Rational Habits and Uncertain Prices: Simulating Gasoline Consumption Behavior

When consumers are forward-looking with respect to their demand for a habit-forming good, traditional measures of price elasticity are misleading.  In particular, such measures will underestimate sensitivity to long-run shifts - and therefore underestimate the potential effect of policy instruments that act through price.  Correcting elasticities for the behavior of the price process requires a model with forward-looking consumers, a habit-forming good, and uncertain relative prices.  With appropriate restrictions on the type of price uncertainty, this paper shows that it is possible to solve for the optimal consumption path under any price process.  Simulations then sketch out how habits and the price process shape demand.  Gasoline demand motivates the model and illustrates its implications.