The Rational Addiction (RA) model assumes that individual decisions about the
consumption of harmful and addictive commodities are made on a rational basis (Becker
and Murphy, 1988). In this context, rational means forward looking, i.e. a tendency to
take account of future consequences of current consumption decisions. Different
individuals may well attach different weights to the present relative to the future. The
degree to which an individual is forward looking in her consumption decisions is
revealed not by her current consumption level but rather by the time path of her
consumption of an addictive commodity. Hence, the need to estimate a forward looking
second order difference equation (SODE) as part of the process of testing the RA model.
Most studies using micro level data estimate a single SODE for the whole sample. This
involves estimating an average propensity to be forward looking for the entire sample,
even when it is believed that different fully rational individuals in the same sample may
have different propensities to be forward looking. Forward looking behaviour is an
aspect of treating the consumption of an addictive commodity as part of an inter-temporal
optimization problem. Inter-temporal optimization is characterized by what are known as
saddle point dynamics and the information about an individual’s propensity to be forward
looking is contained in what are known as the characteristic roots of the equation