Optimal Consumption under a Habit-Formation Constraint: the Deterministic Case

TL;DR

This paper derives explicit optimal consumption strategies under a habit-formation constraint in a deterministic setting, revealing how addictiveness influences consumption behavior and explaining the empirical consumption hump.

Contribution

It provides a novel explicit solution to a habit-formation constrained consumption problem using a nonlinear free-boundary approach, analyzing the effects of addictiveness and risk preferences.

Findings

Impatient individuals consume above the minimum rate and reach the minimum wealth-to-habit ratio.

Patient individuals consume at the minimum rate when below a threshold, maintaining a higher wealth-to-habit ratio.

Optimal consumption paths are hump-shaped under certain initial conditions and risk preferences.

Abstract

We formulate and solve a deterministic optimal consumption problem to maximize the discounted CRRA utility of an individual's consumption-to-habit process assuming she only invests in a riskless market and that she is unwilling to consume at a rate below a certain proportion $\alpha\in(0,1]$ of her consumption habit. Increasing $\alpha$, increases the degree of addictiveness of habit formation, with $\alpha=0$ (respectively, $\alpha=1$) corresponding to non-addictive (respectively, completely addictive) model. We derive the optimal consumption policies explicitly in terms of the solution of a nonlinear free-boundary problem, which we analyze in detail. Impatient individuals (or, equivalently, those with more addictive habits) always consume above the minimum rate; thus, they eventually attain the minimum wealth-to-habit ratio. Patient individuals (or, equivalently, those with less addictive habits) consume at the minimum rate if their wealth-to-habit ratio is below a threshold, and above it otherwise. By consuming patiently, these individuals maintain a wealth-to-habit ratio that is greater than the minimum acceptable level. Additionally, we prove that the optimal consumption path is hump-shaped if the initial wealth-to-habit ratio is either: (1) larger than a high threshold; or (2) below a low threshold and the agent is more risk seeking (that is, less risk averse). Thus, we provide a simple explanation for the consumption hump observed by various empirical studies.