The Review of Economic Studies, Ltd.

Deep Habits Author(s): Morten Ravn, Stephanie Schmitt-Groh and Martn Uribe Reviewed work(s): Source: The Review of Economic Studies, Vol. 73, No. 1 (Jan., 2006), pp. 195-218 Published by: Oxford University Press Stable URL: http://www.jstor.org/stable/3700622 . Accessed: 12/05/2012 14:33
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Review Economic of Studies (2006)73, 195-218 ? 2006TheReviewof Economic Studies Limited

0034-6527/06/00080195$02.00

Deep

Habits

MORTENRAVN
European University Institute and CEPR

STEPHANIESCHMITT-GROHE
Duke University, CEPR, and NBER

and MARTINURIBE
Duke University and NBER
First version receivedJanuary2004; final version acceptedJune 2005 (Eds.)

habits over individualvarietiesof goods as opposed to over a composite consumptiongood. We refer to this preference specification as "deep habit formation".Under deep habits, the demand function faced by individualproducersdepends on past sales. This feature is typically assumed ad hoc in customerad hoc formulationsof customer-market and switching-cost models have been criticized for implying

in Thispaper form the habit-formation to anenvironment whichagents model generalizes standard

and is market brand-switching-cost models.A central resultof the paper thatdeephabitsgive rise to This is because whichis in linewiththeempirical evidence. result important, countercyclical mark-ups,

and and movements. Underdeephabits,consumption wages procyclical hencecounterfactual mark-up of econometric estimates the to shocks. paper The respond procyclically government-spending provides
parameters pertainingto the deep-habitmodel.

1. INTRODUCTION The standard model, be it of the internalor externaltype, assumes that househabit-persistence holds form habits from consumptionof a single aggregategood. An importantconsequence of this assumptionis that the introductionof habit formationalters the propagationof macroeconomic shocks only in so far as it modifies the way in which aggregatedemandand possibly the supply of labourrespondto such shocks. In this paper, we generalize the concept of habit formationby consideringthe possibility that privateagents do not simply form habits from their overall consumptionlevels, but rather from the consumptionof individualgoods. We have in mind an environment which consumers in can form habits separatelyover narrowlydefinedcategoriesof goods, such as clothing, vacation destinations,music, cars and not just over consumptiondefinedbroadly.We believe thatthis descriptionof preferences,to which we referas "deephabits",is more compellingthanits standard, For or, in our terminology,"superficial", counterpart. example, the deep-habitformulationis embedded in Houthakker Taylor's(1970) classic work on consumptiondemand.Moreover,the and empirical literatureon consumer behaviouroften finds that consumers' choices over different brandsof goods are affected by past brandchoices (see Chintagunta,Kyriazidouand Perktold, 2001, for a recent example). The assumptionthat agents can form habits on a good-by-good basis has two important implicationsfor aggregatedynamics.First,the demandside of the macroeconomy-in particular, the consumptionEuler equation-is indistinguishable from thatpertainingto an environmentin which agents have superficialhabits. Second, and more significantly,the assumptionof deephabit formationalters the supply side of the economy in fundamentalways. Specifically, when
195

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habits are formed at the level of individualgoods, firms take into accountthat the demandthey will face in the futuredepends on their currentsales. This is because higher consumptionof a particulargood in the currentperiod makes consumers, all other things equal, more willing to buy that good in the futurethroughthe force of habit. Thus, when habits are deeply rooted, the optimalpricingproblemof the firmbecomes dynamic. We embed the deep-habit-formation assumptioninto an economy with imperfectlycompetitive productmarkets.This combinationresults in a model of endogenous, time-varyingmarkups of prices over marginalcost. A centralresult of this paperis that in the deep-habitmodel, mark-upsbehave countercyclicallyin equilibrium.In particular,we show that expansions in shocks, or productivityshocks are output driven by preference shocks, government-spending declines in mark-ups. This implicationof the deep-habitmodel is in line with the accompaniedby empirical literature extant, which finds mark-ups to be countercyclical (Rotemberg and Woodford,1999). The intuitionfor why the deep-habitmodel inducescountercyclicalmovementsin mark-ups is relatively straightforward. a simple version of the deep-habitmodel, the demandfaced by In
an individual firm, say firm i, in period t is of the form qit = Pi,'(qt - Oqt-1) +Oqit-1, where

qit denotes the demandfor good i, pit denotes the relativeprice of good i, and qt denotes the level of aggregatedemand.Firm i takes the evolution of qt as given. The parameter0 e [0, 1) measures the strengthof externalhabit for good i. This demand function is composed of two terms.One termis pi (qt - Oqt-1), displayinga price elasticity of q. The second termis Oqit-1, which originatesexclusively from habitualconsumptionof good i. Therefore,the second termis perfectlyprice inelastic.The price elasticity of the demandfor good i is a weightedaverageof the elasticitiesof the two termsjust described,namely q and 0. The weight on q is given by the share of the price-elasticterm in total demand.When aggregatedemand, qt, rises, the weight of the price-elastictermin total demandincreases,and as a resultthe price elasticityincreases.We refer to this effect as theprice-elasticityeffect of deep habits.Because the mark-up inverselyrelated is to the price elasticity of demand, it follows that under deep habits, an expansion in aggregate demandinduces a decline in mark-ups.Under either superficialhabits or no habits, the demand functionfaced by firmi collapses to qit = pi qqt. In this case, the price elasticity of demandfor good i is independentof the level of aggregatedemand. In fact, it is constant and equal to q, implying a time-invariant mark-up. In additionto the price-elasticityeffect, deep habits influence the equilibriumdynamics of mark-upsthroughan intertemporal effect. This effect arises because firmstake into accountthat currentprice decisions affect futuredemandconditionsvia the formationof habits.Accordingto the intertemporal effect, when the presentvalue of futureper-unitprofitsare expectedto be high, firms have an incentive to invest in customerbase today. They do so by buildingup the current stock of habit. In turn,this increase in habits is broughtaboutby inducing higher currentsales via a decline in currentmark-ups.The dynamic pricing problem at the level of the individual firm that is induced by the introductionof deep externalhabits is akin to that studied in partial equilibriummodels of customer-market pricing (Phelps and Winter, 1970) or brand-switching costs (Klemperer, 1995). An importantdifference between the deep-habitand the switchingcost/customer-market formulationsis that in the deep-habitmodel there is gradualsubstitution between differentiatedgoods ratherthan discrete switches among suppliers.One advantageof this implicationof the deep-habitmodel, from the point of view of analyticaltractability, that is underthe deep-habitformulationone does not face an aggregationproblem.In equilibrium,buyers can distributetheirpurchasesidentically,and still suppliersface a gradualloss of customers if they raise their relativeprices. The deep-habit-formation model can thereforebe viewed as a naturalvehicle for incorporating models into a dynamicgeneral switching-cost/customer-market equilibriumframework.

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Because not all componentsof aggregatedemandmay be subjectto deep-habitformation,it follows thatchanges in the compositionof aggregatedemandwill, in general,affect the strength of the aforementioned effects of deep habits on mark-ups.For price-elasticityand intertemporal instance,if investmentspendingis not subjectto habit-forming behaviour,a shock thatincreases the share of investmentin aggregatespending, such as an aggregateproductivityshock, would reduce the overall importanceof habitsand, as a result, alterthe pricingbehaviourof firms. The countercyclicalityof mark-upsis a particularlyinteresting implication of the deephabit model, for existing general equilibriumversions of customer-market and switching-cost models have been criticized on the groundsthat they predictprocyclical mark-ups(Rotemberg and Woodford,1991, 1995). This criticism, however,is based upon customer-market models in which the demandfunction faced by individualfirms is specified ad hoc and not derivedfrom the optimizing behaviourof households. Our results show that once the demandfor individual model is indeed capable of predicting goods is derivedfrom first principles,a customer-market an empiricallyrelevantcyclical behaviourof mark-ups. A furthercontributionof this paper is to estimate the structuralparametersof the deep externalhabit model. Existing econometricestimates of the degree of habit formationidentify the parameters defininghabits from the consumer'sEuler equation.This restrictioncontinuesto be presentin our deep-habitmodel. Therefore,availableestimatesof the degree of externalhabit formationcan as well be interpreted estimatesof the degree of deep externalhabitformation. as However, the deep-habitmodel contains additionalequilibriumconditions that can be used to identify the habitparameters, namely,supply-siderestrictionsstemmingfromthe optimalpricing decision of firms. In our econometricwork, we exploit these additionalidentifying restrictions to obtainmore efficientestimatesof the habitparameter. resultsare consistentwith previous Our studies, which rely solely on Euler equation estimations,in that they suggest a relatively high degree of habitpersistenceand an inertialevolutionof the stock of habitover time. The remainderof the paperis organizedin four sections. Section 2 develops the deep-habit model in the context of a simple productioneconomy withoutcapital.Section 3 studiesthe equilibriumdynamicsof the deep-habitmodel within a fully fledgedreal-business-cycleenvironment with endogenouslaboursupply,capital accumulation,and a governmentsector.That section investigates the response of aggregateactivity,factorprices, and mark-upsto a variety of shocks. It also reportseconometricestimatesof the parameters the deep-habitmodel. Much of the paof per focuses on the case in which deep habits are externaland additive.Section 4 considersthree importantvariationsof this baseline specification.One variationis a model with good-specific subsistencepoints. In this model the price-elasticityeffect mentionedabove standsin isolation, and the intertemporal with relative effect is absent.The second variationstudies an environment deep habits. In this economy, the price-elasticityeffect is eliminated, whereas the intertemporal effect remains active. The third variationstudies the case of internaldeep habits. It shows that when households internalizetheir propensityto develop addictionto individualgoods, the monopolist'spricingproblemceases to be time consistent.Section 5 concludes. 2. A SIMPLEECONOMYWITHDEEP HABITS Consideran economy populatedby a continuumof identical households of measure 1 indexed by j e [0, 1]. Each household j has preferencesdefined over consumptionof a continuumof differentiated goods, cf . Good varietiesare indexedby i e [0, 1]. Households also value leisure, and thus derive disutility from labour effort, h'. Following Abel (1990), preferences feature "externalhabit formation",or "catchingup with the Joneses". The central difference between Abel's specification and ours is that we assume that consumptionexternalitiesoperate at the level of each individualgood ratherthan at the level of the composite final good. We referto this

