2. Revealed Preference Analysis
Suppose we 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 ...
3. Revealed Preference Analysis
– Test the behavioral hypothesis that
a consumer chooses the most
preferred bundle from those
available.
– Discover the consumer’s
preference relation.
4. 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.
5. Assumptions on Preferences
x2
If preferences are convex and
monotonic (i.e. well-behaved)
then the most preferred
affordable bundle is unique.
x2*
x1*
x1
6. 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).
9. 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
I
D
y and y
D
z
x
so x
I
z.
13. 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
14. Indirect Preference Revelation
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
x2
x1
15. Indirect Preference Revelation
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
x2
D
x1
16. Indirect Preference Revelation
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
D
x1
so x*
x2
I
z.
17. Two Axioms of Revealed
Preference
To apply revealed preference
analysis, choices must satisfy two
criteria -- the Weak and the Strong
Axioms of Revealed Preference.
18. 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.
D
y
not (y
x
D
x).
19. 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.
20. The Weak Axiom of Revealed
Preference (WARP)
What choice data violate the WARP?
22. x is chosen when y is available
so x
y.
x2
The Weak Axiom of Revealed
Preference (WARP)
D
y
x
x1
23. x is chosen when y is available
so x
y.
D
y is chosen when x is available
so y
x.
x2
The Weak Axiom of Revealed
Preference (WARP)
y
D
x
x1
24. x is chosen when y is available
so x
y.
D
y is chosen when x is available
so y
x.
D
These statements are
inconsistent with
x
each other.
x1
x2
The Weak Axiom of Revealed
Preference (WARP)
y
25. 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?
26. Checking if Data Violate the WARP
Choices
Prices
(10, 1)
(5, 5)
(5, 4)
($2, $2)
$22
$20
$18
($2, $1)
$21
$15
$14
($1, $2)
$12
$15
$13
27. Checking if Data Violate the WARP
Choices
Prices
(10, 1)
(5, 5)
(5, 4)
($2, $2)
$22
$20
$18
($2, $1)
$21
$15
$14
($1, $2)
$12
$15
$13
Red numbers are costs of chosen bundles.
28. Checking if Data Violate the WARP
Choices
Prices
(10, 1)
(5, 5)
(5, 4)
($2, $2)
$22
$20
$18
($2, $1)
$21
$15
$14
($1, $2)
$12
$15
$13
Circles surround affordable bundles that
were not chosen.
29. Checking if Data Violate the WARP
Choices
Prices
(10, 1)
(5, 5)
(5, 4)
($2, $2)
$22
$20
$18
($2, $1)
$21
$15
$14
($1, $2)
$12
$15
$13
Circles surround affordable bundles that
were not chosen.
30. Checking if Data Violate the WARP
Choices
Prices
(10, 1)
(5, 5)
(5, 4)
($2, $2)
$22
$20
$18
($2, $1)
$21
$15
$14
($1, $2)
$12
$15
$13
Circles surround affordable bundles that
were not chosen.
31. Checking if Data Violate the WARP
Ch o i c e s
(10,1) (5,5)
Prices
(5,4)
($2,$2)
$22
$20
$18
(10,1)
($2,$1)
$21
$15
$14
(5, 5)
($1,$2)
$12
$15
$13
(5 ,4)
(10, 1) (5, 5) (5, 4)
D
D
D
D
32. Checking if Data Violate the WARP
Ch o i c e s
(10,1) (5,5)
Prices
(5,4)
($2,$2)
$22
$20
$18
(10,1)
($2,$1)
$21
$15
$14
(5, 5)
($1,$2)
$12
$15
$13
(5 ,4)
(10, 1) (5, 5) (5, 4)
D
D
D
D
33. 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)
D
(5, 5)
(5 ,4)
D
D
D
34. Checking if Data Violate the WARP
x2
D
(10,1)
(10,1)
(5,4)
D
(5,4)
x1
35. 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
not ( y
I
D
x or y
D
I
x ).
36. The Strong Axiom of Revealed
Preference
What choice data would satisfy the
WARP but violate the SARP?
37. 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)
38. The Strong Axiom of Revealed
Preference
A: ($1,$3,$10)
(3,1,4).
Choice
Prices
A
B
C
B: ($4,$3,$6)
(2,5,3).
A
$46
$47
$46
B
$39
$41
$46
C: ($1,$1,$5)
(4,4,3).
C
$24
$22
$23
39. The Strong Axiom of Revealed
Preference
Choices
A
Prices
B
C
A
$46 $47 $46
B
$39 $41 $46
C
$24 $22 $23
40. The Strong Axiom of Revealed
Preference
B
C
A
$46 $47 $46
B
$39 $41 $46
In situation A,
bundle A is
directly revealed
preferred to
bundle C;
A C.
Choices
A
Prices
D
C
$24 $22 $23
41. The Strong Axiom of Revealed
Preference
B
C
A
$46 $47 $46
B
$39 $41 $46
In situation B,
bundle B is
directly revealed
preferred to
bundle A;
B A.
Choices
A
Prices
D
C
$24 $22 $23
42. The Strong Axiom of Revealed
Preference
B
C
A
$46 $47 $46
B
$39 $41 $46
In situation C,
bundle C is
directly revealed
preferred to
bundle B;
C B.
