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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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File URL: http://cowles.yale.edu/sites/default/files/files/pub/d16/d1642.pdf
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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
Publication status: Published in Econometrica, 2010
Handle: RePEc:cwl:cwldpp:1642
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Yale University, Box 208281, New Haven, CT 06520-8281 USA

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Web page: http://cowles.yale.edu/

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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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Find related papers by JEL classification:
  • C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General
  • D11 - Microeconomics - - Household Behavior - - - Consumer Economics: Theory
  • D90 - Microeconomics - - Micro-Based Behavioral Economics - - - General

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  1. Abel, Andrew B, 1990. "Asset Prices under Habit Formation and Catching Up with the Joneses," American Economic Review, American Economic Association, vol. 80(2), pages 38-42, May.
  2. Shalev, Jonathan, 1997. "Loss aversion in a multi-period model," Mathematical Social Sciences, Elsevier, vol. 33(3), pages 203-226, June.
  3. Jody Overland & Christopher D. Carroll & David N. Weil, 2000. "Saving and Growth with Habit Formation," American Economic Review, American Economic Association, vol. 90(3), pages 341-355, June.
  4. Botond Kőszegi & Matthew Rabin, 2006. "A Model of Reference-Dependent Preferences," The Quarterly Journal of Economics, Oxford University Press, vol. 121(4), pages 1133-1165.
  5. Amos Tversky & Daniel Kahneman, 1991. "Loss Aversion in Riskless Choice: A Reference-Dependent Model," The Quarterly Journal of Economics, Oxford University Press, vol. 106(4), pages 1039-1061.
  6. Iannaccone, Laurence R., 1986. "Addiction and satiation," Economics Letters, Elsevier, vol. 21(1), pages 95-99.
  7. Kozicki, Sharon & Tinsley, P. A., 2002. "Dynamic specifications in optimizing trend-deviation macro models," Journal of Economic Dynamics and Control, Elsevier, vol. 26(9-10), pages 1585-1611, August.
  8. David K. Backus & Bryan R. Routledge & Stanley E. Zin, 2005. "Exotic Preferences for Macroeconomists," NBER Chapters,in: NBER Macroeconomics Annual 2004, Volume 19, pages 319-414 National Bureau of Economic Research, Inc.
  9. Boldrin, Michele & Christiano, Lawrence J. & Fisher, Jonas D.M., 1997. "Habit Persistence And Asset Returns In An Exchange Economy," Macroeconomic Dynamics, Cambridge University Press, vol. 1(02), pages 312-332, June.
  10. 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.
  11. Ignacio Palacios-Huerta, 2001. "Multiple Addictions," Working Papers 2001-20, Brown University, Department of Economics.
  12. Becker, Gary S & Murphy, Kevin M, 1988. "A Theory of Rational Addiction," Journal of Political Economy, University of Chicago Press, vol. 96(4), pages 675-700, August.
  13. William Neilson, 2006. "Axiomatic reference-dependence in behavior toward others and toward risk," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 28(3), pages 681-692, 08.
  14. Tjalling C. Koopmans, 1959. "Stationary Ordinal Utility and Impatience," Cowles Foundation Discussion Papers 81, Cowles Foundation for Research in Economics, Yale University.
  15. Wendner, Ronald, 2003. "Do habits raise consumption growth?," Research in Economics, Elsevier, vol. 57(2), pages 151-163, June.
  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.
  17. Uribe, Martin, 2002. "The price-consumption puzzle of currency pegs," Journal of Monetary Economics, Elsevier, vol. 49(3), pages 533-569, April.
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