A Dynamic Structural Model of Addiction, Promotions, and Permanent Price Cuts

Addictive goods fundamentally differ from non-addictive goods: consuming more of an addictive good today reinforces the addiction and increases the likelihood of future consumption. Thus, addiction creates an intertemporal link between a consumer’s past and present decisions, altering their incentives to purchase and to hold inventory. Despite the influence of addiction, its impact on consumer purchase strategies and its implications for firms remain unclear. We construct a dynamic structural model with rational addiction and endogenous consumption to investigate how consumers respond differently to temporary versus permanent price promotions for addictive and non-addictive goods. We apply our model to unique consumer panel data on purchases of cigarettes, crackers, and butter. We find that addiction accumulated through past consumption affects decisions for cigarettes but not the two non-addictive categories. Ignoring addiction for cigarettes leads to biased estimates of price sensitivity, inventory holding costs, and stock-out costs. For cigarettes, we find an interesting asymmetry: the temporary consumption elasticity is smaller than the permanent consumption elasticity, but the converse is true for the purchase elasticities. No such asymmetry exists for crackers or butter. We discuss additional implications for retailer and manufacturer pricing strategies.