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variantas "catchingup with the Joneses good by good" or deep habits. Specifically, we assume thathousehold j derivesutility from an object x/ definedby

x =

L! (

Ocit1)11di

(1)

where cit-1 denotes the cross-sectional average level of consumptionof variety in period t - 1, which the household takes as exogenously given. The parameter0 measures i c/t-Idj the degree of external habit formationin consumptionof each variety.When 0 = 0, we have the benchmark case of preferencesdisplayingno consumptionexternalities.The parameter7 > 0 denotes the intratemporal of consumptionacrossdifferent elasticityof substitution habit-adjusted

varieties.
For any given level of x/, purchasesof each varietyi E [0, 1] in period t must solve the dual problem of minimizing total expenditure, Pitc/tdi, subjectttothe aggregationconstraint(1), fo for where Pit denotes the nominalprice of a good of variety i at time t. The optimal level of c/t i E [0, 1] is then given by P (2) xJ +0cit-1, t it = Pt c,1 where =fo, is a nominalprice index. Note thatconsumptionof each variety Pt, , is decreasingin Pilt-di its relativeprice, Pit/Pt; increasingin the level of habit-adjusted consumption, x/; and for 0 > 0, increasingin past aggregateconsumptionof the variety in question. At the optimum,we have that Ptxj = f6 Pit(c/ - Ocit-1)di. The utility functionof the householdis assumedto be of the form

EoZf U(x,hj),
t=O

(3)

where Et denotes the mathematical expectationsoperatorconditionalon informationavailableat time t, f3e (0, 1) representsa subjectivediscountfactor,and U is a periodutility index assumed to be strictly increasingin its first argument,strictly decreasingin its second argument,twice continuouslydifferentiable,and strictlyconcave. In each period t > 0, households are assumedto have access to complete contingentclaims markets.Let rt,t+j denote the stochastic discount factor such that Etrt,t+jzt+j is the price at period t of a randompayment zt+j in period t + j. In addition,households are assumed to be entitled to the receipt of pure profits from the ownershipof firms, (Di. Then, the representative household'speriod-by-period budgetconstraintcan be writtenas (4) x/ + o + Ert,t+d/t+ = d/ +wth + 0, where o 0 The variablewt denotes the real wage rate.In addition,house=-- f (Pit/Pt)cit-ldi. holds are assumed to be subject to a borrowingconstraintthat prevents them from engaging in Ponzi games. The representative household's optimizationproblemconsists in choosing processes h', and dJ+1 so as to maximize the lifetime utility function (3) subject to (4) and x/, a no-Ponzi-game constraint,taking as given the processes for wt, Wt, and oI and initial asset holdings do. The first-order conditionsassociatedwith the household'sproblemare (4),
Uh(xt!,h W-

Ux (xl

,hl)

(5)

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Ux(xJ, hJ)rt,t+l= Ux(xt+1, hf ). 2.1. Firms Each varietyof goods is assumedto be producedby a monopolisticallycompetitivefirm. is given by Equation(2) implies that aggregatedemandfor good i, cit fo i ctdj,
Cit xt -+Ocit-1,

(6)

(7)

where xt - f xtdj is a measure of aggregate demand. The key implication of this demand function is that its price elasticity is procyclical. In effect, an increase in the level of aggregate demand,xt, raises the relativeimportanceof the price-elasticterm (Pit /Pt)-'xt, and reducesthe relative importanceof the price-inelastic,or purely habitual,demandcomponent,Ocit-1. As a result,the price elasticity of demandfor good i faced by the monopolistincreaseswith aggregate demand. We refer to this effect as the price-elasticity effect of deep habits. To the extent that mark-upsof prices over marginalcosts are inverselyrelatedto the price elasticity of demand,the deep-habitmodel predictsthatmark-upsmove countercyclically. Each good i E [0, 1] is manufactured using labour as an input via the linear production technology yit = Athit, where yit denotes output of good i, hit denotes labour input, and At denotes an aggregatetechnology shock. Firmsare assumedto be price setters,to take the actions of all otherfirmsas given, andto standreadyto satisfy demandat the announced prices.Formally, firm i must satisfy yit > cit. Firm i's profitsin period t are given by @it -= (Pit/Pt)cit tthit. Note thatreal marginalcosts areequalto wt/At and areindependentof scale andcommon across firms.Nominal marginalcosts are thus given by MCt = (Pt wt/At). Let pit denote the mark-up of prices over marginal costs charged by firm i, and ,pt the average mark-upcharged in the economy, that is, pit = Pit/MCt and pt = Pt/MCt. We can then express profits of firm i in period t as #it - 1 = pit (8) cit , Pt and the aggregatedemandfaced by firm i as
i= (Pit"xt +Ocit-1.

(9)

The firm's problem consists in choosing processes Pit and cit so as to maximize the present discountedvalue of profits,
00

Et

Yrt,t+j
j=0

it+j,

(10)

subjectto (8) and (9), given processes rt,t+j, Pt, and xt. The Lagringianof firm i's problemcan be writtenas
L? -= Eo
Cit + Vit xt cit

ro,t

--

where vit is a Lagringe multiplierassociatedwith equation(9). The first-order conditionscorrespondingto this optimizationproblemare (9) and

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vit
Uit
-

/Pt

+0Etrt,t+1 vit+1

The multipliervit representsthe shadowvalue of selling an extraunit of good i in period t. The first of the above optimalityconditions states that the value of selling an extraunit of good i in periodt, vit, has two components.One is the short-run profitof a sale, given by (pit - I)/l t. The second componentreflects futureexpected profitsassociated with selling an extra unit of good i in the currentperiod. In effect, a unit increase in sales in the currentperiod induces, via habit formation,additionalsales in the amount of 0 units in the next period. The present discounted value of these 0 additionalunits of sales is OEtrt,t+lvit+l, which is precisely the second term on the R.H.S. of the first optimality condition shown above. The second optimality condition equates the costs and benefits of a unit increase in the relative price. The benefit is given by units at a an increase in revenue in the amount of cit stemming from selling all intramarginal The cost is the decline in demandthat the price increase induces, and is given by higher price. to xt, evaluatedat the shadow value of sales, vit. It is straightforward see from the i itj above two optimalityconditions that in the absence of habit formation(0 = 0), the mark-upis constantand equal to q/(q - 1). We note thatthe pricingdecisions of the monopolistare time consistent.This is because the currentdemandis independent futureexpected values of Pit/ Pt. This independenceof current of demandfrom futureexpected relativeprices is a consequenceof our maintainedassumptionthat deep habits are external.Under the alternativehypothesis that habit formationis internal, the demandfor good i in period t will depend not just on the price of good i in period t but also on future expected prices. This featureof demand in the internaldeep-habitmodel in conjunction with the fact thatpast sales affect the monopolist'scurrentprice-settingbehaviourmay give rise to time-inconsistency problems.We discuss the case of deep internalhabitsfurtherin Section 4.3. 2.2. Equilibrium Because all households are identical, consumptionand labour supplies are invariantacross individuals. It follows that we can drop the superscriptj from all variables.We assume that the we initial conditionscit, t = are the same for all goods i e [0, 1]. Further, restrictattentionto --1, in which all firms charge the same price. Therefore,we can also drop the symmetricequilibria, subscripti from all variables.A stationarycompetitiveequilibriumcan then be defined as a set
of stationary processes {xt, ct, ht, rt,t+l, wr, vt, pt} satisfying
t = ct Xt Oct-1,

(11) (12)

Ux(xt,ht)rt,t+l

flUx(xt+l,ht+l), Uh (xt, ht)

wt = - Ux(xt,ht) ,(13) r A, 2 --=

c, = Atht,

(14)
(15)

1 vt = OEtrt,t+lvt+l + 1 ct =
-,

and

(16) (17)

r(ct -Oct-1)vt.

