Pioneered by American economist Paul Samuelson (1915- ), revealed preference theory is a method by which it is possible to discern the best possible option on the basis of consumer behaviour. Essentially, this means that the preferences of consumers can be revealed by their purchasing habits. Revealed preference theory came about because the theories of consumer demand were based on a diminishing MRS (marginal rate of substitution). This diminishing MRS is based on the assumption that consumers make consumption decisions based on their intent to maximize their utility. While utility maximization was not a controversial assumption, the underlying utility functions could not be measured with great certainty. Revealed preference theory was a means to reconcile demand theory by creating a means to define utility functions by observing behavior.

Theory

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If a person chooses a certain bundle of goods (ex. 2 apples, 3 bananas) while another bundle of goods is affordable (ex. 3 apples, 2 bananas), then we say that the first bundle is revealed preferred to the second. It then follows that the first bundle of goods is always preferred to the second. Therefore if the consumer ever purchases the second bundle of goods then it must be the case that the first bundle is unaffordable. Further theory states that preferences are transitive. In other words if we have bundles A, B, C, ...., Z, and A is revealed preferred to B which is revealed preferred to C and so on then it can be concluded that A is revealed preferred to C through Z. With this theory economists can chart indifference curves which adhere to already developed models of consumer theory.

References

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Nicholson, W. (2005) Microeconomics, Thomson, Southwestern.

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