CHAPTER 7 REVEALED PREFERENCES

The principle of revealed preference: Let (x1,x2) be the chosen bundle when prices are (p1,p2) and let
(y1,y2) be some other bundle such that p1x1+p2x2 (>=) p1y1+p2y2. Then if the consumer is choosing
the most preferred bundle she can afford, we must have (x1,x2)>(y1,y2).
Revealed preferred just means that X was chosen when Y was affordable; preference means that
the consumer ranks X ahead of Y.
Conclusion: If we observe that one bundle is chosen when another one is affordable, then we have
learned something about the preferences between the two bundles: namely, that the first is
preferred to the second.
Now suppose that we happen to know that (y1,y2) is a demanded bundle at prices (q1,q2) and that
(y1,y2) is itself revealed preferred to some other bundle (z1,z2). That is, q1y1 + q2y2 (>=) q1z1 +
q2z2. Then we know that (x1,x2)>(y1,y2) and that
(y1,y2)>(z1,z2). From the transitivity assumption we
can conclude that (x1,x2)>(z1,z2).It is natural to say
that in this case (x1,x2) is indirectly revealed
preferred to (z1,z2).
Conclusion: If a bundle is either directly or indirectly
revealed preferred to another bundle, we will say
that the first bundle is revealed preferred to the
second. We can conclude from these observations
that since (x1,x2) is revealed preferred either
directly or indirectly, to all of the bundles in the
shaded area(Y and Z).
Furthermore, we take into account these preferences in
order to determine the best policy to be applied by
examining consumer choices.
Thus, look at figure 7.3, we can conclude that all of the
bundles in the upper shaded area are better than X, and
all of the bundles in the lower shaded area are worse
X, according to the preferences of the consumer who
made the choice. The true indifference curve through X
must lie somewhere between the two shaded sets.

that
than

WEAK AXIOM OF REVEALED PREFERENCE

(WARP)
How can we tell if the consumer is following the maximizing model? What kind of observation would
lead us to conclude that the consumer was not maximizing? (model of consumer choice in an
unchanged environment). If the consumers are choosing the best things they can AFFORD, then
things that are affordable, but not chosen, must be worse than what is chosen.
Main statement: If (x1,x2) is directly revealed preferred to (y1,y2) and the two bundles are not
the same, then it cannot happen that (y1,y2) is directly revealed preferred to (x1,x2).

EXAMPLE OF WARP VIOLATION (FIGURE 7.4) A consumer who chooses both X and Y violates

WARP

STRONG AXIOM OF REVEALED PREFERENCE (SARP)

If (x1,x2) is revealed preferred to (y1,y2) (either directly or indirectly) and (y1,y2) is different
from (x1,x2), then (y1,y2) cannot be directly or indirectly revealed preferred to (x1,x2).
In order to be able to state that the consumer is optimizing his choice, it is a must that SARP is
consistent, otherwise we cannot obtain a utility function that represents consumer's preferences.
In this sense SARP is a sufficient condition for optimizing behavior: if the observed choice satisfy
SARP, then it is always possible to find preferences for which the observed behavior is optimizing
behavior. CONCLUSION: SARP is both a necessary and sufficient condition for observed choices
to be compatible with the economic model of consumer choice.

CHAPTER 8 SLUTSKY EQUATION

The case we want to consider in this chapter is how a consumer's choice of a good responds to changes
in its price.
Giffen good: example where the optimal demand for a good decreases when its price falls.

8.1 THE SUBSTITUTION EFFECT

When the price of a good changes, there are two sorts of effects: 1. the rate at which you can exchange
one good for another changes is altered, this modification is called the substitution effect 2. the total
purchasing power of your income is altered, this modification is called the income effect.
*Purchasing power: when you are able to buy more of a particular good with the same income or
budged your purchasing power has increased (a decrease in the price).
In order to find the change in demand, we will have to decompose into two pieces: The first step is the
pivot which is a movement where the slope of the budged line changes while its purchasing power
stays constant, while the second step consists of a movement where the slope remains constant
and the purchasing power changes.
m= x1 p1.This is the formula for the pivoted budged line: it is just the budget line at the new price
with income changed by ( (increment)) of m. Note that if the price goes down then the adjustment in
income will be negative. For instance, in this case when the price goes down, we need to decrease the
consumer's income in order to keep purchasing power fixed. Similarly, when a price goes up, a
consumer's purchasing power goes down, so the change to in income necessary to keep purchasing
power constant must be positive.
In figure 8.2 (page 140), although bundle (x1,x2)
is still affordable, it is not generally the optimal
purchase at the pivoted budged line. We have
denoted the optimal purchase on the pivoted budget
line by Y. The substitution effect is sometimes
called the change in compensated demand.
IMPORTANT: The pivot gives the substitution
effect, and the shift gives the income effect.
CALCULATING THE SUBSTITUTION
EFFECT.
Given the demand for milk (x1): It is also given m=
120$/week and the price of milk is 3$/quart.
x1= 10+ (m/10p1). Thus his demand for milk will be 14 quarts/week. Now suppose the price of milk
decrease to 2$ per quart. Then his demand at the new price will be 16 quarts. In order to calculate the
substitution effect we must calculate how much income would have to change in order to make the
original consumption of milk just affordable when the price of milk is 2$ quart. m=x1 p1.
m= 14 (2-3)= -14$. Thus the level necessary to keep purchasing power constant must be 106 (12014).
We compare the equation when we have plugged the different values of m and p1.
x1(p'1,m')= 10+ (106/(102))= 15.3.
Thus the substitution effect is X s = x1 (p1, m)- x1(p1, m)
x1 s = 15.3-14= 1.3

