Scenario: A Valley in northeast King County regularly floods. Every year, usually in late fall or early spring, the River overflows its banks enough to close a few roads that run across the valley floor. Normally, the flooding isn’t severe, but roughly every 10 years there is usually one serious flood where most of the valley is several feet under water. Despite the relatively predictable nature of these floods, people still build houses there and those houses routinely get flooded. (Some of them near Fall City are built on “stilts,” but this doesn’t seem as good of a solution as just moving to higher ground.)

Exercise: This exercise has two parts.

(1) Using the concept of moral hazard, propose TWO explanation for why people haven’t moved out of the valley. Are there other explanations for why someone might not move out of the valley that are not related to moral hazard? How plausible are those explanations? If you were an elected public official, what might you do to prevent this moral hazard problem and how effective do you think you would be in implementing your policy. Think about the trade-offs you, as a politician, face.

(2) Provide two other examples of moral hazard and/or offsetting behavior. What other types of rules or regulations would you implement to prevent people from falling into the moral hazard trap? In other words, how would you prevent offsetting behavior in the situations you present? Or can moral hazard be prevented at all?

(*Note that There is a very subtle difference between moral hazard and offsetting behavior. Moral hazard does include offsetting behavior, but not all offsetting behavior involves a moral hazard. )

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