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Revealed Preference Theory: A Comprehensive Guide for Economists

Raymond Parker

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Published in Revealed Preference Theory (Econometric Society Monographs 56)

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In the 1930s, John Hicks and R.G.D. Allen developed a more rigorous version of revealed preference theory. They showed that Pareto's axioms could be used to construct a utility function that represents the consumer's preferences. This utility function can then be used to predict the consumer's choices in different situations.

Rationality: Consumers are assumed to be rational decision-makers who choose the best option from the set of available choices.
Transitivity: If a consumer prefers A to B and B to C, then they must also prefer A to C.
Completeness: Consumers can compare any two options and state which one they prefer.
Consistency: Consumers' choices are consistent over time and across different situations.

Indirect: This approach uses observed choices to infer the consumer's utility function. The utility function can then be used to predict the consumer's choices in other situations.
Direct: This approach uses observed choices to directly test the axioms of revealed preference theory. If the axioms are not satisfied, then the consumer's behavior is considered to be irrational.

Consumer demand: Revealed preference theory can be used to estimate consumer demand curves and predict how consumers will respond to changes in prices and incomes.
Welfare economics: Revealed preference theory can be used to measure consumer welfare and to evaluate the effects of government policies.
Other areas of microeconomics: Revealed preference theory has also been used to study topics such as oligopoly, game theory, and behavioral economics.

Assumptions: The assumptions of revealed preference theory are often unrealistic. For example, consumers may not always make rational choices or their preferences may not be transitive.
Data requirements: The indirect approach to revealed preference theory requires a large amount of data on consumer choices. This data can be difficult to collect and may not be reliable.
Predictive power: Revealed preference theory is not always able to accurately predict consumer behavior. This is because consumers' preferences can change over time or be influenced by factors that are not taken into account by the theory.

Despite these criticisms, revealed preference theory is a powerful tool for studying consumer behavior. It provides a rigorous framework for analyzing consumer choices and predicting how they will respond to changes in the economic environment.