revealed preference theory

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Fig. 172 Revealed preference theory.

revealed preference theory

an explanation for an individual consumer's downward-sloping DEMAND CURVE, requiring the consumer to reveal what his preferences are in given sets of circumstances. The preferences given may be between two or more goods, but where more than two goods exist, money is taken to represent all other goods for ease of graphical analysis, as in Fig. 172.

If a consumer decides that he prefers a combination of money (OM1) and good X (OX1), he will be at point a on the BUDGET LINE (or relative price line) MX. If good X becomes cheaper, so more can be had, his real income increases and he can move to budget line MX2. The combination of goods the consumer prefers is now at, say, b.

However, not all the change is due to increasing real income caused by the fall in the price of good X. Some of it is due to the substitution of the now cheaper good X for others, and this effect is always positive, that is, it is not possible to purchase less of the now cheaper good X after the change to MX2, than when on the budget line MX.

If the consumer's new configuration of goods at b is reduced proportionately, by introducing a hypothetical decrease in income in the form of an inward parallel shift of the budget line to position M2 X3, then the consumer will choose a new position, say, point c; the SUBSTITUTION EFFECT is from X1 to X5, while X5 to X4 is the INCOME EFFECT. See CONSUMER EQUILIBRIUM, INDIFFERENCE CURVE, PRICE EFFECT.