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Foundations of Intrinsic Habit Formation

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Abstract

We provide theoretical foundations for several common (nested) representations of intrinsic linear habit formation. These representations are dynamically consistent and additive, with geometrically decaying coefficients of habit formation. Our axiomatization introduces a revealed preference theory of weaning a decision-maker from her habits using the device of compensation. We characterize linear habit formation in terms of the ability to wean using uniquely determined compensating streams. Moreover, we distinguish between habits that are responsive to weaning and those that are persistent, develop a simple choice-theoretic measure of the rate of habit decay, and demonstrate how to recover the entire sequence of habit formation coefficients from observed choice behavior. We introduce novel monotonicity and separability axioms that are appropriate for time-nonseparable preferences. Our analysis suggests techniques for eliciting dynamic reference points from choice behavior and obtaining discounted utility representations on endogenously generated auxiliary spaces.

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Bibliographic Info

Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 1642.

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Length: 67 pages
Date of creation: Mar 2008
Date of revision:
Publication status: Published in Econometrica, 2010
Handle: RePEc:cwl:cwldpp:1642

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Postal: Yale University, Box 208281, New Haven, CT 06520-8281 USA
Phone: (203) 432-3702
Fax: (203) 432-6167
Web page: http://cowles.econ.yale.edu/
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Postal: Cowles Foundation, Yale University, Box 208281, New Haven, CT 06520-8281 USA

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Keywords: Linear habit formation; Time-nonseparable preferences; Compensation; Weaning; Compensated separability; Gains monotonicity; Endogenously generated auxiliary spaces;

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  1. Jonathan Shalev, 1994. "Loss Aversion in a Multi-Period Model," Game Theory and Information 9407001, EconWPA, revised 18 Mar 1997.
  2. Tjalling C. Koopmans, 1959. "Stationary Ordinal Utility and Impatience," Cowles Foundation Discussion Papers 81, Cowles Foundation for Research in Economics, Yale University.
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  8. William Neilson, 2006. "Axiomatic reference-dependence in behavior toward others and toward risk," Economic Theory, Springer, vol. 28(3), pages 681-692, 08.
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  11. Xiaohong Chen & Sydney C. Ludvigson, 2004. "Land of Addicts? An Empirical Investigation of Habit-Based Asset Pricing Behavior," NBER Working Papers 10503, National Bureau of Economic Research, Inc.
  12. Wendner, Ronald, 2003. "Do habits raise consumption growth?," Research in Economics, Elsevier, vol. 57(2), pages 151-163, June.
  13. Iannaccone, Laurence R., 1986. "Addiction and satiation," Economics Letters, Elsevier, vol. 21(1), pages 95-99.
  14. Sharon Kozicki & P.A. Tinsley, 2001. "Dynamic specifications in optimizing trend-deviation macro models," Research Working Paper RWP 01-03, Federal Reserve Bank of Kansas City.
  15. Christopher D. Carroll & Jody Overland & David N. Weil, 1995. "Saving and growth with habit formation," Finance and Economics Discussion Series 95-42, Board of Governors of the Federal Reserve System (U.S.).
  16. Shi, Shouyong & Epstein, Larry G, 1993. "Habits and Time Preference," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 34(1), pages 61-84, February.
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