Economic ideas you should forget — the axioms of revealed preference

4 Mar, 2019 at 21:21 | Posted in Economics | 1 Comment

The axioms of revealed preference have been part of the foundations of economics since they were formulated by Paul Samuelson in 1947. These principles allowed economists to continue to use the calculus of utilitarianism even though utilitarianism had ceased to be a fashionable philosophical doctrine. And they enabled economists to give a particular, and special, meaning to the term rationality. In modern economics rationality is equated with consistency.

But consistency, as Ralph Waldo Emerson said, is ‘the hobgoblin of little minds, adored by little statesmen and philosophers and divines’. Ordinary people do not equate rationality with consistency. It is consistent but not rational to maintain the belief that there are fairies at the bottom of the garden …

The problem is that in a complex world, there is no objective means of defining whether two situations are in fact the same or are different. This is particularly problematic when this axiomatic approach is applied to choices made with imperfect knowledge and under radical uncertainty, which in practice describes most of the choices we make in the real world.

John Kay

As so often, Kay hits the nail on the head.

The very raison d’être for developing revealed preference theory in the 1930’s and 1940’s was to be able to ascertain people’s preferences by observation of their actual behaviour on markets and not having to make unobservable psychological assumptions or rely on any utility concepts. This turned out to be impossible. Samuelson et consortes had to assume unchanging preferences, which, of course, was in blatant contradiction to the attempt of building a consumer and demand theory without non-observational concepts. Preferences are only revealed from market behaviour when specific theoretical constraining assumptions are made. Without making those assumptions there are no valid inferences​ to make from observing people’s choices on a market.

But still, ​a lot of mainstream economists consider the approach offered by revealed preference theory ​great progress. As people like Robinson, Georgescu-Roegen, and Kornai have shown, this is, however, nothing but an illusion. Revealed preference theory does not live up to what it claims to offer. As part of the economist’s​ tool-kit, ​it is of extremely limited use.

If we want to be able to explain the behaviour and choices people make, we have to know​ something about people’s beliefs, preferences, uncertainties​, and understandings. Revealed preference​ theory does not provide us with any support whatsoever in accomplishing that.