• Chapter 7 Revealed Preference

• Economists infer from choices a lot!

free money on the floor
my new office

• Before, from w to choice

• now from choice to w
• this has policy content: household,
university
Choices
• Chapter 7 Revealed Preference

• Key Concept: what does choice reveal

about preferences?

• The weak axiom of revealed preference

(WARP)

• The strong axiom of revealed preference

(SARP)
• Some maintained assumptions

• A1: The consumer’s preferences are

stable over the time period for which we
observe his/her choice behaviors.

• A2: There exists a unique demanded

bundle for each budget set (easy to relax).

• A3: The consumer is always choosing the

best s\he can afford (model of behavior).
• If (x1, x2) is chosen at (p1, p2, m),
(y1, y2)≠ (x1, x2) and p1y1+p2 y2≤m,
then (x1, x2) is directly revealed preferred
to (y1, y2).
• Denote this by (x1, x2) d (y1, y2).

• d is solely about choices though choices

are related to preferences.
• (x1, x2) d (y1, y2).

• d is solely about choices though choices

are related to preferences.
• From revealed preference (d) to
preference (w)

• Suppose (x1, x2) d (y1, y2) and the

consumer is choosing the best s\he can
afford, then (x1, x2) s (y1, y2).
• The weak axiom of revealed preference
(WARP)

• If (x1, x2) d (y1, y2), then it cannot happen

that (y1, y2) d (x1, x2).
• WARP is a weak and logical implication
of consumers’ maximizing behaviors.

• An example
observation p1 p2 x1 x2

1 1 2 1 2

2 2 1 2 1

3 1 1 2 2
 Bundles

1 2 3

1 5 4* 6

Prices 2 4* 5 6

3 3* 3* 4
• If (x1, x2) d (y1, y2) and (y1, y2) d (z1, z2),
then we say that (x1, x2) is indirectly
revealed preferred to (z1, z2).

• Denote this by (x1, x2) id (z1, z2).

• Allow indirect revealed preference for

“chains” of observed choices longer than
3.
• If either (x1, x2) d (y1, y2) or (x1, x2) id (y1,
y2), we say (x1, x2) is revealed preferred to
(y1, y2).

• Denote this by (x1, x2) r (y1, y2).

• Give an example to recover preferences.

• How do we know whether the consumer

is maximizing if we only observe choices?
• We are questioning A3 (the idea is A1
and A2 are OK).
• The strong axiom of revealed preference
(SARP)

• If (x1, x2) r (y1, y2), then it cannot

happen that (y1, y2) r (x1, x2).
• SARP is a necessary and sufficient
condition for optimizing behavior,
but the proof is beyond the scope of
this course.

• Sufficiency: If choices satisfy SARP,

then we can construct preferences for
which the observed behavior is
optimizing.
 bundles

1 2 3

1 20 10* 22(**)

prices 2 21(**) 20 15*

3 9* 15(**) 10
• Index numbers
• Compare the consumption bundles of a
consumer at two different times.
• Let b stand for the base period.
• Let t stand for some other period.

• At t: prices (p1t, p2t), consumption (x1t, x2t)

• At b: prices (p1b, p2b), consumption (x1b,
x2b)
• Quantity index: compare the average
consumption of these two periods,
naturally could use the prices to be the
weights
• Laspeyres quantity index (use base price):
Lq=(p1b x1t + p2b x2t)/(p1b x1b + p2b x2b), if
Lq<1, at base price, base is chosen over t,
so better off at base than at t (Lq>1?)
• Paasche quantity index (use t price):
Pq=(p1t x1t + p2t x2t)/(p1t x1b + p2t x2b), if
Pq>1, at t price, t is chosen over base, so
better off at t than at base (Pq<1?)
• Price index: compare the average price of
these two periods, naturally could use the
quantities to be the weights
• Laspeyres price index (use base q):
Lp=(p1t x1b + p2t x2b)/(p1b x1b + p2b x2b)
(wage adjustment)
if Lp<1 (says nothing since prices
different)
• Paasche price index (use time q):
Pp=(p1t x1t + p2t x2t)/(p1b x1t + p2b x2t) (GDP deflator)
• Define a new index of the change in total
expenditure M=(p1t x1t + p2t x2t)/(p1b x1b +
p2b x2b).
• Lp<M: p1t x1b + p2t x2b <p1t x1t + p2t x2t, t
period is better than base (intuitively,
when income grows faster than prices,
better off after this change)
• Pp>M: p1b x1b + p2b x2b> p1b x1t + p2b x2t,
base is better than t (intuitively, when
prices grow faster than income, worse off)
• Social security: indexing so that base
consumption is still affordable, then t
cannot be worse than base
• Chapter 7 Revealed Preference

• Key Concept: what does choice reveal

about preferences?

• The weak axiom of revealed preference

(WARP)

• The strong axiom of revealed preference

(SARP)