What are Revealed Preferences and Budget Constraint?
Revealed means “Let Out,” and Preference means “Choice”; Choice Reveals Preference.
Budget constraint refers to the limitation that is occurred because of the limited income.
Example: Suppose you have an option to choose between a cone of Butterscotch or Chocolate ice cream, both of which cost $40/-, you choose a chocolate ice cream because you like its taste better. Thus chocolate is preferred over butterscotch. This is the principle on which the Revealed Preference Theory RPT) works.
If you have total money of $50/- for spending on ice cream, then this is called your budget constraint.
RPT is a behaviorist ordinal utility theory introduced by Economist Paul Samuelson, distinct from the ordinal Utility theory of Hicks and Allen.
RPT analyses consumer preference for a combination/bundle of goods given his budget constraints on the basis of observation of consumer behavior in the market.
RPT involves determining the value for the indifference curve that consumers hold for an environmental good by observing their market purchases that relate to environmental quality, e.g., the purchase of air fresheners, water purifiers, disinfectants, etc. reveal the amount a consumer would be willing to pay for air & water quality.
Assumptions on which RPT works:
- Consumers are rational.
- Consumers behave consistently.
- Consumer choice for a combination reveals his preference for that.
- The consumer chooses only one combination at a given price-income line.
- Consumer preference methods are a combination of more goods over less in any situation.
When will a Consumer Buy an Item?
RPT helps to find out all that is needed to know just by observing an individual’s market behavior, by seeing what he or she buys at different prices, assuming that his or her buying experiences do not change his or her preference pattern or his or her purchase desires. It is based on the idea that a consumer will decide to buy some particular combination of items either because he likes it or it is cheaper or has better utility or quality.
Example: Suppose a consumer observes that of two collections of goods offered for sale, he chooses to buy A over B. One cannot conclude that he prefers A to B since possibly he bought A as it was cheaper, but he actually liked B. Had one been unaware of the prices and then the consumer would choose A, one could say that he liked it better than B, and A has revealed preference over B.
Income – Price Relation
RPT holds that consumer behavior characteristics and preferences can be revealed by what they purchase under income & price circumstances.
Since some issues were identified in the Utility concept of economic theory by Economist Bentham, which was subjective and difficult to quantify, Professor Samuelson came up with RPT based on Consumer Behavior in which three primary axioms were identified as below:
1. Weak Axiom (WARP):
Analogy: At a given price and income, if one good is purchased over another, the consumer choice theory will always make the same choice unless he benefits from the other in terms of price, quality, etc.; it is based on the concept of affordability.
2. Strong Axiom (SARP):
Analogy: In a two-dimensional world, where the consumer theory has a choice only between two goods, the weak and strong axioms can be shown equivalent.
Example: If bundle X is preferred over bundle Y and bundle Y over bundle Z, then X is preferred over Z. If (x1, y1) is revealed preferred directly or indirectly over (x2, y2), then (x2, y2) cannot be preferred to (x1, y1) directly.
3. Generalized Axiom (GARP)
Analogy: At a given price and income, an individual gets the same level of valuation and utility function benefit from more than one consumption bundle. No unique bundle that maximizes utility exists.
Earlier contributions to the literature on stochastic choice and preference paid little attention to the nonparametric economic problem of choices made by a competitive consumer. Economists Bandyopadhyay, Dasgupta, and Pattanaik (1999) studied this problem in a revealed preference framework for individual stochastic choices, the Weak Axiom of Stochastic Revealed Preference (WASRP). In discussing the effect of compensated price changes, they confined themselves to a case where only one price could change at a time since their focus was on the sign of the 'own-price effect' on demand for a commodity. Thus, before one can have an RPT for stochastic consumer preference analysis and choice experiments that subsume and extends the deterministic theory based on WARP, one needs to identify the implications of WASRP. It permits many prices to change simultaneously.
Thus, RPT based on WASRP is more extensive in empirical scope and completeness than the standard RPT based on WARP for a consumer’s deterministic choices.
- Neglects Indifference in Consumer Behaviour, the consumer does not reveal his indifference in a single-valued demand function on a budget line while choosing a specific set of goods.
- Not possible to separate Substitution effect, i.e., fall in sales for a product due to rise in its price resulting in consumer shift to cheaper alternatives) from Income effect.
- Excludes Giffen Paradox (the possibility that standard competitive demand with nominal wealth being constant can be upward sloping, violating the law of demand) since it considers only positive income elasticity of demand theory.
- The consumer does not choose only 1 Combination of goods; the assumption that he chooses only one combination in a given price income situation is incorrect since the consumer usually chooses something out of all combinations but seldom purchases all combinations together.
- Choice does not reveal Preference; the assumption that Choice functions reveal preference is not always correct since the choice is made on the basis of rational consumer behavior, keeping in mind factors like income, price, usage, etc., but not always can a consumer choose what he prefers.
- Fails to derive Market Demand Curve since this theory applies only to an individual consumer.
- Not valid for Game theory; RPT is invalid for situations where individual choosers are known to be capable of employing strategies of a game theory, i.e., the process of modeling strategic interaction between 2 or more players in a situation containing set rules and outcomes.
- Fails in risky or uncertain situations, i.e., it fails to analyze consumer behavior in choices involving risk or uncertainty.
Context and Application
This topic is important for the students pursuing the below-mentioned disciplines.
- Masters in Economics
- Master in Business Administration
- Masters in Commerce
- Bachelor of Economics
- Bachelor of Commerce
- Substitution Effects
- Environmental Economics
- Micro Economics
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