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It is of interestto comparethese equilibriumconditions to those arisingfrom the standard habit-formation model. That is, from a model where the single-periodutility function depends on the quasi-differencebetween currentand past consumption of the composite good as opposed to the quasi-differencebetween currentand past consumptionof each particularvariety. It is straightforward show that the superficial-habit to model shares with our deep-habitmodel conditions (11)-(15). Of particular interestis the fact thatbecause the consumption equilibrium Euler equation (12) is common to the deep-habitmodel as well as to the standardsuperficialhabit-formation models, existing Euler-equation-based empiricalestimatesof the degree of habit formationcan be interpreted uncoveringthe degree of deep-habitpersistence.Because in our as model the parameter that measuresthe strengthof deep habits appearsin equationsotherthan 0 the consumptionEuler equation (12), our model provides additionalidentificationrestrictions. In Section 3.4, we exploit these additionalrestrictionsin conjunctionwith the Euler equationto obtain a more efficient estimateof 0. What sets the deep- and superficial-habit models apart is the fact that under superficial habits, equilibriumconditions (16) and (17) are replacedby the requirementthat the mark-up, pit, be constantand equal to i/(q - 1). This is a significantdifference.The deep-habit-formation model introducesa dynamicwedge between factorprices andtheirassociatedmarginalproducts. That is, the deep-habitmodel gives rise to time-varyingmark-ups.
2.3. The price-elasticity and intertemporal effects of deep habits

It is convenientto express the mark-upas a function of the short-run price elasticity of demand and the present value of expected per-unitfutureprofits. The reason is that these two variables capturethe mainchannelsthroughwhich deep habitsaffect mark-up dynamics.Iteratingequation (16) forward,and assuming that Etrt,tvt+jt+ = 0, one can express vt as the present limj,,ej discountedvalue of expected futureper-unitprofitsinduced by a unit increase in currentsales,
that is, vt = Et Jj=oO rtt+j - t+j . In turn, equation (17) implies that 1

vt

q(1 - Oct-llct)

(18)

It follows from equation (7) that the denominatoron the R.H.S. of this expression is the shortrun price elasticity of demandfor each particular variety of goods in equilibrium.Note that the short-run price elasticity of demandunderdeep habits, q(1 - Oct-1/ct), is smallerthanthe price an elasticity of demandin the absence of deep habits,which is given by q. Furthermore, increase in currentaggregatedemand,ct, relativeto habitualdemand,Oct-1, increasesthe short-run price elasticity of demand. termsyields Using equation(18) to eliminatevt from (16) and rearranging

Pt-'1

-+OEtrtt+lvt+l

"

(19)

This expression defines the equilibriummark-upas a function of the short-term price elasticity of demand, q(1 - Oct-_l/ct), and the present value of futureper-unitprofits induced by a unit increasein currentsales, OEtrt,+vt+1t+l. Clearly,all otherthings constant,an increasein current aggregatedemandrises the short-term price elasticity of demand,inducing a decline in equilibrium mark-ups.This is the price-elasticityeffect of deep habits on mark-ups. At the same time, an increase in the present value of future per-unit profits causes a decline in mark-ups.This is the intertemporal effect of deep habits on mark-ups.The size of the intertemporal effect of deep habits is determinedby two components, the discount factor

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rt,t+l and the presentvalue of futureper-unitprofits,vt+1. The equilibriummark-upis decreasing in the discount factor, which implies that, all else constant, a rise in the real interest rate should be associatedwith an increase in the currentmark-up.This is because if the real interest rateis higher,then the firmdiscountsfutureprofitsmore, and thus has less incentivesto invest in marketshare today. Also, the mark-upis decreasingin vt+l, the value of futureper-unitprofits discountedto periodt + 1. The intuitionfor why the currentmark-upis decreasingin vt+l is that if future per-unitprofits are expected to be high, then the value of having marketshare in the futureis also high, and thus thereis an incentive to increase the futurecustomerbase. A higher customerbase in the futurecan be achieved by charginglower mark-upstoday. The implied negative relationbetween mark-upsand expected futureprofits and between mark-upsand the discount factor distinguishes the mark-updynamics in the deep-habitmodel from those impliedby the implicit-collusionmodel of Rotembergand Saloner(1986) andRotemberg and Woodford(1992). In that model, collusion among firms is sustainedby the credible threatof revertingto a perfect competition, marginal-cost-pricing regime, in the event that any firm fails to abide to the terms of the implicit agreement.Thus, the maximumsustainablemarkup in the collusive equilibriumis decreasing in the short-runbenefit from deviating from the implicit collusion and increasingin the long-runbenefit of staying in the collusive relationship. The benefit of cheating is an increasingfunction of currentoutput,while the benefit of sticking to the implicit pricing arrangement an increasingfunction of the presentdiscountedvalue of is futureexpected profits. If 0 = 0, that is, in the absence of deep habits, both the price-elasticityand intertemporal effects vanish, renderingthe mark-uptime invariantand equal to q/(q - 1). A naturalnext step is to explore how the price-elasticityand intertemporal effects of deep habits affect quantitatively the dynamics of outputand mark-upswithin the context of a more realistic model of the macroeconomy. 3. A FULLYFLEDGEDMODELWITHDEEP HABITS In this section, we embed deep habits into a fully fledged dynamicgeneralequilibriummodel of the business cycle. The goal is to quantitatively characterizethe equilibriumbehaviourof markin responseto a varietyof aggregatedemandand supply shocks. We contrastthe responseof ups mark-upsin the model with deep habitsto thatarisingeitherin models featuringno habit formaat habit-formation models incorporating tion, or in standard dynamiccomplementarities the level of aggregateconsumption(i.e. superficialhabits). The theoreticalframeworkconsideredhere is richerthan the one studied in Section 2, in that it featurescapital accumulation,a more general formulationof deep habits, and three sources of aggregatefluctuations:governmentpurchases, of preference,and productivityshocks. In what follows, we sketchthe structure the model, leavand ing a more detailedderivationto a separateappendix(Ravn, Schmitt-Groh6 Uribe, 2004a). 3.1. Households Householdj e [0, 1] is assumedto have preferencesthatcan be describedby the utility function
O0

t=O

where vt is an exogenous and stochasticpreferenceshock thatfollows a univariate autoregressive process of the form Vt = Pvot-1 + e/, with pu e [0, 1) and et distributed i.i.d. with mean 0 and standarddeviation ac. This shock is meant to captureinnovationsto the level of privatenonbusiness absorption.

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Unlike in the simple model of Section 2, we now consider a preference specification in which the stock of externalhabit dependsnot only upon consumptionin the previousperiod, also on consumptionin all past periods.Formally,the level of habit-adjusted .but consumption,xJ, is now given by 1/(1-1/

x=

L(cj-Osit)b-1)1di
sit = psit-1 + (1 - p)cit.

where sit-1 denotes the stock of externalhabit in consuming good i in period t - 1, which is assumedto evolve over time accordingto the following law of motion The parameterp E [0, 1) measures the speed of adjustmentof the stock of external habit to variationsin the cross-sectional average level of consumptionof variety i. When p takes the value 0, preferencesreduceto the simple case studiedin Section 2. Households are assumed to own and invest in physical capital. At the beginningof a given period t, household j owns capitalin the amountof kJ thatit can rent out at the rate ut in period t. The capital stock is assumedto evolve over time accordingto the following law of motion

where i/ denotes investmentby householdj in periodt. Investmentis assumedto be a composite good producedusing intermediategoods via the technology
1/(1-1/7) it =

iIit
-0

it

Note thatwe do not assume any habitin the productionof investmentgoods. However,if we were to reinterpret deep-habitmodel as a switching-costmodel, then one may plausiblyarguethat our in fact, the aggregateinvestmentgood should dependnot only on the currentlevel of purchases of intermediate investmentgoods but also on theirrespectivepast levels. 3.2. The government In each periodt > 0, nominalgovernmentspendingis given by Ptgt. We assumethatreal government expenditures,denotedby gt, are exogenous, stochastic, and follow a univariate,first-order autoregressive process of the form ln(gt/g) = Pgln(gt-1/g)+ Ce, where the innovationeg distributesi.i.d. with mean 0 and standarddeviation ug. The governmentallocates spending over intermediategoods git so as to maximize the quantityof a composite good producedwith intermediategoods accordingto the relationship
xt

=f(Oit
=

-Osit-)/"di]

The variablest denotes the stock of habit in good i and is assumedto evolve over time as
sgt

psg-1

+ (1 -p)git.

