molly w. dahl georgetown university econ 101 – spring 2009
DESCRIPTION
Revealed Preference Analysis Suppose we observe the demands (consumption choices) that a consumer makes for different budgets. This reveals information about the consumer’s preferences. We can use this information to Test the behavioral hypothesis that a consumer chooses the most preferred bundle from those available. Discover the consumer’s preference relation.TRANSCRIPT
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Revealed Preference
Molly W. DahlGeorgetown UniversityEcon 101 – Spring 2009
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Revealed Preference Analysis
Suppose we observe the demands (consumption choices) that a consumer makes for different budgets. This reveals information about the consumer’s preferences. We can use this information to Test the behavioral hypothesis that a consumer
chooses the most preferred bundle from those available.
Discover the consumer’s preference relation.
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Assumptions on Preferences Preferences
do not change while the choice data are gathered.
are strictly convex.are monotonic.
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Assumptions on Preferences
x2
x1x1*
x2*
If preferences are strictly convex and monotonic then the most preferredaffordable bundle is unique.
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Direct Preference Revelation
Suppose that the bundle x* is chosen when the bundle y is affordable. Then x* is revealed directly as preferred to y (otherwise y would have been chosen).
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Direct Preference Revelation
x2
x1
x*
y
The chosen bundle x* isrevealed directly as preferredto the bundles y and z.
z
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Direct Preference Revelation
That x is revealed directly as preferred to y will be written as x DRP y.
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Indirect Preference Revelation Suppose x is revealed directly preferred
to y, and y is revealed directly preferred to z. Then, by transitivity, x is revealed indirectly as preferred to z. Write this as x IRP z
so x DRP y and y DRP z x IRP z.
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Indirect Preference Revelation
x2
x1
x*
z
z is not affordable when x* is chosen.
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Indirect Preference Revelation
x2
x1
x*y*
z
x* is not affordable when y* is chosen.
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z is not affordable when x* is chosen.x* is not affordable when y* is chosen. So x* and z cannot be compared directly.
Indirect Preference Revelation
x2
x1
x*y*
z
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z is not affordable when x* is chosen.x* is not affordable when y* is chosen. So x* and z cannot be compared directly.
Indirect Preference Revelation
x2
x1
x*y*
zBut x* DRP y*and y* DRP z so x* IRP z.
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Two Axioms of Revealed Preference
To apply revealed preference analysis, choices must satisfy two criteria -- the Weak and the Strong Axioms of Revealed Preference.
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The Weak Axiom of Revealed Preference (WARP)
If the bundle x is revealed directly as preferred to the bundle y then it is never the case that y is revealed directly as preferred to x; i.e.
x DRP y not (y DRP x).
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The Weak Axiom of Revealed Preference (WARP) Choice data which violate the WARP are
inconsistent with economic rationality. The WARP is a necessary condition for
applying economic rationality to explain observed choices.
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The Weak Axiom of Revealed Preference (WARP)
What choice data violate the WARP?
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The Weak Axiom of Revealed Preference (WARP)x2
x1
xy
x is chosen when y is availableso x DRP y.
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The Weak Axiom of Revealed Preference (WARP)x2
x1
xy These statements are
inconsistent with each other.
x is chosen when y is availableso x DRP y.
y is chosen when x is availableso y DRP x.
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Checking if Data Violate the WARP A consumer makes the following
choices:At prices (p1,p2)=($2,$2) the choice was
(x1,x2) = (10,1).At (p1,p2)=($2,$1) the choice was (x1,x2)
= (5,5).At (p1,p2)=($1,$2) the choice was (x1,x2)
= (5,4). Is the WARP violated by these data?
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Checking if Data Violate the WARP
ChoicesPrices (10, 1) (5, 5) (5, 4)
($2, $2) $22 $20 $18
($2, $1) $21 $15 $14
($1, $2) $12 $15 $13
Red numbers are costs of chosen bundles.
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Checking if Data Violate the WARP
ChoicesPrices (10, 1) (5, 5) (5, 4)
($2, $2) $22 $20 $18
($2, $1) $21 $15 $14
($1, $2) $12 $15 $13
Circles surround affordable bundles thatwere not chosen.
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Checking if Data Violate the WARP
( 1 0 , 1 ) ( 5 , 5 ) ( 5 , 4 )
( 1 0 , 1 ) D D
( 5 , 5 ) D
( 5 , 4 ) D
Ch o i c e s P r i c e s ( 1 0 , 1 ) ( 5 , 5 ) ( 5 , 4 )
( $ 2 , $ 2 ) $ 2 2 $ 2 0 $ 1 8
( $ 2 , $ 1 ) $ 2 1 $ 1 5 $ 1 4
( $ 1 , $ 2 ) $ 1 2 $ 1 5 $ 1 3
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Checking if Data Violate the WARP
( 1 0 , 1 ) ( 5 , 5 ) ( 5 , 4 )
( 1 0 , 1 ) D D
( 5 , 5 ) D
( 5 , 4 ) D
(10,1) is directlyrevealed preferredto (5,4), but (5,4) isdirectly revealedpreferred to (10,1),so the WARP isviolated by the data.
