Question

Write a short note on the revealed preference theory.

Short answer

Answer: The key principles underlying revealed preference theory are the Weak Axiom of Revealed Preference (WARP), the Strong Axiom of Revealed Preference (SARP), and the Independence of Irrelevant Alternatives (IIA).

Step-by-step solution

Introduction of Revealed Preference Theory

Revealed preference theory was developed by economist Paul Samuelson to understand consumer behavior in a market. It is based on the concept that an individual's preference for goods and services can be inferred from the choices they make in various situations, rather than asking them directly about their preferences.

Assumptions of Revealed Preference Theory

There are two main assumptions behind this theory: 1. Consumers are rational: This means that individuals make choices that maximize their satisfaction or utility, within their budget constraints. 2. Preferences are consistent and transitive: This means that if an individual prefers A over B, and B over C, they will also prefer A over C.

Principles of Revealed Preference Theory

There are three key principles that underlie this theory: 1. Weak Axiom of Revealed Preference (WARP): If an individual chooses A over B when both are available, they reveal a preference for A over B. If their preferences are consistent, they should not choose B over A when both are available in the future. 2. Strong Axiom of Revealed Preference (SARP): This extends WARP by considering all possible options in a choice set. If an individual chooses A over all other options in a choice set, it reveals a strong preference for A. In this case, the individual should never choose any other option when A is available. 3. Independence of Irrelevant Alternatives (IIA): If an individual's preferences between two options, A and B, are inferred from their choice behavior, these preferences should not change due to the introduction of a third option, C. In other words, an individual's preference between A and B should be independent of the presence of C in the choice set.

Applications of Revealed Preference Theory

Revealed preference theory has several applications in economics, including: 1. Consumer demand analysis: The theory can be used to estimate the demand for goods and services based on the observed choices of consumers in the market. 2. Evaluation of public goods and services: Revealed preference methods can be used to estimate the value of public goods and services, such as environmental quality, parks, and public transportation, based on individuals' behavior and choices related to these goods and services. 3. Welfare analysis: By understanding individuals' preferences, economists can conduct welfare analysis to evaluate the impact of policies and interventions on overall well-being. 4. Market research: Revealed preference analysis can inform market research for businesses by providing insights into consumer preferences and helping predict responses to changes in product offerings or pricing strategies.