We justify our specificationof the aggregatorfunction for governmentconsumptionby assuming that private households value government spending in goods in a way that is separable from private consumption and leisure and that households derive habits on consumption of

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REVIEWOF ECONOMICSTUDIES

goods. The government'sproblemconsists in choosing git, i E [0, 1], so as government-provided to maximize xg subjectto the budget constraint and taking as given the initial foPigit Ptg, condition git = gt, for t = -1 and all i. In solving this maximizationproblem, the government _ takes as given the effect of currentpublic consumptionon the level of next period's composite good-that is, habits in governmentconsumptionare external.Conceivably,governmenthabits could be treatedas internalto the government,even if they are external to their beneficiaries, however,is analyticallyless tractable. namely,households.This alternative, Public spendingis assumedto be fully financedby lump-sumtaxation. 3.3. Firms Each good i e [0, 1] is manufactured using labourand capitalas inputsvia the following production technology:
Yit = At F(kit, hit) - q,

where yit denotes output of good i, kit and hit denote services of capital and labour, and q denotes fixed costs of production.'The variableAt denotes an aggregatetechnology shock. We assume thatthe logarithmof At follows a first-order autoregressive processInAt = PaIn At-1 + 6a where is a white noise disturbance deviationUa. with standard , ,a The monopolistproducinggood i faces the following demandfunction:
cit + it + ir Pit (xt + it + x) +(sit-1 + St-1)

3.4. Estimationand calibration of We computea log-linearapproximation the policy functionsin the neighbourhood the nonto stochastic steady state of the economy. We calibratethe model to the U.S. economy. The time unit is meant to be one-quarter. estimate the preferenceparameters We definingdeep habitsusing a non-lineargeneralizedmethod of moments (GMM) estimator.The approachthat we take is to exploit the fact that the deep-habitparametersenter both the intertemporal consumption Eulerequation-as in superficial-habit-formation models-and the equilibriumconditionsdetermining the dynamics of the mark-up,which originateon the supply side of the economy. This of characteristic the deep-habitmodel is particularly useful, because it allows for a more efficient that estimationof the habitparameters estimatesof habitparameters arederived thanthe standard solely from the consumptionEulerequation. To facilitate estimation, we assume that utility is separablein consumption and leisure.
Specifically, we assume that U(x, h) =

and y > 0. We use U.S. quarterlydata spanningthe period 1967:Q1 to 2003:Q1. For a detailed -_ and of the econometricestimation,see Ravn, Schmitt-Groh6 Uribe (2004d). Based presentation
on our estimation, we set 0 = 0-86, p = 0-85, q = 5.3, and a = 2.

+y

(1-h)

-X

, where 0 < a

1, O <

1,

Following Prescott (1986), we set the preferenceparametery to ensure that in the deterministic steady state, households devote 20% of their time to market activities. The calibration restrictionsthat identify the remaining structural parametersof the model are taken from and Woodford(1992). We follow their calibrationstrategyto facilitate the comparRotemberg ison of our model of endogenous mark-upsdue to deep habits to their ad hoc version of the
1. The presenceof fixed costs introducesincreasingreturnsto scale in the productiontechnology.We model fixed costs to ensure that profits are relatively small on average, as is the case of the U.S. economy, in spite of equilibrium mark-upsof prices over marginalcost significantlyabove 0.

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205

customer-market model. We assume that the productionfunction is of the Cobb-Douglas type, = kah1-a; a (0, 1). We set the labour share in GDP to 75%, the consumptionshare F(k, h) to 70%, the governmentconsumptionshareto 12%,the annualreal interestrate to 4%, and the Frisch labour supply elasticity equal to 1.3. These restrictionsimply that the capital elasticity of outputin production,a, is 0.25, the depreciationrate, 6, is 0-025 per quarter, subjective the discountfactor,f, is 0-99, and the preferenceparameter, is 3.08. X, We show in Ravn et al. (2004a) that the steady-statemark-upof price over marginalcost,
,u, is given by qm

qm - 1' where
m + Sg) (Sc -

O(p - 1) + I - flp

(1-Ipp)(1-O)

i <,

where sc, Sg, and si denote the steady-stateshares of consumption,governmentpurchases,and investmentin output,respectively.Our calibrationimplies a somewhathigh averagemark-upof 1.32. Note, that in the case of perfect competition,thatis, when q - oc, the mark-upconverges to unity. In the case of no deep habit, that is, when 0 = 0, we have that m = 1, and the mark-up equals ql/( - 1) = 1-23, which relatesthe mark-upto the intratemporal elasticity of substitution across varietiesin the usual way. Because underdeep habits, the parameter is less than unity, m firms have more marketpower underdeep habits than under superficialhabits. This is because, in the former formulation,firms take advantageof the fact that when agents form habits on a basis, the short-run variety-by-variety price elasticity of demandfor each varietyis less than q. We set the serial correlationof all three shocks to 0-9 (i.e. p, = Pg = Pa = 0-9). Table 1 summarizesthe calibration. 3.5. Aggregatedynamics We now characterizequantitativelythe response of the deep-habit model to a variety of exogenous shocks. We consider three sources of aggregate fluctuations: preference shocks, vt, shocks, gt, and productivityshocks, At. Row 1 of Figure 1 displays imgovernment-spending of the mark-up,output,wages, and consumptionto an increasein the preference pulse responses shock vt in the amountof 1% of steady-state,habit-adjusted consumption.The response of the model is shown with a solid line. For comparison,the figurealso depicts the response deep-habit of economies with superficialhabit, shown with a dashedline, and no habit, shown with a dotted line. Under all three model specifications, consumptionand output increase as a result of the preferenceshock. Consumptionincreases because the shock raises the marginalutility of consumption.At the same time, the shock induces an expansionin laboursupplybecause it reduces the value of leisurein termsof consumption.This explainswhy outputincreasesin all threecases. The expansionin the supply of labourputs downwardpressureon wages. In the economies with superficialhabit or no habit, the labourdemandschedule is unaffectedby the preferenceshock on impact. In these two economies, the combinationof an unchangedlabourdemand schedule and an increasein the laboursupply causes the equilibriumwage to fall. By contrast, in the deep-habitmodel the mark-upfalls significantly on impact by about This decline in the mark-upleads to an increase in the demand for labour at any given 0.4%. wage rate. This expansionin labourdemandmore than compensatesthe increasein laboursupply, resultingin an equilibriumincrease in wages of about0-3%. The reason why mark-upsfall in the deep-habitmodel is that in responseto the increasein the demandfor goods, the habitual, price-inelasticcomponentof demandbecomes relativelyless important, makingdemandfor each

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TABLE 1 Calibration Symbol Value Description Inverseof intertemporal elasticity of substitution

f
r 0 p
a

0.9902
2

factor discount Subjective

0.86 0.85
0-25

of formation Degree habit stock of Persistence habit

Capitalelasticity of output

6
1
Ch to

0-0253 5.3 0.2

0.0318 1.3

rate depreciation Quarterly of across varieties Elasticity substitution

Frisch elasticity of laboursupply

to of fraction timedevoted work Steady-state

Steady-statelevel of governmentpurchases

S00853
Pu Pg, Pa 0.9

Fixedcost

Persistenceof exogenous shocks

individualvarietyof goods more price elastic. In turn,the increasein price elasticity leads firms to cut mark-ups. This pricingstrategyinduces agentsto form habitsthatfirmscan lateron exploit by charginghighermark-ups.Summarizing,the differencebetweenthe deep-habitmodel andthe models with either superficialor no habit is thatunderdeep habitsthe mark-upbehaves counterpreferenceshock. cyclically, and real wages are procyclicalin responseto an expansionary Row 2 of Figure 1 shows the responseof the threeeconomiesunderanalysisto a 1%increase in governmentconsumption.Government-spending shocks aresimilarto preferenceshocks of the describedabove in thatthey increaseaggregateabsorptionand laboursupply.In the case of type shocks, the laboursupply increasesbecause the expansionin unproductive government-spending leaves households poorer.The increase in labour supply introducesdownward public spending pressureon wages. In the economies with superficialhabits or no habits, the real wage indeed falls in equilibrium.In the economy with deep habits, firmsreducemark-upsby abouthalf a per cent. The resultingexpansion in labourdemandis strong enough to offset the income effect on labour supply.As a result, real wages rise in equilibrium.Thus, as in the case of innovationsin shocks triggercountercyclicalmark-upmovementsand privatespending,government-purchases movements.This findinghinges on our maintainedassumptionthatgovernment procyclicalwage consumptionis subjectto good-specific habit formation. Of particularinterest is the fact that the deep-habitmodel predicts that privateconsumption rises in response to an increase in governmentspending. In the model without deep-habit formation(with or without superficial-habit formation),privateconsumptionspending declines as governmentspendingrises. This decline in consumptionis drivenby the negative income effect introducedby higherunproductive public spending.Underdeep habits,the negativeincome effect is offset by a strong substitutioneffect away from leisure and into consumptioninduced by the increase in wages associated with the fall in mark-ups.The positive response of private shocks predictedby the deep-habitmodel is in line with consumptionto government-spending the data, for recently,a numberof authorshave found that autonomousincreasesin government and spendinglead to higherprivatesector consumption(see, e.g. Fatais Mihov, 2001; Blanchard and Perotti, 2002; and Gall, L6pez-Salido and Vall6s, 2003). In particular,Gall et al. (2003) document that for the U.S. economy, a 1% increase in governmentspending is followed by a persistentand significantincreasein privateconsumptionthatpeaks at over 0-25%after 10 quarters. Although the deep-habitmodel underpredicts magnitudeof the consumptionincrease, the it is remarkable that it can overturnthe predictionof standard neoclassical models of a negative relationshipbetween public and privateconsumption.

