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Misunderstanding Demonstrated Preference

In the past few weeks, I’ve been involved in an email exchange about the differences in methodology between the Austrian school and the Chicago school. The correspondence has revealed some surprising misunderstandings of a key Austrian view, demonstrated preference, and what I hope to do in this week’s article is to give an account of that view and some of the misunderstandings about it.

The best account of demonstrated preference is in Murray Rothbard’s essay “Towards a Reconstruction of Utility and Welfare Economics” (1956). Essentially, the doctrine is this. When you make a choice, it’s usually among a few options. The choice is an action, and the action demonstrates, or reveals, that the option, or preference, that you choose ranks higher than the competing options. As Rothbard puts it,

Human action is the use of means to arrive at preferred ends. Such action contrasts to the observed behavior of stones and planets, for it implies purpose on the part of the actor. Action implies choice among alternatives. Man has means, or resources, which he uses to arrive at various ends; these resources may be time, money, labor energy, land, capital goods, and so on. He uses these resources to attain his most preferred ends. From his action, we can deduce that he has acted so as to satisfy his most highly valued desires or preferences.

The concept of demonstrated preference is simply this: that actual choice reveals, or demonstrates, a man’s preferences; that is, that his preferences are deducible from what he has chosen in action. Thus, if a man chooses to spend an hour at a concert rather than a movie, we deduce that the former was preferred, or ranked higher on his value scale. Similarly, if a man spends five dollars on a shirt we deduce that he preferred purchasing the shirt to any other uses he could have found for the money. This concept of preference, rooted in real choices, forms the keystone of the logical structure of economic analysis, and particularly of utility and welfare analysis.

When we talk about “preferences” or “options” here, what is meant are the alternatives that an actor has in mind when he decides what to do. We aren’t assuming that these preferences remain constant over a substantial period of time, much less that the actor has “in his mind” a list of all possible actions he could take in all possible worlds and that this list also remains the same for a long period. Because we don’t assume these things, we also don’t assume “transitivity of preferences.” If you prefer A to B, B to C, and A to C, then your preferences are transitive; but if your preferences are A over B, B over C, and C over A, they are intransitive. Many people think that intransitive preferences are irrational, for reasons we won’t go into here.

In the Austrian view, this issue doesn’t arise, because we’re concerned only with someone’s choice at a particular time. If the actor now has to choose between A and B, we don’t assume that he considers how to choose in situations that involve other options, nor do we assume that his preference for A over B remains constant. As Rothbard puts it, “The prime error here is the assumption that the preference scale remains constant over time. There is no reason whatever for making any such assumption. All we can say is that an action, at a specific point of time, reveals part of a man’s preference scale at that time. There is no warrant for assuming that it remains constant from one point of time to another.”As Rothbard points out, there is a difference between constancy and consistency, and the former isn’t a requirement of reason.

[C]onstancy and consistency are two entirely different things. Consistency means that a person maintains a transitive order of rank on his preference scale (if A is preferred to B and B is preferred to C, then A is preferred to C). But the revealed preference procedure does not rest on this assumption so much as on an assumption of constancy —that an individual maintains the same value scale over time. While the former might be called irrational, there is certainly nothing irrational about someone’s value scales changing through time. Hence, no valid theory can be built on a constancy assumption.

One of the participants in the email exchange raised this objection:

It [demonstrated preference] at most reveals his higher preference, his preference between two alternatives he is free to choose between…. Consider a prude who is made unhappy by other people’s consumption of pornography. In the free market society he doesn’t have the option of forbidding it, even though his highest preference might be an otherwise free market plus a ban on pornography. If there were only two other people in the society he could offer to pay them to agree not to consume pornography, but in a society of millions transaction costs plus the public good problem—the ban is a public good from the standpoint of all the other prudes—make that impractical.

The mistake here is that demonstrated preference concerns only choices that face an actor at a time. It isn’t about how he ranks possible states of affairs. I’d “prefer,” in one sense of that word, a world in which everyone held the correct view (mine, of course) of how society should be organized, but that sense of preference isn’t relevant to Austrian economics.

Another comment about demonstrated preference didn’t aim to undermine it directly, but rather to show that the doctrine brought with it baggage Austrians wouldn’t welcome. Austrians are against logical positivism, but, the commenter said,

[t]here is actually something like logical positivism in Austrian economics. I mean the idea that one can’t make interpersonal utility comparisons, as well as the more fundamental idea that “preference” must mean “revealed preference”. This is very reminiscent of the positivistic idea that all meaningful statements must be testable by sensory observation. Good rationalists reject this assumption.

Maybe they do, but “demonstrated preference,” as Austrians use this concept, means that choice reveals the chooser’s highest preference. It isn’t a claim about the meaning of “preference.” 

This objection, one must say, doesn’t “demonstrate” much acquaintance with Austrian economics. It’s good to have it anyway. As W.V.O. Quine once said, “Every knock a boost.