Chapter 98 Intertemporal Choice under Habit Formation

The fundamental question addressed in this research is the degree to which models of optimal intertemporal choice are good descriptions of non-interactive individual intertemporal behavior in the presence of habit formation. The existence of loss avoidance does, however, not explain why subjects consume too much in the first few periods. This chapter conjecture that overconsumption during the first periods is driven by cognitive limitations. If subjects are unable to compute the aggregate present value of future costs which is associated with each level of consumption, they face a form of subjective uncertainty. Hence, psychologically relevant features of the decision problem play an important role. This chapter also presents the fact that the present benefits of consumption are relatively large, immediately available, and thus unambiguously given is likely to be of psychological relevance because it renders present benefits highly salient.