RAVNET AL.
Mark-up 0.4 0.2 0 --0 2 -

DEEP HABITS
03 Wage 1 Consumption

207

0-8 06

Output

0.2 -----04
0-2 .20
-

0.1

0-5-

-0.4

10 Mark-up

20

10 Output

20

-0.1

10 Wage

20

10 Consumption

20

0.5

0.6

0.6

0-02

0
0.4--0.2 -0.5 -1 -0-2 0-4--0.2 0 -0-02

10 Mark-up

20

10 Output

20

-0-2

10 Wage

-0-04 20 0

10 Consumption

20

0-2

2 1-5

1-5

0 04 03 0.2 0.1

0 -------------02 -0.4 -0-6 0 10

1V-..0
0-5 20 0 0
0"-

10

20

10

20

10

20

Deep habit
Note:

- - - Superficial habit

..... No habit

Row 1, preferenceshock;row 2, government-spending shock;row 3, technology shock. Impulse responses are measuredin per cent deviations from steady state. Horizontal axes display the numberof quarters afterthe shock. FIGURE 1 Impulse responses under deep habits

Row 3 of Figure 1 displays the consequences of a 1%increase in total factorproductivity. Here, underdeep habits,firmsalso choose to cut mark-upsto gain customerbase. As a result,the wage rate increasesmore underdeep habitsthanundereither superficialhabitsor no habits. In the past decade, a growingliterature arguedthatproductivityshocks play only a limhas ited role as a source of business-cycle fluctuations.For example, in a recent surveyof this literature,Gall and Rabanal(2004) estimatethattechnology is responsiblefor about 15%of the variations in outputand hours at business-cycle frequency.Moreover,these authorsconclude thatthe empiricalevidence points to demandfactors as the main force behind the positive comovement between outputand labourinputmeasures.It follows from the Gall and Rabanalconclusion that a measureof the ability of any model to fit the datais its predictionsregardingthe comovement between labour and output, conditional on demand shocks being the main source of fluctuations. Cooley and Prescott(1995) reporta correlationbetween labourproductivityand outputof 0.34. Ourdeep-habit-formation model predictsa correlationof 0.33 conditionalon governmentpurchasesshocks being the sole source of uncertaintyand of 0.72 when only preferenceshocks

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are present.By contrast,the respectivepredictedcorrelationsunderthe superficial-habit model are -0.1 and -0-85. This finding suggests that the deep-habitmodel has the potentialto offer a betterexplanationof salientbusiness-cycleregularities neoclassicalframework, thanthe standard with or without superficialhabits. The predictedcountercyclicalbehaviourof mark-upsin the deep-habitmodel standsin stark contrastto ad hoc versions of switching-cost or customer-market models such as the one dein Rotembergand Woodford(1991, 1995). For a formalquantitative comparisonof the veloped deep-habitmodel andthe RotembergandWoodford(1991, 1995) versionof the customer-market model, see Ravn et al. (2004d). There,we show thatunderall three shocks consideredabove, the model predictsthat the mark-upmoves in the same Rotembergand Woodfordcustomer-market directionas output.Also, in responseto demandshocks, whetherprivateor public, wages move countercyclically. model To understandwhy the Rotembergand Woodfordversion of the customer-market model based on deep-habit producesso differenta mark-upbehaviourthanthe customer-market to formation,it is important note thatin the deep-habitmodel the demandfaced by an individual firm featuresa positive, price-insensitiveterm,0(sit-1 +s_ -1), that dependsonly on past sales. Due to this term,the price elasticityof demandfor an individualvarietyincreaseswith currentagIn gregatedemand,providingan incentivefor firmsto lower mark-ups. the Rotemberg-Woodford customer-market model, there is no such price-insensitiveterm.As a result, the elasticity of demand for an individualvariety is independentof currentaggregatedemand conditions. As we discuss later in Section 4.2, a version of our deep-habitmodel in which the single-periodutility function depends not on the quasi-differencebetween currentand past consumptionof each variety but ratheron the quasi-ratioof these two variablesdelivers a specificationfor the demand function faced by an individualfirm that is closer to the one adoptedad hoc by Rotembergand Woodford. 4. EXTENSIONS Thus far, we have focused on an additivespecificationof deep habits.We identifiedtwo channels throughwhich the presenceof deep habitsaffects mark-ups,factorprices, and aggregateactivity: a staticprice-elasticityeffect and an intertemporal effect. In the fully fledgeddeep-habitmodel of Section 3, the price-elasticityeffect of deep habitsdominatesthe equilibriumdynamicsof markups in the sense thatincreasesin aggregatedemand,regardlessof their origin, cause an increase in the price elasticity of the demand for each variety of goods, thereby inducing a decline in mark-ups.Here, we study two extensions of the deep-habitmodel that allow us to analyse the effect effects in isolation.First,we shutdown the intertemporal price-elasticityandintertemporal by considering a model with good-specific subsistencepoints. Second, we eliminate the priceeffect by consideringan environmentwith elasticity effect, while maintainingthe intertemporal relativedeep-habitformation. An assumptionmaintainedup to this point is that deep habits are externalto the individual consumer.The main rationalfor adoptingthis modelling strategyis analyticalconvenience. A naturalextension is to consider the case in which householdsinternalizetheir addictivepropensity. We take on this task at the end of this section. 4.1. Good-specificsubsistencepoints In this extension, we consider a variantof the fully fledged model of Section 3 in which the effect of deep habits vanishes, whereas the price-elasticityeffect remains active. intertemporal Specifically, we assume here that agents derive utility from the quasi-differencebetween con-

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209

sumptionof individualvarietiesand a good-specific subsistencepoint. Formally,we replacethe function (1) with aggregator
1/(1-1/1/)

xt

(ct

c*)

*di

wherec7 is a constantsubsistencelevel of consumptionof varietyi. We incorporate good-specific subsistence points for the consumptionof public goods as well. This preference specification gives rise to an aggregatedemandschedule for each individualvarietyof the form g. it)+c C For a detailed analysis of this model, see Ravn, Schmitt-Groh6 Uribe (2004c). This demand and function shares with the one correspondingto the deep-habitmodel the presence of a purely price-inelasticterm,here given by c7 + g7. As a result,the price elasticity of demand,like in the deep-habitmodel, is smallerthanq andprocyclical.This meansthatthe presenceof good-specific subsistence points induces a price-elasticityeffect that rendersthe mark-upcountercyclical.A significant difference between the good-specific subsistence-pointand the deep-habit models is that in the former the price-inelasticterm of the demand function is exogenous to the firm. effect present in Consequently,the pricing problem of the firm is static and the intertemporal the deep-habitmodel ceases to exist. The good-specific subsistence-pointmodel is, therefore, an ideal environment study the price-elasticityeffect in isolation. to 2 displays, with broken lines, the dynamics of mark-ups,wages, output, and conFigure and sumptionin response to positive preference,government-spending, productivityshocks in the good-specific subsistence-point model. For comparison,the figurealso reproduceswith solid lines the correspondingdynamics of the fully fledged deep-habitsmodel. The calibrationof the subsistence-pointmodel mimics that of the fully fledged, additive deep-habitmodel presented in Section 3. We set the subsistence level of aggregateabsorptionc* + g* so that the steadystate mark-upis 32% as in the deep-habit model. The figure shows that, as expected, for all three shocks considered,the mark-up behaves countercyclicallyin the good-specific subsistencemodel. However, in comparison to the deep-habit model, the mark-upmovements are point small. Indeed, the decline in mark-upsis insufficientto induce procyclical wage movementsin response to demand shocks, a feature of the data that has been used to judge the empirical theories of endogeperformanceof the standard real-business-cyclemodel as well as alternative nous mark-ups(Rotembergand Woodford,1992). Similarly,the good-specific subsistence-point model fails to deliver a procyclical consumptionresponse, following an increasein government spending, an empiricalregularitystressed in Gall et al. (2003). One reason why the deep-habit and the subsistence-point models imply quantitatively such differentdynamicsis the fact thatfor given values of the steady-statemark-upand the parameterq, the deep-habitmodel features a much largerprice-inelasticcomponentof demand.As a consequence, the price-elasticityeffect is strongerin the deep-habitmodel than in the good-specific subsistence-pointmodel. The reason why the price-inelasticcomponentof demandis small in the good-specific subsistence-point model is the absence of the intertemporal effect presentin the deep-habitmodel. The deep-habit model has the ability to be consistent, both with a relatively large price-inelasticcomponentof demand and a realistic average mark-upbecause the intertemporal effect pushes the long-run effect lowers long-runmark-upsis that mark-updown. In turn,the reasonwhy the intertemporal the marginalrevenue schedule that is relevantto the firm includes, in additionto the traditional static marginalrevenue schedule, a positive componentoriginatingin the fact that an additional sale in the presentincreases sales in the futureby expandingcustomerbase throughhabits. cit + git +iit =Pi
(t +t

