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This paper analyzes the equilibrium efficiency in a Ramsey model with habit formation. Uniqueness and saddle-path stability of the steady state is proved analytically. The competitive equilibrium is efficient at the steady state. However, the presence of externalities arising from average past consumption renders the competitive equilibrium inefficient off the steady state because agents do not take (fully) into account the indirect effect that consumption has in utility through its influence on habits. The efficient equilibrium can be decentralized by means of a consumption tax that converges to an arbitrary constant value, or by means of an income tax that converges to zero.
Published Online: 2007-5-3
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