The Economics of Addiction

Written by Anvitha Jagannathan

1 in 7 people aged 18-25 (or 5.1 million people) suffered from a substance use disorder in 2017 in the US. Addiction is a problem we face every day in this country, costing us $740 billion annually. Yet, we are not taught a business solution or economic model to understand this issue, much less solve it. Classical economic theories simply state that humans must be rational and make rational choices after weighing their utilities from various options and choosing the one that maximizes their own utility. Under a classical economic model, addiction is considered “irrational” and thus unfathomable in rational beings because we are assumed to be able to make choices that maximize our long-term utility. Classical economic models unfortunately do not account for external factors that influence our decisions like our emotions, societal pressure and our body’s own addictive tendencies. These are all important variables in understanding addiction. Although addiction is deeply rooted in psychology, the field of behavioral economics can be used to provide a framework on how to model addiction and the rationale behind it.

Behavioral economics merges psychology and economics by creating models of robust psychological insights into human behavior to explain decision-making. Behavioral economics can date as far back as Adam Smith but has only recently grown in prominence as more people are starting to appreciate this field’s ability to quantify and explain certain circumstances that neoclassical economics cannot. Behavioral economics models take into account human emotions (to some extent) while still retaining the utility maximization theorem that is at the heart of economics. This is done by assigning weights to preferences and introducing biases like risk aversion, loss aversion and overconfidence.

The portion of behavioral economics that I think would be most helpful in explaining addiction is the idea of a present-biased individual being risk-seeking in losses and thus, not being economically rational about their choices. To understand these concepts, we first need to look into Prospect Theory,  which is an economic model that shows how people calculate their expected utility in terms of some reference point rather than in absolute values and make choices based on levels of risk and uncertainty. Furthermore, we need to understand the concept of present-biased discounting through the quasi-hyperbolic discounting model. This model states that we weigh present outcomes more than future ones (in other words, we’re impatient) but when we’re faced with choices that are exclusively in the future, we don’t show this impatience. 

All these theories, albeit confusing, provide a framework to think about addiction through the lens of economics. Addiction is a choice of losses, where an individual is forced to choose between losing the substance they are addicted to and losing their health or facing whatever negative consequences could arise from their addiction. Being risk-seeking in losses (refer Prospect Theory above), people choose to take the risk of the possible negative consequences in the future as opposed to denying themselves the immediate satisfaction of giving into their addiction. The “delay discounting” and time preferences modeled in behavioral economics can help us understand why people give a higher value to their current satisfaction and do not weigh their future losses highly enough. After all, activities like smoking, drinking etc. bring enough satisfaction/utility when done in moderation to provide a desire to do them again. So, we as a society do not insist on a complete ban of these. However, people who suffer from addiction continue to use the same present-biased weightage to justify their “just one more” rhetoric. They also tend to be more impulsive and impatient for the immediate reward offered by their vice of choice, leaving them vulnerable to an “irrational” model of discounting (sometimes to the point of completely ignoring) the long-term, negative effects of their choices and making their inherent decision model heavily present-biased.

Although these models do not give us a complete understanding of behavioral economics or addiction, they do provide a starting point for us to understand how it is completely rational to be a victim of addiction. Economic theory and addiction seem an unlikely pair, but perhaps looking at addiction through the lens of economic theory might provide additional insight on why people make certain choices and maybe, just maybe, might help us as individuals overcome this issue now that we know why it happens.