A Dynamic Model of Rational Addiction: Evaluating Cigarette Taxes

Addiction creates an intertemporal link between a consumer’s past and present decisions, altering their responsiveness to price changes relative to nonaddictive products. We construct a dynamic model of rational addiction and endogenous consumption to investigate how consumers respond to policy interventions that aim to reduce purchases of cigarettes. We find that, on average, the category elasticity is about 35 percent higher when the model correctly accounts for addiction. However, some policies spur substitution from more expensive single packs to less expensive cartons of cigarettes, resulting in higher overall consumption for some consumers.