We present a new theory of rational addiction. Addictive consumption is compulsive, influenced by subtle stochastic cravings. Crucially, the consumer lacks complete information regarding the stochastic process generating the cravings whose likelihood may be afected by past consumption. The model generates behavior, e.g., recurring recividism, associated with boundedly-rational agents. Welfare enhancing policy involves providing information about the true process. Our theory provides micro-foundation for non-linear intrinsic habit formation. There is also the possibility of extrinsic habit-forming behavior with contrarian peer group effect due to informational cascades. We derive some new results on monotonicity properties of the value function.
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