210
0
Mark-up 08

REVIEWOF ECONOMICSTUDIES
Output 0.3 02 Wage 0.8 Consumption

-0.1 -0.2 -0.3 -0.4 0 10 Mark-up 0"5 20

0.6 0.4
02

0.6 0 1 "0 0 10 Output 20 0 -0.1 04 02 0 \

10 Wage 1

20

10 Consumption

20

002

0"6 0-4 0.2

0"6 04 02 0---------

-0.5

-50

-0-02

-1

10 Mark-up
-

20 -0.2 0

10 Output

20 -0.2 0

10 Wage

20

-0-04

10 Consumption

20

0
-0.2 -04 -06 -0"8 0

2 15 15 1

1.5 1

0.4 03 0.2

N0.5 0-5 10 20 0 0 10 20 0 0 10

01 20 0 0 10 20

Deep habit
Note:

- - - Good- specific subsistence point

Row preferenceshock:row 2. government-spending shock:row 3, technologyshock. 1, Impulse responses are measuredin per cent deviations from steady state. Horizontal afterthe shock. axes display the numberof quarters FIGURE 2

subsistence under points Impulse responses good-specific 4.2. Relative deep habits

A key ingredientin generatingthe price-elasticityeffect of deep habitsin the fully fledgedmodel of Section 3 is a price-inelasticterm in the demand for individual varieties. We now wish to effect of shut down the price-elasticityeffect in order to shed more light on the intertemporal deep habits. We do so by turningattentionto a relative formulationof deep habits. In contrast to additivehabits, relativehabits give rise to demandfunctionsfor individualvarietiesof goods that do not featurea price-inelasticterm. As a result,underrelativehabits,the price elasticity of demandis constant.In this case, equilibriummovementsin mark-upsare drivenexclusively by effects. intertemporal A single feature distinguishesthe relative deep-habitmodel from its additive counterpart. Namely, the fact that under relative deep habits the aggregatorfunction depends on the quasiratio of consumptionof each varietyto past (or habitual)consumptionof thatvariety,as opposed to dependingon the quasi-differencebetween these two variables,as is the case under additive deep habits. Formally,underrelativedeep habits, each household j e [0, 1], derives utility from an object xt/, given by

RAVNETAL.

DEEP HABITS

211

x.=

1 (
--di
cit-1

di]

This aggregator functiongives rise to an aggregatedemandfor each varietyof goods i E [0, 1] of the form
it Ptcit1 xt, (20)

where Pt is a price index that firms take as exogenously given. We note that in the standard model without deep habits, the parameterq, denotingthe intratemporal elasticity of substitution across varieties, must be greaterthan 1 in orderfor the monopolist problemto be well defined. We maintainthis assumptionhere in order to be able to comparethe dynamic implications of models with and without deep habits. It follows that if the demandfor each particular varietyis to be increasingin the stock of habit (cit-1 in the simple formulationanalysed here), then the 0 parameter must be negative.In the numericalanalysisthatfollows, we set 0 at -0.1.2 We show elsewhere (Ravn, Schmitt-Groh6 and Uribe, 2004b) that in the context of the simple economy withoutcapitalof Section 2, the above demandfunctiongives rise in equilibriumto a mark-upof the form ttt [ 1- - )Ct+l
+OEtrt,t+Vt+(1 (21)

This expression is directly comparablewith its counterpart the additive deep-habitmodel, in given by equation (19). Under relative deep habits, the price-elasticityeffect of deep habits on mark-upsvanishes. This can be seen from the fact that the second term in the bracketedexpression, denotingthe short-run price elasticity of demand,is constantand equal to 1/il. By contrast, under additivedeep habits, the short-run price elasticity is procyclical, which contributesto the of It countercyclicality mark-ups. follows thatunderdeep relativehabitsthe only channelthrough which deep habits affect mark-upsis the intertemporal effect, embodiedin the thirdterm of the bracketedexpression.As in the case of additivedeep habits, this term representsthe discounted value of futuredemandinducedby an additionalsale in the currentperiod.This termis different from its additive-habits in counterpart two respects.First,underadditivehabits,a unit increasein currentsales raises next period's sales by 0. Underrelativehabits,a unit increasein currentsales raises next period's sales by 0(1 - q)ct+1/ct. As a result,underrelativedeep habits, an expected increasein the growthrateof aggregatedemandinduces firmsto lower currentmark-upsso as to broadentheir customerbase. The second differenceis thatunderrelativedeep habitsthe shadow value of a unit sale in period t, vt, is constantand equal to 1/r (see Ravn et al., 2004b), whereas underadditivedeep habitsit is time varyingand countercyclical.A featurecommon to both the relative- and the additive-habit models is the predictionthat equilibriummark-upsincreasewith interestrates (i.e. putincreaseswhen rt,t+l falls). In the simple version of the relativedeep-habitmodel analysedhere, mark-upsmove countercyclically in response to productivityshocks (At), but procyclically in response to shocks to privateaggregatedemand(vt) (see figure 1 in Ravn et al., 2004b). The differencein the cyclical behaviourof mark-upsunder supply and demand shocks is entirely driven by the dynamics of the interestrate.Underboth types of shock, aggregatedemandincreaseson impactand then converges monotonicallyto its steady-stateposition. This means thatct+1/ct is below its steady-state level along the entiretransition.Accordingto equation(21), this patternof consumptiongrowth
2. The possibility that positive values of 0 give rise to counterintuitive implicationsfor the relationbetween the stock of habit and the demandfor goods also arises in the superficialformulationof relativehabits.In effect, in this case, the marginalutility of consumptionis decreasingin the stock of habit when 0 is positive and the curvature the period of utility functionis less pronouncedthanunderlogarithmicpreferences.

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should contributeto elevatedmark-uplevels underboth types of shock. However,underdemand shocks the interest rate increases, reinforcingthe rise in mark-ups,whereas under the supply shock the real interestratefalls, offsetting the effect of consumptiongrowth.The reasonwhy the real interestraterises in responseto a positive preferenceshock is thatpreference-shock-adjusted consumption,xt - Vt, falls on impact and converges monotonicallyto its long-runposition. In turn,the reasonwhy the real interestrate falls in responseto a positive technology shock is that, in the absence of any investmentopportunities,agents must be given disincentivesto save (or incentives to consume) the initial increasein output.This disincentivetakes the form of low real interestrates. Consider now, the effects of relative deep habits in the fully fledged model with capital accumulationand governmentpurchasespresentedin Section 3. In this model, the aggregate demandfor each varietyof goods i e [0, 1] faced by a monopolistis given by:
cit + gir + ii Xt

+ -t--00-0) it
it1

Pit

xt9 [sitg-11

+ P

it it,

]0(1-0)

where Pt, P and Pt denote price indices of habit-adjusted privateconsumption,habit-adjusted g, public consumption,and privateinvestment,respectively,which the firm takes as exogenously given (for a detailedderivationof the above demandschedule, see Ravn et al., 2004b). As in the case of the simple model withoutcapital accumulationor governmentspendinganalysedearlier in this section, all terms on the R.H.S. of the above demandfunction are price elastic, with an elasticity equal to q. As a result, the price-elasticityeffect of deep habits, stemming from the presence of purelyinelastic terms, is also absentin the fully fledged variantof the relativehabit effect of deep habitsdeterminesthe behaviour model analysedhere.As a result,the intertemporal of mark-ups. There is, however, a key difference between the above demand function and the one belonging to the simpler formulationwhere the only component of aggregatedemand is private consumption,given by equation (20). Namely, in the above demandfunction, not all terms include the stock of habit as a factor.Specifically,the thirdterm does not featurea habitualfactor, reflectingthe assumptionthat the demandfor individualvarieties of goods for investmentpurof poses is not subjectto habitformation.This characteristic the demandfunctionsfor individual varieties in the fully fledged model is of fundamentalimportancein shaping the dynamic response of mark-ups.Specifically, changes in the compositionof demand will alter the strength of the intertemporal effect. For instance, a technology shock that affects mostly the demandfor privateinvestment,which is not subjectto habitformation,will induce a pricingbehaviourcloser to that pertainingto an economy without habit formation,than the pricing decision that is induced by either a preferenceshock or a government-spending shock, which affects primarilythe demandfor habit-affectedcomponentsof aggregatedemand. Figure 3 displays the dynamicresponse of the mark-upand othermacroeconomicvariables of interestto positivepreference,government-spending, technology shocks. The behaviourof and mark-upsshown in the figureis dominatedby changes in the compositionof aggregatedemand. To understandthe effects of changes in the composition of demand on the equilibriummarkup, it is of use to determinethe steady-statevalue of the mark-upin the fully fledged relative habit model, denoted and in two variantsthereof: namely, the steady-statemark-upin the /, = 0), denotedby juNOH; and the steady-statemark-upin a model absence of deep habits(0 = -o where investmentspendingis subjectto habit formation,that is, the steady-statemark-upin an economy, where all componentsof aggregatedemandare subjectto habitformation,denotedby
~ ALLH. It can be shown that /1ALLH the preferenceshock and the government-spending shock amplify the importanceof the habitual < <NOH

(see Ravn et al., 2004b). Now, because both

RAVN ETAL.
0-02 Mark-up 0-4 0-3 0.2 -0-02 0.1 -0-04 0 10 20 0 0 10 Output 0.06 0"04 20 Output

DEEP HABITS
-0-04 Wage 1 Consumption

213

0-

-0-06
0-5 -0-08 0

-0.1

10 Wage

20

10 Consumption

20

2 0 -2 -4 -6

x 10-3 Mark-up

-0-01 -0-012 -0-014

-0-01 -0-015 -0-02 -0-025

0-02 -0-016 0 10 Mark-up 20 0 0 10 Output 20 -0.018 0 10 Wage 20

-0-03

10 Consumption

20

0-15 0.1

-5 51

1 0.8 -

0.4 0-35

0.05 0 -0"05 0 10 Note: 20

0"5

0.6

0.3 0.25 0 10 20 02 0 10 20

04 0 0 10 20 0.2

Row 1, preferenceshock;row 2, government-spending shock;row 3, technology shock. Impulse responses are measuredin per cent deviations from steady state. Horizontal axes display the numberof quartersafterthe shock.

