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The economics of flood insurance
The economics of flood insurance

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3.4 Market failure and building on flood plains

In the case of developers building on flood plains, builders will consider the price they are able to sell a home for and decide how many homes to build (and where) in order to maximise their profit from supplying homes.

As you have already seen in Section 2.1, building and selling homes on flood plains can be an attractive option, because alternatives would be more costly (for example: building on more expensive land that is not prone to flooding; building on elevated land that is harder to access or get planning permission for; and so on). In Section 2.2 you saw that there may be a range of reasons why buyers might choose these homes.

Crucially, though, the developers are not basing their supply decisions on the full costs of these homes. They are escaping the cost of future flooding or flood-risk protection, which must nevertheless be borne by somebody. In economic terminology, there is a negative externality of production. The demand-and-supply model can help to demonstrate how this distorts the supply of housing causing more flood-risk homes to be built than the socially optimal amount, as shown in the slideshow in Figure 9.

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Figure 9 Modelling the negative externality of building on a floodplain
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