Matt stormed back on to the blog yesterday with a post on the importance of habits in explaining human behaviour. Here I want to explore the way in which economists describe habits in a bit more depth. In particular, Matt asked why economists talk about habit persistence in such an ad hoc way. I don’t think it’s very ad hoc at all and I’ll try to explain why.
What are habits?
Having a habit means that you’re more likely to do something the more you’ve done it in the past. You’ve done it before, so that makes you more likely to do it now. The implication is that your current payoff from the activity depends upon how much you’ve done it in the past. The ‘how much you’ve done it in the past’ is what Matt refers to as ‘capital’, in the vein of Becker and Murphy’s seminal discussion of cigarettes.
How do economists describe habits?
Now the description in economic models is fairly obvious: your ‘utility’ depends not just on how much of something you get today, but also how much you got in the past. The easiest way to model that is to take the difference of today’s consumption and yesterday’s. That way, you want to consume more of something than you did yesterday, and consuming less than yesterday will make you less happy. Essentially, yesterday’s consumption can be thought of as the stock of ‘capital’ that Matt referred to. The more capital you’ve built up over time, the more you want to do the thing again today. Hence, with this simple mechanism, we get habit formation and persistence.
What I’ve just described is called ‘internal’ habit persistence because it depends on your personal consumption levels. However, it is easily generalised to societal habits by taking the stock of built up consumption to be average social consumption, or the consumption of one’s neighbours. Then we call it ‘external’ habit persistence.
Why do they do it that way?
So far so good, but the question Matt asked is why it’s modelled that way. As he pointed out, it’s not enough just to say it fits the observed behaviour: we also have to ask why. Now that we’ve got this far it’s actually fairly straightforward. Habit persistence is simply the dependence of your personal payoff on a reference level of consumption, as opposed to being dependent on the level of consumption.
Economists have studied reference dependence ever since the canonical work of Kahneman and Tversky on prospect theory back in 1979. They drew on the psychological evidence to show that people care not about the level of consumption but the change in consumption relative to some reference point. Now, there is a lot of discussion about what an appropriate reference point is. Depending on what the reference point is you can get very different behaviours, and there can hardly be a dozen different reference points (although some weighting across them may be plausible).
The main point for our discussion is that viewing habit persistence as the result of reference-dependent utility allows us to sheet it back to some empirical literature on psychology and behaviour.