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. Smoking increases the probability that a worse health state occurs in the future and indirectly increases the likelihood that the individual enters the absorbing terminal state sooner. This cost where continual smoking brings the smoker closer to an undesired state is factored into the smoker's decision each period.