Exploiting the Choice-Consumption Mismatch: A New Approach to Disentangle State Dependence and Heterogeneity

Abstract

This paper offers a new identification strategy for disentangling structural state dependence from unobserved heterogeneity in preferences. Our strategy exploits market environments where there is a choice-consumption mismatch. We first demonstrate the effectiveness of our identification strategy in obtaining unbiased state dependence estimates via Monte Carlo analysis and highlight its superiority relative to the extant choice-set variation based approach. In an empirical application that uses data of repeat transactions from the car rental industry, we find evidence of structural state dependence, but show that state dependence effects may be overstated without exploiting the choice-consumption mismatches that materialize through free upgrades.

Keywords: Consumer dynamics, Heterogeneity, Quasi-experiment econometrics, Service industry, State dependence

JEL Classification: C1, C5, L00, L80, M2, M3