Habit Formation and the Theory of Addiction

In the light of repeated rejections of the Hall (1978) version of the life cycle‐permanent income hypothesis and other empirical puzzles, the habit formation hypothesis has increased in popularity since the 1980s. However, existing formulations of habit persistence do not always perform well empirically. This paper pursues two objectives: (i) to outline the habit persistence hypothesis, and (ii) to review the theory of addiction with a focus on issues of relevance to the theory of consumption. In the literature on addiction, two research traditions are discernible: rational addiction and myopic addiction. The former approach emphasises forward‐looking behaviour and defines memory loss as a univariate process. The latter relies on multiple objectives and highlights the role of contractual behaviour. The paper argues that future research in consumption with habits ought to pay more attention to non‐separabilities, allow for multivariate processes when modelling memory loss and consider rational habit modification.