On the Micro-Level Irrelevance of Habit Formation in Complete Markets

This paper characterizes conditions for external habit formation to render habit-driven equilibrium outcomes observationally equivalent to habitfree equilibrium outcomes in multi-agent complete markets. The uniformity of the ratios of habit levels to aggregate consumptions across consumption goods leads to the irrelevance of habit formation to excess demand and asset prices. Thus, external habit formation may have no tangible effect on excess demand and the equity premium if the cross-sectional habitual variations are not substantial. The micro-level analysis of habit formation produces useful information about the habitual effect on the individual welfare and the existence of competitive equilibrium which cannot be addressed in a representative agent framework.