THE INCOME EFFECT

The second step is the shift of the budget line which is the movement that occurs when income changes
while relative prices remain constant. In figure 8.2, we simply change he consumer's income from m' to
m, keeping the prices constant at (p1', p2). In figure 8.2, this change moves us from the point (y1,y2) to
(z1,z2). As a matter of fact, the income effect, is the change in the demand for good 1 when we change
income from m' to m, holding the price of good 1 fixed at p'1.
If the good is a normal one, the decrease in income will lead to a decrease in demand. If the good is
an inferior good, then the decrease in income will lead to an increase in demand.
CALCULATING THE INCOME EFFECT Xn = x1(p1, m)- x1(p1, m)
x1 (p'1,m)= 16
x1 (p'1,m')=15.3
Thus the income effect for this problem is the difference between the previous calculations which
equals 0.7.
SIGN OF THE SUBSTITUTION EFFECT
If the price goes down, then the change in the demand for the good due to substitution must be
positive.
That is, p1> p'1, then we must have x1(p'1,m') (>=) x1(p1,m), so that the substitution effect must be
positive. If we consider the the pivoted budget line. The bundle X must be preferred to all of the
bundles on the part of the pivoted line that lies inside the original budget set. This means that the
optimal choice on the pivoted budget line must not be one of the bundles that lies underneath the
original budget line. In conclusion, the optimal choice on the pivoted line would have to be either
X or some point to the right of X (in this case we know that we would choose Y).
IMPORTANT STATEMENT: The substitution effect always moves opposite to the price
movement. We say that substitution effect is negative, since the change in the demand due to the
substitution effect is opposite to the change in price: if the price increases, the demand for the good
due to the substitution effect decreases.
THE TOTAL CHANGE IN DEMAND
The total change in demand equals the substitution effect plus the income effect. This equation is
called the Slutsky identity.
While the substitution effect must always be the opposite the change in the price, the income effect can
go either way. If we have a normal good, then the substitution effect and the income effect work in the
same direction: an increase in price means that demand will go down due to the substitution effect. If
the price goes up, it is like a decrease in income, which, for a normal good means a decrease in
demand.
If we have an inferior good, it might happen that the
income effect outweighs the substitution effect and it could
result in a positive change of the total demand.
CONCLUSION: this would mean that an increase in
prices could result in an increase in the total demand.
This is the case of the giffen good or the inferior good. The
slutsky identity shows wthat this kind of perverse effect
can only occur for inferior goods. Thus a giffen good
must be an inferior good. But an inferior good is not
necessarily a Giffen good: the income effect not only has
to be of the wrong sign, it also has to be large enough to

outweigh the right sign of the substitution effect. See figure 8.3page 145.
THE LAW OF DEMAND: If the demand for a good increases when income increases, then the
demand for that good must decrease when prices increase. This follows the slutsky equation: if the
demand increases when income increases, we have a normal good.
EXAMPLES OF INCOME AND SUBSTITUTION EFFECTS
PERFECT COMPLEMENTS: When we pivot the budget line around the chosen point, the optimal
choice at the new budget line is the same as at the old one, this means that the substitution effect is
zero. The change in demand is due entirely to the income effect. See figure 8.4
PERFECT SUBSTITUTES: Here the demand bundle jumps from the vertical axis to the horitzontal
axis. The entire change in demand is due to the substitution effect. See figure 8.5 page 149.
QUASILINEAR PREFERENCES: A shift in income causes no change in demand for good 1. This
means that the entire change in demand for good 1 is due to the substitution effect, and that the income
effect is zero. see figure 8.6

HICKS SUBSTITUTION EFFECT

Suppose that instead of pivoting the budget line around the original consumption bundle, we now roll
the budget line around the indifference curve through the original consumption bundle (figure 8.9). In
this way we present the consumer with a new budget line that has the same relative prices as the final
budget line but has different income. The purchasing power he has under this budget line will no
longer be sufficient to purchase his original bundle of goods- but it will be sufficient to purchase a
bundle that is just indifferent to his original bundle.
CONCLUSION: THE HICKS SUBSTITUTION EFFECT. Here we pivot the budget line around
the indifference curve rather than around the original choice.
Thus Hicks substitution effect keeps utility constant rather than keeping purchasing power constant.
IMPORTANT DIFFERENCE: the slutsky substitution effect gives the consumer just enough money to
get back his old level of consumption, while the Hicks substitution effect gives the consumer just
enough money to get back to his old indifference curve.