revealed-preference

Revealed Preference: What Do People Really Want?

Revealed preference, is a theory offered by the American economist Paul Samuelson in 1938. The theory asserts that consumers’ behavior – assuming a constant income and an item’s price – is the best indicator of their hidden preferences. In short, that is how people reveal what they really want.

For the sake of this article, we’ll leave out the pure economics definition of revealed preferences to insert it into a new theory of rationality. Let’s start with Nassim Nicholas Taleb’s view of revealed preferences.

Taleb’s view on revealed preferences

The axiom of revelation of preferencesstates the following: you will not have an idea about what people really think, what predicts people’s actions, merely by asking them –they themselves don’t know.

As highlighted in his article “How to be Rational about Rationality” revealed preferences move around three axioms:

  • Judging people on their beliefs is not scientific
  • There is no such thing as “rationality” of a belief, there is rationality of action
  • The rationality of an action can only be judged by evolutionary considerations

This theory of rationality moves around a few key points which can shift your perspective and make you a better business person.

Science and scientism

As science has been so successful in certain fields (take physics) over the centuries, we matured the belief that scientific principles developed by hard sciences could be applied to soft sciences, or to human nature in general.

This belief brought to the rise of scientism, or the core belief that things could be stripped from their “irrational” part to make them rational.

Here rationality, though, is measured in terms of beliefs rather than the actions that come from those beliefs.

And this is the primary fallacy scientism falls into.

A person imbued with scientism will criticize religion, yet she will believe in economic theories that narrow down reality to a model that is not only far from it, but that from the collective standpoint might have negative consequences for society overall.

Domain dependence

Understanding that the scientific method can be used in certain fields, but it loses value in other domains, is critical. In the realm of human, messy affairs, it is essential to have a different mindset. While experimentation, it’s still the key, it will have a different meaning.

Experimentation won’t be tied to a narrow domain, but close to creativity and the ability to draw ideas from fields and domains that are far off from the one where you’re trying to apply a solution. Thus, it will require a broad range of creativity, a lot of experimentation, and the ability to have a broad spectrum of experiments.

Rationality based on survival of fit actions

Your eyes are not sensors aimed at getting the electromagnetic spectrum of reality. Their job description is not to produce the most accurate scientific representation of reality; rather the most useful one for survival.

Still, in his article “How to be Rational about Rationality,” Taleb highlights how eyes are wired to survival rather than giving an accurate or scientific representation of reality.

This view highlights how rationality is not about logical explanations. As many things in the real messy world can’t be explained, as there is a hidden meaning, which might not be revealed.

We need to trust more the subconscious side, which calls up to look us for actions that survive time, rather than explanations and how those might fit the current context or prevailing intellectual view.

Skin in the game

What matters, in the end, is what they pay for goods, not what they say they “think” about them, or what are the reasons they give you or themselves for that. (Think about it: revelation of preferences is skin in the game).

Another core concept connected to this revealed preference view is that of skin in the game or the fact that in order to reveal what people really want.

One way is to have them pay for something, as this implies an action, which isn’t frictionless, thus if performed might reveal strong subconscious preferences, hard to explain rationally, but work as a strong hidden signal.

Beliefs are cheap; actions do cost

For beliefs are … cheap talk. A foundational principle of decision theory (and one that is at the basis of neoclassical economics, rational choice, and similar disciplines) is that what goes on in the head of people isn’t the business of science. First, what they think may not be measurable enough to lend itself to some scientific investigation. Second, it is not testable. Finally, there may be some type of a translation mechanism too hard for us to understand, with distortions at the level of the process that are actually necessary for think to work.

For the sake of understanding this theory, it’s essential to look at actions!

Key takeaways

  • Revealed preferences can help us uncover what people really want.
  • Revealed preferences are about what people do when they are skin in the game.
  • It’s also about rationality meant as the survival of actions that gain us fit in the real world.
  • It’s not about elegant theories or beliefs, but it’s about those beliefs that lead to actions that make the collective survive.
  • In short, that is about uncovering hidden cues from the subconscious mind, so that we avoid attaching rationality to things in hindsight.

Connected Business Concepts

Heuristics

heuristic
As highlighted by German psychologist Gerd Gigerenzer in the paper “Heuristic Decision Making,” the term heuristic is of Greek origin, meaning “serving to find out or discover.” More precisely, a heuristic is a fast and accurate way to make decisions in the real world, which is driven by uncertainty.

Bounded Rationality

bounded-rationality
Bounded rationality is a concept attributed to Herbert Simon, an economist and political scientist interested in decision-making and how we make decisions in the real world. In fact, he believed that rather than optimizing (which was the mainstream view in the past decades) humans follow what he called satisficing.

Second-Order Thinking

second-order-thinking
Second-order thinking is a means of assessing the implications of our decisions by considering future consequences. Second-order thinking is a mental model that considers all future possibilities. It encourages individuals to think outside of the box so that they can prepare for every and eventuality. It also discourages the tendency for individuals to default to the most obvious choice.

Lateral Thinking

lateral-thinking
Lateral thinking is a business strategy that involves approaching a problem from a different direction. The strategy attempts to remove traditionally formulaic and routine approaches to problem-solving by advocating creative thinking, therefore finding unconventional ways to solve a known problem. This sort of non-linear approach to problem-solving, can at times, create a big impact.

Moonshot Thinking

moonshot-thinking
Moonshot thinking is an approach to innovation, and it can be applied to business or any other discipline where you target at least 10X goals. That shifts the mindset, and it empowers a team of people to look for unconventional solutions, thus starting from first principles, by leveraging on fast-paced experimentation.

Biases

biases
The concept of cognitive biases was introduced and popularized by the work of Amos Tversky and Daniel Kahneman in 1972. Biases are seen as systematic errors and flaws that make humans deviate from the standards of rationality, thus making us inept at making good decisions under uncertainty.

Dunning-Kruger Effect

dunning-kruger-effect
The Dunning-Kruger effect describes a cognitive bias where people with low ability in a task overestimate their ability to perform that task well. Consumers or businesses that do not possess the requisite knowledge make bad decisions. What’s more, knowledge gaps prevent the person or business from seeing their mistakes.

Occam’s Razor

occams-razor
Occam’s Razor states that one should not increase (beyond reason) the number of entities required to explain anything. All things being equal, the simplest solution is often the best one. The principle is attributed to 14th-century English theologian William of Ockham.

Mandela Effect

mandela-effect
The Mandela effect is a phenomenon where a large group of people remembers an event differently from how it occurred. The Mandela effect was first described in relation to Fiona Broome, who believed that former South African President Nelson Mandela died in prison during the 1980s. While Mandela was released from prison in 1990 and died 23 years later, Broome remembered news coverage of his death in prison and even a speech from his widow. Of course, neither event occurred in reality. But Broome was later to discover that she was not the only one with the same recollection of events.

Crowding-Out Effect

crowding-out-effect
The crowding-out effect occurs when public sector spending reduces spending in the private sector.

Bandwagon Effect

bandwagon-effect
The bandwagon effect tells us that the more a belief or idea has been adopted by more people within a group, the more the individual adoption of that idea might increase within the same group. This is the psychological effect that leads to herd mentality. What is marketing can be associated with social proof.

Read Next: BiasesBounded RationalityMandela EffectDunning-Kruger

Read Next: Heuristics, Biases.

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