DP4269 Deep Habits

Author(s): Morten O Ravn, Stephanie Schmitt-Grohé, Martín Uribe
Publication Date: February 2004
Keyword(s): business cycles, customer market models, habit formation, switching cost models, time varying mark-ups
JEL(s): D10, D12, D42, E30
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4269

This Paper generalizes the standard habit formation model to an environment in which agents form habits over individual varieties of goods as opposed to over a composite consumption good. We refer to this preference specification as ?deep habit formation?. Under deep habits, the demand function faced by individual producers depends on past sales. This feature is typically assumed ad-hoc in customer market and brand switching cost models. A central result of the Paper is that deep habits give rise to counter cyclical mark-ups, which is in line with the empirical evidence. This result is important because ad-hoc formulations of customer-market and switching-cost models have been criticized for implying pro-cyclical and hence counterfactual mark-up movements. The Paper also provides econometric estimates of the parameters pertaining to the deep habit model.