COWLES FOUNDATION FOR RESEARCH IN
ECONOMICS Box 208281
COWLES FOUNDATION DISCUSSION PAPER NO. 1642 Foundations of Intrinsic Habit Formation Kareen Rozen March 2008 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. |