Choices
A
Prices
D
C
$24 $22 $23
43. The Strong Axiom of Revealed
Preference
Choices
A
Prices
B
C
A
A
$46 $47 $46
A
B
$39 $41 $46
B
C
$24 $22 $23
C
B
C
D
D
D
44. The Strong Axiom of Revealed
Preference
Choices
A
Prices
B
C
A
A
$46 $47 $46
A
B
$39 $41 $46
B
C
$24 $22 $23
C
B
C
D
D
The data do not violate the WARP.
D
45. The Strong Axiom of Revealed
Preference
We have that
D
C, B
D
A and C
A
A
D
B
so, by transitivity,
I
B, B
I
C and C
A
B
A
I
A.
B
C
C
D
D
D
The data do not violate the WARP but ...
46. The Strong Axiom of Revealed
Preference
We have that
D
C, B
D
A and C
A
A
D
B
so, by transitivity,
I
B, B
I
C and C
A
B
I
A.
I
D
D
C
C
I
A
B
I
D
The data do not violate the WARP but ...
47. The Strong Axiom of Revealed
Preference
D
A is inconsistent
with A
B
I
B.
A
B
I
D
D
C
C
I
A
B
I
D
The data do not violate the WARP but ...
48. The Strong Axiom of Revealed
Preference
D
C is inconsistent
with C
A
I
A.
A
B
I
D
D
C
C
I
A
B
I
D
The data do not violate the WARP but ...
49. The Strong Axiom of Revealed
Preference
D
B is inconsistent
with B
C
I
C.
A
B
I
D
D
C
C
I
A
B
I
D
The data do not violate the WARP but ...
50. The Strong Axiom of Revealed
Preference
A
The data do not violate
the WARP but there are
3 violations of the SARP.
B
I
D
D
C
C
I
A
B
I
D
51. 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 well-behaved preference
relation that “rationalizes” the data.
So our 3 data cannot be rationalized
by a well-behaved preference
relation.
52. 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?
56. 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:
59. 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).
D
C
x1
60. 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).
D
C
x1
Begin with bundles revealed
to be less preferred than bundle A.
76. 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
78. Recovering Indifference Curves
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
A E: (p1,p2)=(5,2); (x1,x2)=(12,30).
D
C
A
x1
82. 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
83. 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
84. 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
86. Recovering Indifference Curves
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
A E: (p1,p2)=(5,2); (x1,x2)=(12,30).
D
C
A
x1
90. Recovering Indifference Curves
x2
E
A
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
91. Recovering Indifference Curves
x2
E
A
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
92. Recovering Indifference Curves
x2
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.
E
A
x1
100. 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.
101. 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.
102. Quantity Index Numbers
A quantity index is a price-weighted
average of quantities demanded; i.e.
t
t
p1x1 + p 2x 2
Iq =
b
b
p1x1 + p 2x 2
(p1,p2) can be base period prices (p1b,p2b)
or current period prices (p1t,p2t).
103. 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
104. 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
106. Quantity Index Numbers
If
b t
b t
p1 x1 + p 2 x 2
Lq =
<1
pbxb + pbxb
1 1
2 2
then
b t
b t
b b
b b
p1 x1 + p 2 x 2 < p1 x1 + p 2 x 2
so consumers overall were better off
in the base period than they are now
in the current period.
107. Quantity Index Numbers
If
t t
t t
p1x1 + p 2x 2
Pq =
>1
t b
t b
p1x1 + p 2x 2
then
t t
t t
t b
t b
p1x1 + p 2x 2 > p1x1 + p 2x 2
so consumers overall are better off
in the current period than in the base
period.
108. 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).
109. 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
110. 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
111. 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
112. Price Index Numbers
If
Lp =
t
p1xb + pt xb
1
2 2
<
b b
b b
p1 x1 + p 2 x 2
then
t b
t b
p1x1 + p 2x 2
<
t t
p1x1 + pt xt
2 2
b b
b b
p1 x1 + p 2 x 2
=M
t t
t t
p1x1 + p 2x 2
so consumers overall are better off
in the current period.
113. 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
pbxb + pbxb
1 1
2 2
<
b b
b b
p1 x1 + p 2 x 2
then
b t
b t
p1 x1 + p 2 x 2
so consumers overall were better off
in the base period.
114. 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.
115. 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.
116. Full Indexation?
The usual price index proposed for
indexation is the Paasche quantity
index (the Consumers’ Price Index).
What will be the consequence?
117. 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.
119. Full Indexation?
x2
Base period budget constraint
Base period choice
x2b
Current period budget
constraint before indexation
x1b
x1
120. Full Indexation?
x2
Base period budget constraint
Base period choice
Current period budget
constraint after full indexation
x2b
x1b
x1
121. Full Indexation?
x2
Base period budget constraint
Base period choice
Current period budget
constraint after indexation
x2b
x1b
Current period
choice
after indexation
x1
122. Full Indexation?
x2
Base period budget constraint
Base period choice
Current period budget
constraint after indexation
x2b
x2
t
x1b
x1 t
Current period
choice
after indexation
x1
123. 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
x2 t
x1b
x1 t
x1
124. 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:
125. Full Indexation?
Author
Point Est.
Int. Est.
Adv. Commission to
Study the CPI (1995)
Congressional
Budget Office (1995)
Alan Greenspan
(1995)
Shapiro & Wilcox
(1996)
1.0%
0.7 - 2.0%
0.2 - 0.8%
0.5 - 1.5%
1.0%
0.6 - 1.5%
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?
127. 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?
(1 + 0 ⋅ 01) 20 = 1 ⋅ 0120 = 1 ⋅ 22 so after
A:
20 years social security payments
would be about 22% “too large”.
