  Suppose we have the choice data
satisfy the SARP.
◆  Then we can discover approximately
where are the consumer’s
indifference curves.
◆  How?
52
◆  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)?
53
◆  The
table showing direct preference
revelations is:
54
A B C D E
A D D
B
C
D D D D
E D D D
Direct revelations only; the WARP
is not violated by the data.
55
◆  Indirectpreference 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:
56
A B C D E
A D D
B
C
D D D D
E D D D
Both direct and indirect revelations; neither
WARP nor SARP are violated by the data.
57
◆  Sincethe choices satisfy the SARP,
there is a well-behaved preference
relation that “rationalizes” the
choices.
58
x2 A: (p1,p2)=(1,1); (x1,x2)=(15,15)
B: (p1,p2)=(2,1); (x1,x2)=(10,20)
E C: (p1,p2)=(1,2); (x1,x2)=(20,10)
D: (p1,p2)=(2,5); (x1,x2)=(30,12)
B E: (p1,p2)=(5,2); (x1,x2)=(12,30).
D
A C
x1
59
x2 A: (p1,p2)=(1,1); (x1,x2)=(15,15)
B: (p1,p2)=(2,1); (x1,x2)=(10,20)
E C: (p1,p2)=(1,2); (x1,x2)=(20,10)
D: (p1,p2)=(2,5); (x1,x2)=(30,12)
B E: (p1,p2)=(5,2); (x1,x2)=(12,30).
D
A C
x1
Begin with bundles revealed
to be less preferred than bundle A. 60
x2 A: (p1,p2)=(1,1); (x1,x2)=(15,15).
x1
61
x2 A: (p1,p2)=(1,1); (x1,x2)=(15,15).
x1
62
x2 A: (p1,p2)=(1,1); (x1,x2)=(15,15).
A is directly revealed preferred

to any bundle in
x1
63
x2 A: (p1,p2)=(1,1); (x1,x2)=(15,15)
B: (p1,p2)=(2,1); (x1,x2)=(10,20).
E
D
A C
x1
64
x2 A: (p1,p2)=(1,1); (x1,x2)=(15,15)
B: (p1,p2)=(2,1); (x1,x2)=(10,20).
x1
65
x2
A is directly revealed preferred
to B and …
x1
66
x2
B is directly revealed preferred
to all bundles in
B
x1
67
x2
so, by transitivity, A is indirectly
revealed preferred to all bundles
in
B
x1
68
x2
so A is now revealed preferred
to all bundles in the union.
B
A
x1
69
x2 A: (p1,p2)=(1,1); (x1,x2)=(15,15)
E C: (p1,p2)=(1,2); (x1,x2)=(20,10).
D
A C
x1
70
x2 A: (p1,p2)=(1,1); (x1,x2)=(15,15)
C: (p1,p2)=(1,2); (x1,x2)=(20,10).
A C
x1
71
x2 A is directly revealed
preferred to C and ...
A C
x1
72
x2 C is directly revealed preferred
to all bundles in
x1
73
x2 so, by transitivity, A is
indirectly revealed preferred
to all bundles in
x1
74
x2 so A is now revealed preferred
B
A
C
x1
75
x2 so A is now revealed preferred
Therefore the indifference
curve containing A must lie
B
everywhere else above
A this shaded set.
C
x1
76
◆  Now,
what about the bundles
revealed as more preferred than A?
77
x2 A: (p1,p2)=(1,1); (x1,x2)=(15,15)
B: (p1,p2)=(2,1); (x1,x2)=(10,20)
E C: (p1,p2)=(1,2); (x1,x2)=(20,10)
D: (p1,p2)=(2,5); (x1,x2)=(30,12)
B E: (p1,p2)=(5,2); (x1,x2)=(12,30).
A
D
A C
x1
78
x2 A: (p1,p2)=(1,1); (x1,x2)=(15,15)
D: (p1,p2)=(2,5); (x1,x2)=(30,12).
A
D
x1
79
x2 D is directly revealed preferred
to A.
A
D
x1
80
to A.
Well-behaved preferences are
convex
A
D
x1
81
to A.
convex so all bundles on the
line between A and D are
A preferred to A also.
D
x1
82
to A.
line between A and D are
A preferred to A also.
D
As well, ...
x1
83
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
84
x2
bundles revealed to be
strictly preferred to A
A
D
x1
85
x2 A: (p1,p2)=(1,1); (x1,x2)=(15,15)
B: (p1,p2)=(2,1); (x1,x2)=(10,20)
E C: (p1,p2)=(1,2); (x1,x2)=(20,10)
D: (p1,p2)=(2,5); (x1,x2)=(30,12)
B E: (p1,p2)=(5,2); (x1,x2)=(12,30).
A
D
A C
x1
86
x2 A: (p1,p2)=(1,1); (x1,x2)=(15,15)
E: (p1,p2)=(5,2); (x1,x2)=(12,30).
x1
87
x2
E is directly revealed preferred
to A.
E
x1
88
x2
to A.
E Well-behaved preferences are
convex
x1
89
x2
to A.
line between A and E are
preferred to A also.
A
x1
90
x2
to A.
line between A and E are
preferred to A also.
A
As well, ...
x1
91
x2 all bundles containing the
same amount of commodity 1
and more of commodity 2 than
E E are preferred to E and
therefore are preferred to A
also.
A
x1
92
x2
More bundles revealed
to be strictly preferred
E
to A
x1
93
x2
Bundles revealed
E earlier as preferred
to A
B
A C
D
x1
94
x2
All bundles revealed

