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Revealed preference approach for Managerial Economics Mcom Delhi University

Revealed preference approach for Managerial Economics Mcom Delhi University

Revealed preference approach for Managerial Economics Mcom Delhi University

Revealed preference theory, pioneered by American economist Paul Samuelson,[1] is a method of analyzing choices made by individuals, mostly used for comparing the influence of policies on consumer behavior. These models assume that the preferences of consumers can be revealed by their purchasing habits. Revealed preference theory came about because existing theories of consumer demand were based on a diminishing marginal rate of substitution (MRS). This diminishing MRS relied on the assumption that consumers make consumption decisions 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 defining utility functions by observing behavior.

Revealed preference approach for Managerial Economics Mcom Delhi University

Managerial Economics: Demand Analysis

Demand Demand is the quantity of good and services that customers are willing and able to purchase during a specified period under a given set of economic conditions. The period here could be an hour, a day, a month, or a year. The conditions to be considered include the price of good, consumer’s income, the price of the related goods, consumer’s preferences, advertising expenditures and so on. The amount of the product that the customers are willing to buy, or the demand, depends on these factors. There are two types of demand. The first of these is called direct demand. This model of demand analysis individual demand for goods and services that directly satisfy consumers desires. The prime determinant of direct demand is the utility gained by consumption of goods and services. Consumers budget, product characteristics, individuals preferences are all important determinants of direct demand. The other type of demand is called derived demand. Derived demand is the demand resulting from the need to provide the final goods and services to the consumers. Intermediate goods, office machines are examples of derived demand. An other good example is mortgage credit. Mortgage credit demand is not demanded directly, but derived from the demand for housing.

Market demand function The market demand function for a product is a function showing the relation between the quantity demanded and the factors affecting the quantity of demand. A demand function for the good X can be expressed as follows: Quantity of product X demanded = Qx = f (the price of X, prices of related goods, expectations of price changes, income, preferences, advertising expenditures and so on. ) For use in managerial decision making, the relation between quantity of demand and each demand determining variable must be specified.

Demand Curve The demand function specifies the relation between the quantity demanded and all factors that determine demand. But the demand curve expresses the relation between the price of a product and the quantity demanded, holding constant all the other factors affecting demand.

Revealed preference approach for Managerial Economics Mcom Delhi University

1. Neglects Indifference:

It neglects “indifference” in the consumer behaviour altogether. It is, of course, true that the consumer does not reveal his indifference in a single-valued demand function in or on the budget line when he chooses a particular set of goods.

Revealed preference approach for Managerial Economics Mcom Delhi University

2. Not Possible to Separate Substitution Effect:

Samuelson’s Fundamental Theorem is conditional and not universal. It is based on the postulate that positive income elasticities imply negative price elasticities. Since the price effect consists of the income and substitution effects, it is not possible to isolate the substitution effect from the income effect on the level of observation. If the income effect is not positive, price elasticity of demand is indeterminate. On the other hand, if the income elasticity of demand is positive, the substitution effect following a change in price cannot be established. Thus, the substitution effect cannot be distinguished from the income effect in the Samuelsonian Theorem.

3. Excludes Giffen Paradox:

Samuelson’s revealed preference hypothesis excludes the study of the Giffen Paradox, for it considers only positive income elasticity of demand. Like the Marshallian Law of Demand, the Samuelsonian Theorem fails to distinguish between negative income effect of a Giffen good combined with a weak substitution effect and a negative income effect with a powerful substitution effect. Samuelson’s Fundamental Theorem is, therefore, inferior to and less integrated than the Hicksian price effect which provides an all inclusive explanation of the income effect, the substitution effect and of Giffen’s Paradox.

4. Consumer does not choose only one Combination:

The assumption that the consumer chooses only one combination on a given price-income situation is incorrect. It implies that the consumer chooses something of everything of both the goods. But it is seldom that anybody purchases something of everything.