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Checking if Data Violate the WARP
(5,4) DRP (10,1)
(10,1) DRP (5,4)
x1
x2
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The Strong Axiom of Revealed Preference (SARP)
If the bundle x is revealed (directly or indirectly) as preferred to the bundle y and x y, then it is never the case that the y is revealed (directly or indirectly) as preferred to x; i.e. x DRP y or x IRP y
not ( y DRP x or y IRP x ).
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The Strong Axiom of Revealed Preference
What choice data would satisfy the WARP but violate the SARP?
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The Strong Axiom of Revealed Preference
Consider the following data:
A: (p1,p2,p3) = (1,3,10) & (x1,x2,x3) = (3,1,4)
B: (p1,p2,p3) = (4,3,6) & (x1,x2,x3) = (2,5,3)
C: (p1,p2,p3) = (1,1,5) & (x1,x2,x3) = (4,4,3)
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The Strong Axiom of Revealed Preference
ChoicePrices A B C
A $46 $47 $46
B $39 $41 $46
C $24 $22 $23
A: ($1,$3,$10) (3,1,4).
B: ($4,$3,$6) (2,5,3).
C: ($1,$1,$5) (4,4,3).
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The Strong Axiom of Revealed Preference
ChoicesPrices A B C
A $46 $47 $46
B $39 $41 $46
C $24 $22 $23
A B C
A D
B D
C D
The data do not violate the WARP.
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The Strong Axiom of Revealed Preference
A B C
A D
B D
C D
The data do not violate the WARP but ...
We have thatA DRP C, B DRP A and C DRP B
so, by transitivity,A IRP B, B IRP C and C IRP A.
I
I
I
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The Strong Axiom of Revealed Preference
A B C
A D
B D
C D
I
I
I
B DRP A is inconsistent
with A IRP B.
The data do not violate the WARP but ...
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The Strong Axiom of Revealed Preference
A B C
A D
B D
C D
I
I
I
The data do not violatethe WARP but there are3 violations of the SARP.
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The Strong Axiom of Revealed Preference
That the observed choice data satisfy the SARP is a condition necessary and sufficient for there to be a well-behaved preference relation that “rationalizes” the data.
So our data cannot be rationalized by a well-behaved preference relation.
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Recovering Indifference Curves
Suppose we have the choice data satisfy the SARP.
Then we can discover approximately where are the consumer’s indifference curves.
How?
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Recovering Indifference Curves
Suppose we observe:A: (p1,p2) = ($1,$1) & (x1,x2) = (15,15)B: (p1,p2) = ($2,$1) & (x1,x2) = (10,20)C: (p1,p2) = ($1,$2) & (x1,x2) = (20,10)D: (p1,p2) = ($2,$5) & (x1,x2) = (30,12)E: (p1,p2) = ($5,$2) & (x1,x2) = (12,30).
Where lies the indifference curve containing the bundle A = (15,15)?
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Recovering Indifference Curves
The table showing direct preference revelations is:
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Recovering Indifference Curves
Direct revelations only; the WARPis not violated by the data.
A B C D EA D DBCD D D DE D D D
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Recovering Indifference Curves
In this example, indirect preference revelations add no extra information. The table showing both direct and indirect preference revelations is the same as the table showing only the direct preference revelations:
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Recovering Indifference CurvesA B C D E
A D DBCD D D DE D D D
Both direct and indirect revelations; neitherWARP nor SARP are violated by the data.
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Recovering Indifference Curves
Since the choices satisfy the SARP, there is a well-behaved preference relation that “rationalizes” the choices.
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Recovering Indifference Curvesx2
x1
A
B
E
C D
A: (p1,p2)=(1,1); (x1,x2)=(15,15)B: (p1,p2)=(2,1); (x1,x2)=(10,20)C: (p1,p2)=(1,2); (x1,x2)=(20,10)D: (p1,p2)=(2,5); (x1,x2)=(30,12)E: (p1,p2)=(5,2); (x1,x2)=(12,30).
Begin with bundles revealedto be less preferred than bundle A.
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Recovering Indifference Curvesx2
x1
A
A: (p1,p2)=(1,1); (x1,x2)=(15,15).
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Recovering Indifference Curvesx2
x1
A
A: (p1,p2)=(1,1); (x1,x2)=(15,15).
A is directly revealed preferredto any bundle in
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Recovering Indifference Curvesx2
x1
A
B
E
C D
A: (p1,p2)=(1,1); (x1,x2)=(15,15)B: (p1,p2)=(2,1); (x1,x2)=(10,20).