E to be preferred to A
B
A
C
D
x1
95
◆  Now
we have upper and lower
bounds on where the indifference
curve containing bundle A may lie.
96
x2

to be preferred to A
x1
All bundles revealed to be less preferred to A
97
x2

to be preferred to A
x1
All bundles revealed to be less preferred to A
98
x2
The region in which the
indifference curve containing
bundle A must lie.
x1
99
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.
100
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.
101
Quantity Index Numbers
◆  Aquantity index is a price-weighted
average of quantities demanded; i.e.
p1x1t + p 2xt2
Iq =
b b
p1x1 + p 2x 2
◆  (p1,p2)
can be base period prices (p1b,p2b)
or current period prices (p1t,p2t).
102
◆  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
103
◆  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
104
◆  Howcan quantity indices be used to
make statements about changes in
welfare?
105
b t b t
p1 x1 + p 2 x 2
◆  If Lq = <1 then
b b b b
p1 x1 + p 2 x 2
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.
106
t t t t
p1x1 + p2x 2
◆  If Pq = >1 then
p1t xb
1 + p t b
2x 2
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.
107
Price Index Numbers
◆  A price index is a quantity-weighted
average of prices; i.e.
t t
p1x1 + p 2x 2
Ip =
b b
p1 x1 + p 2 x 2
◆  (x1,x2) can be the base period bundle
(x1b,x2b) or else the current period
bundle (x1t,x2t).
108
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
109
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
110
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
111
Price Index Numbers
◆  If
p1t xb
1 + p t b
2x 2
t t t t
p1x1 + p 2x 2
Lp = < =M
b b b b b b b b
p1 x1 + p 2 x 2 p1 x1 + p2 x 2
then
t b t b t t t t
p1x1 + p2x 2 < p1x1 + p2x 2
so consumers overall are better off in

the current period.
112
Price Index Numbers
◆  But, if
t t t t t t t t
p1x1 + p 2x 2 p1x1 + p 2x 2
Pp = > =M
b t b t b b b b
p1 x1 + p 2 x 2 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.
113
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.
114
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.
115
Full Indexation?
◆  The usual price index proposed for
indexation is the Paasche quantity
index (the Consumers’ Price Index).
◆  What will be the consequence?
116
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.
117
Full Indexation?
x2
Base period budget constraint
Base period choice
x 2b
x 1b x1
118
Full Indexation?
x2
Base period choice
x 2b
Current period budget
constraint before indexation
x 1b x1
119
Full Indexation?
x2
Base period choice
x 2b constraint after full indexation
x 1b x1
120
Full Indexation?
x2
Base period choice
x 2b constraint after indexation
Current period choice

after indexation
x 1b x1
121
Full Indexation?
x2
Base period choice
x 2b constraint after indexation
x2 t Current period choice

after indexation
x 1b x 1t x1
122
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
x 2b the base and current periods.
x 2t
x 1b x 1t x1
123
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:
124
Full Indexation?
Author Point Est. Int. Est.
Adv. Commission to 1.0% 0.7 - 2.0%
Study the CPI (1995)
Congressional 0.2 - 0.8%
Budget Office (1995)
Alan Greenspan 0.5 - 1.5%
(1995)
Shapiro & Wilcox 1.0% 0.6 - 1.5%
(1996)
125
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?
126
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 20
◆  A: (1+ 0.01) =1.01 =1.22 so after
20 years social security payments
would be about 22% “too large”.
127

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ch7 Revealedpreferences

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Chapter 7

◆ Supposethat the bundle x* is chosen

($2, $1) $21 $15 $14

($1, $2) $12 $15 $13

($2, $1) $21 $15 $14

($1, $2) $12 $15 $13

Red numbers are costs of chosen bundles.

($2, $1) $21 $15 $14

($1, $2) $12 $15 $13

Circles surround affordable bundles that

($2, $1) $21 $15 $14

($1, $2) $12 $15 $13

Circles surround affordable bundles that

($2, $1) $21 $15 $14

($1, $2) $12 $15 $13

Circles surround affordable bundles that

($2,$1) $21 $15 $14 (5, 5) D

($1,$2) $12 $15 $13 (5 ,4) D

($2,$1) $21 $15 $14 (5, 5) D

($1,$2) $12 $15 $13 (5 ,4) D

(10,1) is directly (10, 1) (5, 5) (5, 4)

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)

B: ($4,$3,$6) A $46 $47 $46

C: ($1,$1,$5) C $24 $22 $23

B $39 $41 $46

C $24 $22 $23

B $39 $41 $46 B D

C $24 $22 $23 C D

B $39 $41 $46 B D

C $24 $22 $23 C D

The data do not violate the WARP.

The data do not violate the WARP but ...

The data do not violate the WARP but ...

The data do not violate the WARP but ...

The data do not violate the WARP but ...

The data do not violate the WARP but ...

A is directly revealed preferred

All bundles revealed

All bundles revealed

All bundles revealed

so consumers overall were better off

so consumers overall are better off in

so consumers overall are better off in

Notice that this index uses current

Current period choice

x2 t Current period choice

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◆  Supposethat the bundle x* is chosen