Habits and externalities

Abstract We develop a conceptual model characterizing two types of individuals: one myopic and the other hyperopic. A myopic individual ignores his private contributions to both a social and private negative externality, as well as the effect that his accumulation of stuff (i.e., the stock of consumption goods) has on his habit parameter. A hyperopic individual internalizes both externalities as well as his habit‐formation effect. We find that the hyperopic individual consumes a greater amount of a clean good and a lesser amount of a dirty good, with the magnitude of the latter difference being greater than the magnitude of the former. Consequently, the hyperopic individual's cumulative consumption of the two goods is lower. The hyperopic individual's lower cumulative consumption also contributes to a less‐persistent consumption habit. Further, we explore the extent to which the allocation of consumption across the clean and dirty goods made by an astigmatic individual (an intermediate type of individual who internalizes the private externality, as well as the habit‐formation effect) diverges from the myopic individual's allocation. We consider the implications of our findings for traditional environmental tax policy as it applies to myopic and astigmatic individuals. Conceptually, we find that Pigovian tax rates in the presence of habit formation diverge from corresponding standard rates that ignore habit formation based on the difference between the magnitudes of the cumulative marginal benefit associated with habit formation and the marginal cost associated with the accumulation of stuff. Results from a simple numerical analysis demonstrate these conceptual results and more.