Do temptations sway optimal policy?

University essay from Handelshögskolan i Stockholm/Institutionen för nationalekonomi

Abstract: We analyze the implications of temptation goods for economic policy in a general equilibrium model with dynasties of heterogeneous households. Temptation goods are defined as goods that generate positive utility for the generation that consumes them but are not valued by any previous generation. Declining temptations imply that the fraction of marginal euro spent on temptation goods declines as overall consumption increases. Our theoretical analysis shows that declining temptations increase equilibrium labor effort and equilibrium income but have no effect on the equilibrium savings rate. For quantitative analysis, we use European Union data with alcoholic beverages, tobacco and narcotics defined as temptation goods in the benchmark specification. We find that temptations have virtually no effect on equilibrium levels of labor effort, income or income inequality compared to a model in which temptations are ignored. Also,optimal policy that maximizes either income or welfare remains unchanged. However, a paternalistic government that does not value spending on temptation goods would underestimate the optimal level of redistribution by ignoring temptations.

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