Habits, Complementarities and Heterogenenity in Alcohol and Tobacco Demand: A Multivariate Dynamic Model

In this paper we test the existence of rational habit formation in a multivariate model for alcohol and tobacco consumption. The theoretical framework, based on a dynamic adjustment cost model with forward-looking behaviour, is enhanced to include the intertemporal interactions between the two goods. The analysis of the within-period preferences completes the intertemporal model, allowing to evaluate the static substitutability/complementarity relationships. The empirical strategy consists in a two step estimation procedure. In the first stage, the parameters of the demand system are obtained, while in a second stage Euler equations are estimated by a dynamic fixed-effects panel data model. Estimation results, based on a cohort dataset constructed from a series of crosssections of the ISTAT Italian Household Budget Survey, reveal a significant complementarity relationship between alcohol and tobacco. The Euler system estimation does not reject the hypothesis of intertemporal dependence, providing support for a forward-looking behaviour in alcohol and tobacco consumption. Moreover, we find significant intertemporal interactions for tobacco adjustments, while alcohol consumption seems to follow only its own adjustment dynamics.