Revealed preference approach for Managerial Economics Mcom Delhi University

5. Choice does not reveal Preference:

The assumption that “choice reveals preference” has also been criticised. Choice always does not reveal preference. Choice requires rational consumer behaviour. Since a consumer does not act rationally at all times, his choice of a particular set of goods may not reveal his preference for that. Thus the theorem is not based on observed consumer behaviour in the market.

6. Fails to derive Market Demand Curve:

The revealed preference approach is applicable only to an individual consumer. Negatively inclined demand curves can be drawn for each consumer with the help of this approach by assuming ‘other things remaining the same.’ But this technique fails to help in drawing market demand schedules.

7. Not Valid for Game Theory:

According to Tapas Majumdar, the revealed preferences hypothesis “is invalid for situations where the individual choosers are known to be capable of employing strategies of a game theory type.”

8. Fails in Risky or Uncertain Situations:

The revealed preference theory fails to analysis consumer’s behaviour in choices involving risk or uncertainty. If there are three situations, A, B, and C, the consumer prefers A to В and С to A. Out of these, A is certain but chances of occurring В or С are 50-50. In such a situation, the consumer’s preference for С over A cannot be said to be based on his observed market behaviour.

Conclusion:

It appears from the above discussion that the revealed preference approach is in no way an improvement over the indifference curve analysis of Hicks and Allen. It is unable to isolate the substitution effect from the income effect, neglects Giffen’s Paradox and fails to study market demand analysis. But the fact is that in a single-valued demand function, the indifferent behaviour is replaced by the observed market behaviour of the consumer. This makes the revealed preference theory somewhat more realistic than the indifference curve technique.

Recommended Mcom Notes

M. Com. (Part-I)

M. Com. (Part-II)

Revealed preference approach for Managerial Economics Mcom Delhi University

Superiority of Revealed Preference Theory:

The revealed preference approach is superior to the Hicksian ordinal utility approach to consumer behaviour.

(i) It does not involve any psychological introspective information about the behaviour of the consumer. Rather, it presents a behaviouristic analysis based on observed consumer behaviour in the market. This approach has helped, according to Samuelson, to divest the theory of demand of the “last vestiges” of the psychological analysis. Thus the revealed preference hypothesis is more realistic, objective and scientific than the earlier demand theorems.

(ii) It avoids the “continuity” assumption of the utility and indifference curve approaches. An indifference curve is a continuous curve on which the consumer can have any combination of the two goods. Samuelson believes that there is discontinuity because the consumer can have only one combination.

(iii) The Hicksian demand analysis is based on the assumption that the consumer always behaves rationally to maximise his satisfaction from a given income. Samuelson’s demand theorem is superior because it completely dispenses with the assumption that the consumer always maximises his satisfaction, and makes no use of the dubious hypothesis like the Law of Diminishing Marginal Utility of the Marshallian analysis or the Law of Diminishing Marginal Rate of Substitution of the Hicksian approach.

(iv) In the first stage of Samuelson’s demand theorem the ‘over compensation effect’ is more realistic as an explanation of consumer behaviour than the Hicksian substitution effect. It permits the consumer to shift to a higher price-income situation in case of rise in the price of X and vice versa. Thus it is an improvement over Hicks’ substitution effect. Similarly, the second stage of the Samuelsonian Theorem explains the Hicksian ‘income effect in a much simpler way. Hicks himself admits the superiority of Samuelson’s theory when he writes that as a clear alternative to the indifference technique its presentation is the newest and important contribution of Samuelson to the theory of demand.

(v) This theory provides the basis for welfare economics in terms of observable behaviour based on consistent choice.

Revealed preference approach for Managerial Economics Mcom Delhi University

Use following books for M.COM

Recommended read:

Part A Firm and Market for Managerial Economics Mcom Delhi University
Unit I Demand and The Firm for Managerial Economics Mcom Delhi University

Revealed preference approach for Managerial Economics Mcom Delhi University

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