Neoclassical Consumer Theory - Essay Example

Micro Economics - Revealed Preference Theory Introduction Neo ical consumer theory furnishes a rich set of testable significances for how consumer demand reacts to alterations in proportional prices and income. According to Ross (2005, p.247) “Neo classical theory is a form of economic analysis that we can apply to patterns of exchange in any market whatsoever, regardless of whether the agents that comprise it are people, animals, firms, countries, or computers selling derivatives to each other, and regardless of whether they calculate their goals and strategies themselves.” The Principle of Revealed Preference is a methodological model which follows the standard economic approach, whereby pragmatic alternatives are expended only to disclose the mental preferences of the individual over the set of objects as sensed by the modeller. When economists enlighten a person’s activity, they assign to preferences that justify the action which means that the chosen action is justified. On the other hand when economists forecast a person’s activity, they decide the choice the person would logically take, given the preferences and environmental conditions. The issue with justifications and forecasting of this kind is that the preferences applied in them call forth experimental principles. Preferences are prejudiced mental states that are not openly apparent; hence the query develops whether they are well-matched with good scientific pattern. The rationale most frequently supported by economists today to defeat these doubts is that of practical behaviourism. This only means that preferences must be derived solely from observed behaviour, and self-examination is normally not allowable. Revealed Preference Theory vs. Neoclassical theory The most well-known method that economists use to assign preferences harmonising this principle is the revealed preference concept. It arrogates that the contentment of certain axioms over an agent’s selections tantamount to the reality of a preference ordering that justifies these choices. From this alleged comparability, economists obtain some significant results. The claims are as follows: first, if one can infer, the preference ordering from the ascertained alternatives and if the choice axioms are fulfilled, and second, the absurdity of the preference ordering if the choice axioms are dishonored. If both of these claims were true, revealed preference theory would certainly be a very authoritative tool. Neo-Classical Effect Paul Samuelson in 1938 initiated revealed preference theory and this he arrogated to be “dropping off the last vestiges of the utility analysis” (Samuelson 1938, p.62). With this suggestion he came upon the right note with the positive minded, to whom the mention to subjective states like preferences appeared usually dishonest to scientific pattern. From this understanding developed the fundamental understanding that revealed preference theory might discontinue from reference to mental properties altogether. According to Little (1949, 97): “If an individual’s behaviour is consistent, then it must be possible to explain that behaviour without reference to anything other than behaviour.” The introduction of radical behaviourism in economics by refusing any scientific role for mental attributes never came through. The difficulty arose when Little, tried to denote what ‘consistent behaviour’ was. According to him consistent behaviour is: “Consistent behaviour, by definition, can be taken to mean: (a) if an individual once chooses A rather than B, then he will always do so, (b) choice is a transitive relation and (c) the individual never chooses a smaller collection when a larger is available”(Little, 1949, p. 91). It is suitable that the behaviour of the consumer is steady in the sense that they would not change their choice of a bundle A over a bundle B at a time and then again choose B over A at some other time. This can be attained by the following assumption about the consumer’s behaviour. Weak Axiom of Revealed Preference (WARP): under which a consumer’s behaviour meets WARP when x0 is preferred to x1, x1 is never revealed preferred to x0 which means that x1 is not affordable so x0 is selected. On the other hand if the cost of x1 is more than x0 then x1 is chosen and vice versa. Under such circumstances WARP can be expressed as: p0 · x1 _ p0 · x0 =) p1 · x0 > p1 · x1 The weak axiom does not state that x1 will never be selected under any situations. Actually this axiom means that when x1 is chosen at some price p1, then x0 will be more costly than x1 at prices p1. Strong Axiom of Revealed Preference (SARP): is a state in which a consumer’s behaviour meets SARP if, for every succession of different bundles x0, x1 …xk, where x0 is revealed preferred to x1, and x1 is revealed preferred to x2 …and xk−1 is revealed preferred to xk, it is not the case that xk is revealed preferred to x0. Briefly, SARP agrees when x is instantly or circuitously revealed preferred to y, y is never revealed preferred to x. Slutsky substitution effect In its simplest form the Slutsky substitution effect states that: Price effect = income effect + substitution effect Income effect and price effect Slutsky affirmed in 1915 that demand theory is established on the conception of ordinal utility. This thought was formulated by Hicks who separated the consumers response to a price change into income and substitution effects (Slutsky, 1953). The consequence of Slutsky equation is that it disintegrates the change induced by a price modification into two effects: a substitution effect and an income effect. The substitution outcome is the alteration in evened out demand due to the change in relative prices. He further states that the income effect is the change in demand caused by the effective change in income induced by the price change. In reality the substitution effect is unobservable, while the income effect is observable. Slutsky detached the change in demand referable only to the alteration in proportional prices that is substitution effect by inquiring “What is the change in demand when the consumer’s income is adjusted so that, at the new prices, she can only just buy the original bundle?” put differently, if the ‘real income’ or ‘purchasing power’ stays unaltered, how will the consumer correct his consumption at the new price? If the price of a good decreases then the substitution effect is always positive and vice versa. The clarification is that the original consumption bundle is invariably low-priced. Samuelson’s 1938 theory of revealed preference is actually very rich. It is only the Strong Axiom of Revealed Preference provide a requisite and ample condition for observed choices to be coherent with utility maximisation, it also furnishes a very valuable tool for experimental, nonparametric scrutiny of consumer choices. Till recently, the chief applications of Samuelson’s theory of revealed preference have been in economic theory. References Little, I. M. D. 1949. “A Reformulation of the Theory of Consumers” Behavior, in: Oxford Economic Papers (1): pp. 90–99 Ross, Don. 2005. “Economic Theory and Cognitive Science: Micro explanation.” Cambridge, MA: MIT Press. Samuelson, P. 1938. “A Note on the Pure Theory of Consumers” Behaviour, in: Economics (5): pp.61–71 Slutsky, E 1953. “On the Theory of the Budget of the Consumer”. Readings in Price Theory, K E Boulding and G J Stigler, eds (1953) Read More