Rational habits in gasoline demand

Abstract

The dynamics of demand for energy goods such as gasoline are complicated by investment decisions and behavioral habits. Both types of complication can be captured by a habits model, in which past consumption enters into an agent's current utility function. If the agent is forward-looking, or ‘rational’, then habits imply his consumption of the habit-forming good will be sensitive to his expectation of future market conditions, in particular future prices. This sensitivity implies, in turn, that traditional measures of price elasticity will underproject consumers' responsiveness to policy interventions.This paper examines the implications of rational habits on gasoline demand. Using a simple model encompassing myopic and rational habits, I demonstrate that an agent with rational habits will respond to anticipated future price changes and react more strongly to permanent than to temporary price changes, with this distinction increasing in the strength of the habit. I then estimate several habits models using panel data on U.S. states for the years 1989 through 2008. My preferred specification yields evidence of rational habits, and moreover I find consumers to be twice as responsive to tax-driven price changes as to market-driven price changes. Taxes and other policies that operate through the gasoline price are a more powerful policy instrument than traditional price elasticity would lead us to believe.