Optimal Consumption Under a Habit-Formation Constraint: The Deterministic Case

Abstract

We formulate and solve a deterministic optimal consumption problem to maximize the discounted constant relative risk aversion utility of an individual’s consumption-to-habit process assuming they only invest in a riskless market and that they are unwilling to consume at a rate below a certain proportion of their consumption habit. Increasing increases the degree of addictiveness of habit formation, with (respectively, ) corresponding to nonaddictive (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.