More importantly, it provides a practical and intuitive way of incorporating a stochastic health state into a structural model of rational addiction. The paper explicitly models the unobserved stochastic addiction and health process. The health generating process is identified using external medical data. This model allows us to consider the effects of regulating the level of nicotine in cigarettes, subsidizing quitting behavior, finding a cure for lung cancer, and temporal changes in prices. The paper explicitly models smoking and quitting behavior using a utility maximizing framework with uncertainty, taking into account the effects the individual's behavior has on the addiction and health process.
Addiction is modeled as an unobserved stock that accumulates stochastically.
Current consumption provides instantaneous utility and also adds to this unobserved stock, which affects the marginal utility from future consumption. Health is approximated by a discrete state variable. The individual is assumed to be in one of three possible states, either high, low or an absorbing terminal state. The model uses information on the individual's smoking history together with data from external medical studies to estimate the individual's health status. In effect, this estimated health status incorporates the morbidity of smoking addiction and together with endowed individual's characteristics becomes a source of individual heterogeneity.