V2

2. You are also considering purchasing a different house by the coast. Coincidentally, owning this house also gives you an annual benefit of $7,000 and an annual cost of $2,000. Assume a discount rate of 5% and that you will own this house indefinitely. (15 points) a. Suppose that the house you are considering turns out to be located in the flood zone (Federal Emergency Management Agency (FEMA) calls it Special Flood Hazard Area, which is defined as the area that will be inundated by the flood event having a 1-percent chance of occurrence in any given year). Under the perfect information (i.c., market capitalizes this information into the market price), would the land value of this house be lower or higher with this information compared to the case that the house is not in the flood zone? Why? b. The chance that the house will be completely destroyed in the case of flood events is expected to be 10%. In this case, what would be the expected value of annual net benefits? Assume that there will be no additional costs incurred. What would be the capitalized value of annual net benefits (i.e., land value)? c. Now suppose that you can buy flood insurance from National Flood Insurance Program (NFIP). If the insurance is actuarially accurate (i.e., premium reflects the actual expected loss), how much would you pay annually for the insurance as a premium? What would be the annual net benefits after the premium payment? What is the land value? d. Now suppose that NFIP subsidizes the premium by charging the homeowners only the portion of the expected loss. Explain how this subsidy affects your decision in purchasing the house (e.g., does it encourage buying this house? Does it inform the risk associated with living in this house?)