FIGURE 3 Impulseresponsesunderrelativedeep habits

demandfor goods, firms have an incentive to lower the mark-upfrom its steady-statevalue / toward uJALLH,the steady-statemark-upbelonging to an economy where all components of aggregatedemandare subjectto habitformation.Similarly,in responseto a positive productivity shock thatenlargesthe componentof aggregatedemandnot subjectto habitformation,firmswill have a tendency to raise the mark-upfrom its steady-statevalue to some level closer to ,NOH, the steady-statemark-uppertainingto an economy withouthabits. 4.3. Internaldeep habits Thus far, we have restrictedattentionto the case in which habits for each individual variety are external.This case can be interpreted two ways. One is that households are catching up in with their neighbours on a good-by-good basis. For instance, if the Joneses buy an expresso externalhabitscan machine,theirneighboursfeel the urge to purchaseone as well. Alternatively, be interpreted arising from addictedindividualsthat fail to internalizetheir dependence.We as adopt the externalform of habit formation,as opposed to the internalone, for purely analytical reasons. Namely, the assumptionof externalhabit formationon a good-by-goodbasis preserves the separationof the problem of choosing total consumptionexpendituresover time from that of choosing expenditureson individualvarieties of goods at a given point in time. Under deep

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REVIEWOF ECONOMICSTUDIES

internalhabits, such separationis broken, and the consumerproblembecomes more complex. Here, we explicitly consider the case of internaldeep habits. In the Appendix, we show that under internaldeep habits the aggregatedemandfor good i in the simple productioneconomy withoutcapitalof Section 2 takes the form
cit =
k=0

OkEtrt,t+kPit+k

Xt + ocit-1,

where Xt is a measureof aggregatedemand. This demand function shares key characteristicswith that arising in the case of external deep habits (equation(7)). Namely, the demandfor each good varietyis composed of two terms: a habitual term, Ocit-1, that is completely price inelastic; and a price-elastic term, [kZ-0 OkEtrt,t+kPit+k]F- Xt, that is increasingin some measureof aggregate activity, Xt. All other things equal, if aggregatedemandincreases (Xt goes up), the relative importanceof the priceelastic term rises and the elasticity of demandincreases. This suggests a procyclicalprice elasticity as in the case of externaldeep habits. However,a fundamentaldifferencebetween externaland internaldeep habits is that under internal deep habits, currentdemand for a particularvariety depends not only on its current relativeprice but also on all futureexpected relativeprices. This differencedramatically changes the natureof the firm's problem.In particular, under internaldeep habits the firm's problemis no longer time consistent, as in each period the monopolist has the incentive to renege from price promises made in the past that were optimal (profit maximizing) at the time they were made. A full analysis of the optimalpricing behaviourunderalternative economic environments commitmentor discretionin its many differentforms such as Markov-perfect (e.g. equilibria,or is beyond the scope of this paperand is left for futureresearch. reputational equilibria)
4.4. Deep habits and sticky prices

Over the past decade, focus in macroeconomicresearchhas shifted from the real-business-cycle paradigmto models in which nominalfrictionsare at centre stage, namely to the new Keynesian synthesis.The key elements of the new Keynesianmodel are stickyproductprices andmonopoly firms. power at the level of intermediate-goods-producing As in the deep-habitmodel, in the sticky-pricemodel, mark-upsof prices over marginal costs are positive and time varying.However, the mark-updynamics implied by these two formulationsare quite different.Indeed, Schmitt-Grohd Uribe (2004) study a calibratedmodel and with sticky prices a la Calvo-Yun and superficialhabits, among several other real and nominal rigidities.Figures 1 and 2 of that paperdisplay the responseof the economy to productivityand shocks, respectively,underthe assumptionthat monetarypolicy takes the government-spending form of a simple Taylorrule. A numberof featuresof these impulseresponsesserve as a guide to empiricallydistinguishbetween a sticky-pricemodel with superficialhabits and a flexible-price model with deep habits. In response to a positive productivityshock the deep-habitmodel predicts a decline in mark-ups,whereas the sticky-pricemodel predictsan increase in mark-ups.3 in Further, responseto a positive government-spending shock, consumptionandreal wages fall in the sticky-pricemodel, whereas in the deep-habitmodel both variablesincrease. Like the deephabit model, the sticky-pricemodel predicts a decline in mark-upsin responseto an increasein public spending. However, the movements in mark-upsimplied by the sticky-pricemodel are quantitatively negligible (of the orderof 0.01% in responseto a 1%increasein public spending).
3. For the intuitionbehindthis predictionof the sticky-pricemodel see Schmitt-Groh6 Uribe (2004). and

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215

Doing justice to a comparisonof the predictionsof the deep-habitand sticky-pricemodels lies outside the scope of the presentstudy. A naturalquestionthat emerges from the above comparisonis whetherincorporating deep habits into the sticky-price model could improve the behaviour of mark-upsimplied by this model. In Ravn, Schmitt-Groh6 Uribe (2004e), we study the case of sticky prices and deep and habits.When deep habitsare combinedwith sticky prices, the linearizedPhillips curve becomes
7rt -E-ftt+

? +Knct

+0

m1ct -
-K

1I
1-0

fl[Et?t+l? + Etit,,t+i]

[-1

where a hat over a variabledenotesper cent deviationsfrom steady state,Kis a positive constant, = and mct denotes marginalcosts. Marginal costs are just the inverse of the mark-up,or tt 1/mct. All other variablesand parametersare as defined earlierin the paper.First, note that in the absence of deep habits, that is, when 0 = 0, the Phillips curve is the same as in the standard neo-Keynesianmodel. We note that for a given inflation path, the mark-upin the sticky-price model with deep habits differs from that in a sticky-pricemodel without deep habit as follows: (1) all else constant,an increase in currentoutput,yt > 0, reduces the mark-upand (2) all else constant, an increase in the futurevalue of sales, it+l > 0, or a reductionin the discount rate, rt,t+l > 0, reduces the mark-up.When monetarypolicy takes the form of a simple Taylorrule, then inflationfalls in the sticky-pricemodel withoutdeep habitsin responseto a positive technology shock. The above equation shows that as long as the currentdecline in inflation is larger thanthe expected futureinflationdecline, marginalcosts must fall, which is, mark-upsmustrise. However, in the presence of deep habits, it is, in principle,possible that mark-upsfall instead, because output increases and the present value of future sales, Etrt,t+lvt+1, may increase. So there is the possibility thataddingdeep habits to a sticky-pricemodel will resultin the prediction thatmark-upsfall in responseto a positive technology shock. Anothernoteworthyfeatureof the Phillips curve in the sticky-pricemodel with deep habits is thatit featureslagged values of output.This is interestingbecause the inflationdynamicspredicted by the model may display more inertia.Standard sticky-pricemodels have been criticized heavily for their inabilityto predictthe observedinertialbehaviourof inflation. 5. CONCLUSION In modem macroeconomics,it is commonplaceto assume thathouseholdshave preferencesover a large numberof differentiatedgoods. This assumptionis made, for instance, in models with imperfectlycompetitiveproductmarkets.At the same time, there appearsto be some consensus that the assumptionof habit formationis of greatuse in accountingfor key business-cycle regularities, in particular, consumptionand asset-pricedynamics. An obvious question that emerges in modelling economies with habitformationand a largevarietyof goods availablefor consumption is at what level habits are formed. That is, are habits createdat the level of each individual has consumptiongood or at the level of a consumptionaggregate.The existing literature focused exclusively on the lattermodelling strategy.This paperis motivatedby our readingof the available empirical literatureon consumptionbehavioursuggesting that the former alternativeis at least equally compelling. A centralfinding of our investigationis that the level at which habit formationis assumed to occur is of great macroeconomicconsequence. When habits are formed at the level of each individualvarietyof consumptiongoods, the demandfunctionfaced by a firmdepends not only on the relative price of the good and aggregateincome-as in the standardcase--but also on

