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Optimal Consumption of Polluting and Non-Polluting Goods: The Role of Habits

We present a basic exogenous growth model with two consumption goods that differ as regards their contributions to environmental pollution. Allowing for habit formation of the polluting good, we show under which conditions habit formation raises the consumption of the clean good relative to the dirty one in the competitive economy. Further, we demonstrate when habit formation generates a lower steady-state pollution stock compared to the situation without habits. Finally, we determine the Pigou tax rates and we illustrate that the social optimum may imply a higher steady-state pollution than the competitive economy if the habit formation is sufficiently strong.