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Recovering Indifference Curvesx2
x1
A
B
A: (p1,p2)=(1,1); (x1,x2)=(15,15)B: (p1,p2)=(2,1); (x1,x2)=(10,20).
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Recovering Indifference Curvesx2
x1
A
B
A is directly revealed preferredto B and …
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Recovering Indifference Curvesx2
x1
B
B is directly revealed preferredto all bundles in
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Recovering Indifference Curvesx2
x1
B
so, by transitivity, A is indirectlyrevealed preferred to all bundles in
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Recovering Indifference Curvesx2
x1
B
so A is now revealed preferredto all bundles in the union.
A
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Recovering Indifference Curvesx2
x1
A
B
E
C D
A: (p1,p2)=(1,1); (x1,x2)=(15,15)
C: (p1,p2)=(1,2); (x1,x2)=(20,10).
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Recovering Indifference Curvesx2
x1
A C
A: (p1,p2)=(1,1); (x1,x2)=(15,15)
C: (p1,p2)=(1,2); (x1,x2)=(20,10).
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Recovering Indifference Curvesx2
x1
A C
A is directly revealedpreferred to C and ...
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Recovering Indifference Curvesx2
x1
C
C is directly revealed preferredto all bundles in
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Recovering Indifference Curvesx2
x1
C
so, by transitivity, A isindirectly revealed preferredto all bundles in
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Recovering Indifference Curvesx2
x1
C
so A is now revealed preferredto all bundles in the union.
BA
Therefore the indifferencecurve containing A must lie everywhere else above this shaded set.
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Recovering Indifference Curves
Now, what about the bundles revealed as more preferred than A?
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Recovering Indifference Curvesx2
x1
A
B
E
C D
A: (p1,p2)=(1,1); (x1,x2)=(15,15)B: (p1,p2)=(2,1); (x1,x2)=(10,20)C: (p1,p2)=(1,2); (x1,x2)=(20,10)D: (p1,p2)=(2,5); (x1,x2)=(30,12)E: (p1,p2)=(5,2); (x1,x2)=(12,30).A
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Recovering Indifference Curvesx2
x1
D
A: (p1,p2)=(1,1); (x1,x2)=(15,15)
D: (p1,p2)=(2,5); (x1,x2)=(30,12).
A
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Recovering Indifference Curvesx2
x1
D
D is directly revealed preferredto A.
A
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Recovering Indifference Curvesx2
x1
D
D is directly revealed preferredto A.Well-behaved preferences areconvex
A
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Recovering Indifference Curvesx2
x1
D
D is directly revealed preferredto A.Well-behaved preferences areconvex so all bundles on the line between A and D are preferred to A also.A
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Recovering Indifference Curvesx2
x1
D
D is directly revealed preferredto A.Well-behaved preferences areconvex so all bundles on the line between A and D are preferred to A also.A
As well, ...
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Recovering Indifference Curvesx2
x1
D
all bundles containing thesame amount of commodity 2and more of commodity 1 thanD are preferred to D and therefore are preferred to A also.A
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x1
DA
bundles revealed to be strictly preferred to A
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x1
A
B
E
C D
A: (p1,p2)=(1,1); (x1,x2)=(15,15)B: (p1,p2)=(2,1); (x1,x2)=(10,20)C: (p1,p2)=(1,2); (x1,x2)=(20,10)D: (p1,p2)=(2,5); (x1,x2)=(30,12)E: (p1,p2)=(5,2); (x1,x2)=(12,30).A
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Recovering Indifference Curvesx2
x1
A
E
A: (p1,p2)=(1,1); (x1,x2)=(15,15)
E: (p1,p2)=(5,2); (x1,x2)=(12,30).
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Recovering Indifference Curvesx2
x1
A
E
E is directly revealed preferredto A.Well-behaved preferences areconvex so all bundles on the line between A and E are preferred to A also.
As well, ...
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Recovering Indifference Curvesx2
x1
A
E
all bundles containing thesame amount of commodity 1and more of commodity 2 thanE are preferred to E and therefore are preferred to A also.
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Recovering Indifference Curvesx2
x1
A
EMore bundles revealed to be strictly preferred to A
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Recovering Indifference Curvesx2
x1
A
B
C
E
D
Bundles revealedearlier as preferredto A
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Recovering Indifference Curvesx2
x1
B
C
E
D
All bundles revealedto be preferred to A
A
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Recovering Indifference Curves
Now we have upper and lower bounds on where the indifference curve containing bundle A may lie.
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Recovering Indifference Curvesx2
x1
All bundles revealedto be preferred to A
A
All bundles revealed to be less preferred to A
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Recovering Indifference Curvesx2
x1
The region in which the indifference curve containing bundle A must lie.
A