Moral Hazard and Optimal Commodity Taxation

The central result of this paper is that when moral hazard ispresent,competitive equilibrium is almost always (constrained) inefficient. Moral hazard causes shadow prices to deviate from market prices. To remedy this market failure, the government could introduce differential commodity taxation. Moral hazard causes people to take too little care to prevent accidents. The corresponding dead-weight loss can be reduced by subsidizing (taxing) those goods the consumption of which encourages (discourages) accident avoidance.At the (constrained) optimum, the sum of the deadweight losses as-sociated with moral hazard, on the one hand, and differential commodity taxation, on the other, is minimized.