# Revealed Preference Theory, Introduction and Graphical Representation

## Introduction

• Propounded by Paul Samuelson
• Ordinal utility analysis
• This theory analyses preference for a combination of goods on the basis of observed consumer behavior in the market.
• The demand theorem given by Samuelson, also known as the Fundamental theorem of consumption theory, states that a commodity that is known to have an increased demand when the income rises must have a decrease in demand when there is a rise in its price.
• In other words, when income elasticity of demand is positive, price elasticity of demand is negative.

## Choice Reveals Preference

• This theory of demand is based on the revealed preference hypothesis which states that choice reveals preference.
• According to this theorem, a consumer buys a combination of goods because of two reasons:
• Either the consumer likes the combination more than the other combinations even if it costs more,
• Or the combination is cheaper than the other combinations.

## Assumptions

• If a consumer chooses a combination, he reveals his preference for that combination.
• Tastes and preferences of the consumer are constant
• A consumer always prefers a combination with more goods than a combination with less goods.
• Only one combination is chosen at a given price-income line.
• Based on strong ordering.
• If A is preferred to B in one situation, combination B cannot be preferred to A in another situation. Therefore, the consumer is consistent in his behavior. This is called two-term consistency.
• If combination A is preferred to B, and B is preferred to C, then A is assumed to be preferred to C. This is known as transitivity or three-term consistency.
• The income elasticity of demand is positive, that is, when the income of the consumer rises, he demands more of the commodity and vice-versa.

## Demand Theorem in Case of Rise and Fall in Price

• We will now analyze the demand theorem in two cases:
• when price rises,
• and when price falls.
• We will assume that there are two commodities, X and Y.

## Mcqs

Q. 1. Who propounded the revealed preference theory?

1. Milton Friedman
2. Paul Krugman
3. Paul Samuelson

D. Kenneth Arrow

Q. 2. When income elasticity of demand is positive, the price elasticity of demand is:

A. Negative

B. Positive

C. Not correlated

D. None of the above

Q3. Which of the following is an assumption of the revealed preference theory?

A. A consumer will always choose a combination with less goods as opposed to a combination with more goods.

B. If a consumer chooses combination X in one situation, he may choose other combinations such as Y or Z in other situations.

C. If combination A is preferred to B and B is preferred to C, combination A is assumed to be preferred to C.

D. The income elasticity of demand is negative.

Q. 4. . Revealed preference theory assumes

A. Weak ordering

B. Strong ordering

C. Constant ordering

D. Multiple ordering