Rational Addiction, Cointegration and Tobacco and Alcohol Demand

In this paper we embed the Almost Ideal Demand System within a dynamic disequilibrium model, and derive a set of interrelated Euler equations which characterizes optimal consumption allocations under adjustment costs. It is argued that when applied to alcohol and tobacco expenditure, the proposed specification features the rational addiction hypothesis, as both forward-looking rational behaviour and habit formation are explicitly accounted for. The suggested estimation approach controls for potential nonstationarity in the underlying timeseries. Results relative to UK tobacco and alcohol demand support the adopted specifications and highlight the degree of complementarity between addictive goods.