Revealed Preference Theory

Revealed Preference Theory (RPT) is an economic concept that gauges consumer preferences based on the goods they purchase under various price and income scenarios. It was developed to reconcile the utility and demand theories by analyzing customers' behavior through utility functions.

The belief that customers act rationally roots the foundation of the theory. By holding the price of goods and customers' income constant, one can determine their purchasing preferences. The theory is best understood through the Weak Axiom of Revealed Preference (WARP), Strong Axiom of Revealed Preference (SARP), and Generalized Axiom of Revealed Preference (GARP).

• Revealed preference theory is an economic model to uncover individual preferences based on observed buying patterns.
• Revealed preference theory provides a useful tool for analyzing and predicting consumer behavior, particularly regarding how consumers react to price changes and income levels.
• It reconciles the utility concept with demand theory by assuming customer choices reflect their preferences. The theory assumes constant prices, incomes, and consistent consumer tastes over time.
• Researchers have identified eight main limitations of the theory, including the fact that individual choices may not always reflect true preferences.

Revealed preference theory's axioms provide a systematic framework for analyzing and evaluating consumer choices, allowing businesses and policymakers to make informed decisions based on consumer behavior patterns. By understanding customers' preferences, companies can better tailor their products and services to meet their needs, increasing sales and customer satisfaction. It, thus, is essential for understanding consumer preferences by examining their purchasing behavior.

In 1938, economist Paul Anthony Samuelson developed the theory of RPT to quantify the revealed preference theory of consumer behavior. Samuelson illustrated that if a person is given two commodities to choose from (A & B) and two combinations of these commodities (X & Y) with the same quality and price, the person will choose the combination (X) over (Y) because they prefer it.

The price line represents the customer's real income-price situation, and the consumer may choose any combination on or to the left of the price line, creating a choice triangle from which they can buy any goods. Consumers consider combinations on the price line equally desirable, deem combinations below the price line inferior, and consider those above the price line superior. The difference between the preferred and inferior zones is known as the ignorance zone.

In summary, RPT provides an essential framework for analyzing consumer behavior and understanding their preferences by examining their purchasing decisions at different prices and income levels.

Assumptions of revealed preference theory:

• Consumer tastes remain constant over time.
• The choices a consumer makes reveal their preferences.
• On a price-income line, the consumer selects only one combination.
• Consumers prefer larger sets of goods to smaller ones.
• Consumers have complete and transitive preferences, meaning that if A is preferred over B, and B is preferred over C, then A is preferred over C.
• Consumer behavior exhibits consistency over time.
• Consumers demand more goods as their income increases and less as their income decreases.
• A consumer will purchase more of a product if the price drops significantly.

Let us look into the diagrammatic representation of revealed preference theory:

The revealed preference theory is a way of understanding people's preferences based on their observable behavior, such as buying decisions. People often depict the theory graphically using a simple budget constraint diagram.

The diagram consists of two axes: the horizontal axis represents the quantity of one good, and the vertical axis represents the quantity of another good. The budget constraint is a straight line that shows all the combinations of the two goods that can occur with a given income level and the prices of the goods. The slope of the budget constraint represents the relative prices of the two goods.

The area under the budget constraint represents all the available feasible consumption bundles, given the income level and prices of the goods. Any point on the budget constraint represents a particular consumption bundle that exhausts the consumer's income. The area above the budget constraint represents unaffordable consumption bundles, given the income level and prices of the goods.

Overall, the revealed preference theory graph provides a visual representation of how consumers choose to allocate their limited income among different goods based on their preferences and the prices of the goods.

Despite its merits, like being realistic, scientific, consistent, and based on minimal assumptions, the revealed preference theory has faced some criticism. The limitations of RPT theory are the following:

• It does not account for the possibility of indifferences in consumer behavior.
• It fails to distinguish between the income and substitution effect of a price change.
• It only derives the demand curve of an individual and not the market demand curve.
• It considers the consumer behavior of only individuals governed by existing market conditions.
• RPT does not consider that consumers can choose from multiple combinations instead of only one.
• The choice made by the consumer does not necessarily reflect their true preference.
• Game theory becomes invalid under RPT.
• RPT tends to fail in risky or ambiguous situations.

This article has been a guide to what is Revealed Preference Theory. Here, we explain the topic with its diagram, assumptions, and limitations. You may also find some useful articles here -

• Comparative Advantage
• Utility Function
• Liquidity Preference Theory