Revealed Preference Theory of Consumer Behavior (RPT)

Revealed Preference Theory(RPT)

The Revealed Preference Theory (RPT) was developed by Paul Samuelson as an alternative to the earlier theories of consumer behavior, such as the Cardinal Approach and Ordinal Approach. Samuelson criticized them for being introspective, and they do not consider the actual preference of the consumer, but rather, they are based on the stated preference. So, these theories can not explain the real-world behavior of the consumer.

According to Samuelson, the consumer reveals his/her preference in the market, and to study the behaviour of consumers, we have to observe the actual behavior of the consumer in the real market. As the consumer is rational, he/she selects the bundle that maximises utility under the given condition. So, whichever bundle the consumer selects is the utility-maximising bundle, and the rest of the other bundles that are available and affordable are inferior to the selected bundle.

This theory is said to be a BREAKTHROUGH in consumer behavior analysis (demand analysis) due to the following reasons:

1. It is more realistic than the earlier theories of demand analysis because it observes the actual behavior of consumers.
2. It is pragmatic because we can use the actual data from the market to study consumer behavior and demand analysis.
3. It is behavioristic and not based on assumptions or stated preferences, and observes the actual behavior.
4. It is more scientific and objective by avoiding the researcher’s behavior in studying consumer behavior, because we observe the actual behavior.
5. This theory can be tested empirically by using the actual data from the market, without relying on specific assumptions.
6. It is less restrictive in terms of the assumptions and conditions to explain the consumer’s equilibrium or behavior.

Basic Assumptions of RPT

1. Rationality: Prefers more to less
2. Consistency (weak preference axiom – WPA): two choices A and B are said to be consistent if A>B, then A≠B
3. Transitivity (strong preference axiom – SPA): three choices A, B, and C are said to be transitive if A>B, B>C, then A>C.
4. Revealed preference axiom: Whatever the consumer selects out of different alternatives that are affordable as well, the selected bundle is a utility-maximizing bundle, and it is the axiom.

Consumer Equilibrium Under RPT

Under this theory, we have to observe the consumer’s actual choice in the market in order to know the equilibrium bundle of the commodities. So, by simply observing the consumer’s choice in the real market, we can explain the consumer’s equilibrium.

To explain this, consider X and Y are two commodities with respective prices Px and Py, and M is the money income of the consumer. Then, the consumer spends this income on X and Y commodities in such a way that the particular bundle of X and Y maximizes utility.

Here,

AB is the initial budget line of the consumer, which shows that the consumer can select any bundle on or below this budget line. Since the consumer is rational, he/she can select any bundle within the budget line. In order to find the consumer’s choice, we have to visit the market and observe his/her selection.

Assume that the consumer is found to be selected E* bundle, which means it is the utility-maximizing bundle, and the rest of the other bundles on the budget line AB or below it are inferior to E*. So, E* is the equilibrium point which represents the utility maximizing bundle where OX* quantity of X and OY* quantity of Y are the utility maximizing quantities.

Therefore, under the Revealed Preference Theory, we observe the actual behavior of the consumer in the market where the consumer reveals his/her preference by selecting a particular bundle. The selected bundle is utility maximizing, and the rest of the others available and affordable bundles are inferior to the selected bundle.

Decomposition of PE into SE, IE using RPT

Normal Goods, Price Decrease

By observing the actual behavior of the consumer under different price and income situations, we can decompose the PE into SE and IE. To explain this, assume that X and Y are two commodities and the price of a normal commodity declines.

Here, AB is the initial budget line, which shows that the consumer can select any bundle on or below this budget line. Being a rational consumer, he/she does not select any bundle below the budget line, which means the consumer selects any bundle on this budget line AB.

Assume that the consumer is found to be selecting bundle E1 in the market, which OX1 quantity of X. It means E1 is the utility-maximizing bundle, and the rest of the others on the budget line AB or below it are inferior to the consumer.

Now, assume that the price of the X declines, and so the budget line swings outward to AC, and in this new budget line, the consumer is observed to be selecting E2. This movement from E1 to E2 is the Price Effect.

i.e. PE =  X1X2

In order to decompose this PE into SE and IE, we have to keep the real income constant, and we follow the Slutskey Method. So, we impose tax in this case in such a way that the budget line after tax is A`C` passing through the initial equilibrium point E1 and parallel to the new budget line AC. In this case, the consumer is found to be selecting the E3 bundle, implying that if real income is kept constant, then the consumer selects the E3 bundle. This movement from E1 to E3 is the Substitution Effect (SE).

i.e. SE = X1X3

If we refund the tax amount, then the consumer moves from E3 to E2, which is Income Effect (IE).

i.e. IE = X3X2

Therefore, the price effect consists of SE and IE, which can also be found by simply observing the actual behavior of the consumer in the real market under different price and income situations.

Giffen Goods, Price Increase