MORAL HAZARD, MONITORING COSTS, AND OPTIMAL GOVERNMENT INTERVENTION

When insurance firms can monitor with non-prohibitive costs the consum ption of risk-influencing goods by an insured they have incentives to tax-subsidize the insured's consumption of the goods. If the governmen t cannot monitor at a lower cost than private insurers, intervention i s neither needed nor desirable. Where the government does have a monit oring-cost advantage, it cannot achieve a constrained optimum by commo dity tax-subsidies alone. It must also augment the level of insurance and in some cases, prohibit private tax-subsidies by insurers. Such '' invasive'' intervention can be avoided if the government regulates the consumption of the risk-influencing goods.