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of past sales of the particular good in question.This characteristic the demandfunctionaltersthe behaviourof the firm,for today's prices are set takinginto accountthatthey will optimalpricing affect not just today's sales but also future sales throughtheir effect on futuredemand.In this way, the assumptionof deep habitsresultsin a theoryof time-varyingmark-ups.The deep-habit for model developed in this paperprovides microfoundations other models in which past sales affect currentdemandconditions at the level of each individualgood, such as customer-market and switching-cost models. General equilibriumversions of these models have been criticized for having the counterfactualimplicationthat mark-upsare procyclical. To our knowledge, all models use ad hoc existing general equilibriumtreatmentsof customer-market/switching-cost of the demand function faced by individual firms. In this paper, we show that specifications once the demand faced by firms is derived from the behaviourof optimizing households, the resultingequilibriumcomovementbetween mark-upsand aggregateactivity can be in line with the empiricalevidence. Most existing theories of countercyclicalmark-upsface a trade-offbetween the elasticity of the mark-upwith respect to aggregatedemandand the level of the mark-up.Typically,when the average mark-upis restrictedto empirically realistic levels, available theories predict too low an elasticity of the mark-upto explain the cyclical behaviourof wages and consumptionin featureof the additiveversion of the deep-habitmodel responseto demandshocks. An attractive in this paper is that it overcomes this trade-off.That is, our theory can predict high developed mark-upelasticities without requiringempiricallyunrealisticlevels of average mark-ups.This propertysuggests that the additivespecificationof deep habits offers the most fertile groundfor furtherinvestigation. For analyticalconvenience,in most of our analysis,habitformationis treatedas external.In the existing relatedliterature, however,the assumptionof internalhabit formationis prominent. Moreover,thereis vast empiricalsupportfor the hypothesisof rationaladdictivebehaviourat the level of individualconsumptiongoods. We have studied the case of internalhabit formationin Section 4.3. There,we have shown that the assumptionof internalgood-specific habit formation rendersthe pricing behaviourof firms time inconsistent.However,because of the scope of this paper,our analysis falls short of fully characterizing equilibriumdynamicsunderinternaldeephabit formation.We believe that pursuingthis avenue is, perhaps,the most relevantnext step in this researchprogramme. APPENDIX:INTERNALDEEP HABITS
the is Whengood-specific habitsareassumed be internal, to household problem to maximize utilityfunction (3) j's to subject theaggregation technology

x/ =

(c , -Oct

01
the budgetconstraint
Pitcdi+
0

O)1-1/1di

Etrt,t+ld/1

=d/

+ wth

J,

and some borrowing limit to avoid Ponzi schemes. The first-order conditions associated with this problem are

Ux(x/,

cit +/lEtUx(x/t+1, h])it -Uh (x/' ,h')=

hJ)

t+ acit

pit,

A wt,

RAVNET AL.
and Srt,t+1 Noting that = -Oa8x+1 /act+l, 8xt+l1/act =

DEEP HABITS

217

8/t+1.

we can write the firstof the above optimalityconditionsas

Zt
where

Pit +tOEtzit+1' Oc-0-1/n

zit =Ux(x', h)[x11/l(ct

Integratingthe firstof these expressionsforwardand underthe assumptionthatzJ is stationary(which is the case in the class of equilibriawe restrictattentionto in this paper),we have
00oo

Zt
Combiningthe last two expressionswe obtain

O)kEt k=O

+kPit+k

c)kERecalling
Recallingthat rtt+l =

t +kPit+k Ux ,h)x +Oc (xt

/2t

+1, we can write the above expressionas

cit ?i

k=O

kxEtr kEtrt,t+kPit+k ,ht,

t

+ ?h Xi itOct ? ci xt

across householdswe obtainthe following aggregatedemandfunctionfor good i in period t Integrating Xt +Ocit-1,

cit =
(Xth

OkEtrt,t+kPit+k k=0

Xt twhere

dj is a measureof aggregatedemand.

Acknowledgements. We thankfor commentsPierpaoloBenigno, Julio Rotemberg,Mike Woodford,and seminar participantsat ColumbiaUniversity, Duke University, the University of North Carolina,the University of Southampton, the 2004 ESSIM meeting (Tarragona),the IIES (Stockholm), the EuropeanUniversity Institute (Florence), the Federal Reserve Banks of Chicago, Cleveland, and Atlanta, Emory University, and the 2004 AustralianConference of Economists. Ravn gratefullyacknowledges financial supportfrom the RTN project "MacroeconomicPolicy Design for MonetaryUnions",fundedby the EuropeanCommission (contractnumberHPRN-CT-2002-00237). REFERENCES ABEL, A. B. (1990), "AssetPrices underHabitFormationand CatchingUp with the Joneses",TheAmericanEconomic ReviewPapers and Proceedings, 80, 38-42. of BLANCHARD, O. and PEROTTI,R. (2002), "An EmpiricalCharacterization the Dynamic Effects of Changes in GovernmentSpendingand Taxes on Output",QuarterlyJournalof Economics, 117, 1329-1368. CHINTAGUNTA,P., KYRIAZIDOU, E. and PERKTOLD, J. (2001), "Panel Data Analysis of Household Brand Choices",Journalof Econometrics,103, 111-153. E. COOLEY,T. F. and PRESCOTT, C. (1995), "EconomicGrowthand Busines Cycles", in T. F. Cooley (ed.) Frontiers of Business Cycle Research(Princeton,NJ: PrincetonUniversityPress) 1-38. A. I. and FATAS, andMIHOV, (2001), "TheEffects of Fiscal Policy on Consumption Employment" Insead). (Manuscript, the GALI, J., LOPEZ-SALIDO,D. and VALLES, J. (2003), "Understanding Effects of GovernmentSpending on Consumption" CREI). (Manuscript, J. GALL, and RABANAL,P. (2004), "TechnologyShocks and AggregateFluctuations:How Well Does the RBC Model Fit PostwarU.S. Data?"(Manuscript, CREI). H. HOUTHAKKER, S. and TAYLOR,L. D. (1970) ConsumerDemand in the UnitedStates: Analyses and Projections (Cambridge:Harvard UniversityPress). P. KLEMPERER, (1995), "Competitionwhen Consumershave Switching Costs: An Overview with Applications to Industrial Reviewof EconomicStudies,62, 515-539. Trade", Macroeconomics,and International Organization,

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PHELPS,E. S. and WINTER,S. G. (1970), "OptimalPrice Policy underAtomistic Competition",in E. S. Phelps (ed.) MicroeconomicFoundationsof Employment InflationTheory(New York:W. W. Norton) 309-337. and PRESCOTT,E. C. (1986), "TheoryAhead of Business Cycle Measurement",Federal Reserve Bank of Minneapolis QuarterlyReview,10, 9-22. RAVN, M., SCHMITT-GROHI,S. and URIBE, M. (2004a), "Deep Habits: Technical Notes" (Manuscript,Duke University). Duke University). S. RAVN, M., SCHMITT-GROHI, and URIBE, M. (2004b), "RelativeDeep Habits"(Manuscript, S. RAVN, M., SCHMITT-GROHE, andURIBE, M. (2004c), "TheMacroeconomicsof SubsistencePoints"(Manuscript, Duke University). S. RAVN, M., SCHMITT-GROHE, and URIBE,M. (2004d), "Deep Habits"(NBER WorkingPaperNo. 10261). S. RAVN, M., SCHMITT-GROHE, and URIBE, M. (2004e), "Deep Habits and Sticky Prices: A Technical Note" Duke University). (Manuscript, Model of Price Wars During Booms", ROTEMBERG,J. J. and SALONER, G. (1986), "A Supergame-Theoretic AmericanEconomicReview,76, 390-407. J. and ROTEMBERG, J. andWOODFORD,M. (1991), "Markups the Business Cycle", in O. J. BlanchardandS. Fischer (eds.) NBERMacroeconomicsAnnual (Cambridge,MA: MIT Press) 63-129. J. ROTEMBERG, J. and WOODFORD,M. (1992), "Oligopolistic Pricing and the Effects of Aggregate Demand on Economic Activity",Journalof Political Economy,100, 1153-1207. Models with ImperfectlyCompetitive J. ROTEMBERG, J. andWOODFORD,M. (1995), "DynamicGeneralEquilibrium in ProductMarkets", T. E Cooley (ed.) Frontiersof Business Cycle Research(Princeton,NJ: PrincetonUniversity Press) 243-293. J. ROTEMBERG, J. and WOODFORD,M. (1999), "The Cyclical Behavior of Prices and Costs", in J. B. Taylorand M. D. Woodford(eds.) Handbookof Macroeconomics(Amsterdam:North-Holland)1051-1135. S. SCHMITT-GROHE, and URIBE, M. (2004), "OptimalOperational MonetaryPolicy in the Christiano-EichenbaumEvansModel of the U.S. Business Cycle" (NBER WorkingPaperNo. 10724).