Rational Addiction, Peer Externalities and Long Run Effects of Public Policy

We develop a dynamic general-equilibrium model of rational addiction to study the decisions concerning nonaddictive and addictive goods consumption, savings, labor supply, and production. The model consists of two-period lived overlapping generations and two separate theaters of economic activity: a composite good and an addictive good sector. We determine the relative price of the addictive good in terms of the composite good. This is particularly novel, considering our framework captures the following three important features: (i) an addiction effect — past consumption of the addictive good raises the marginal utility of present addictive consumption; (ii) a detrimental health effect — current consumption of the addictive good has negative consequences on future utility; and, (iii) a peer externality effect — a peer’s addictive stock has negative implications for the representative individual via interpersonal spillovers. Upon solving the steady-state equilibrium, we perform policy calibration exercises that assess quantitatively the long-run effects of an addictive goods tax and its optimal rate with or without the externality effect. JEL Classification Numbers: D91, H20, I12.