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HAZARD COMPENSATION AND INCENTIVE SYSTEMS: AN ECONOMIC 150 PERSPECTIVE original typesetting files. Page breaks are true to the original; line lengths, word breaks, heading styles, and other typesetting-specific formatting, however, cannot be About this PDF file: This new digital representation of the original work has been recomposed from XML files created from the original paper book, not from the retained, and some typographic errors may have been accidentally inserted. Please use the print version of this publication as the authoritative version for attribution. P(L-L') > C (Adopt) Otherwise (Do not adopt) This rule states that protective measures should be adopted if the expected benefit [P(L-L')] from those measures exceeds the ex ante cost (C). Rather than actually undertaking some type of benefit-cost comparison as implied by the expected-utility model, individuals appear to ignore the negative consequences of an event until after they personally experience an accident or know someone who has suffered a loss. This behavior can be characterized by a threshold model where the perceived probability (p) is below some critical level (p*). It illustrates two psychological phenomena to be considered in designing appropriate incentive mechanisms. First, most people tend to assume that a specific chance event, such as an automobile accident, will not happen to them. A study by Svenson (1981) revealed that 80 percent of all drivers believe that they are better than the average driver. This type of behavior can be understood in terms of the theory of cognitive dissonance (Festinger, 1957). People prefer not to acknowledge potential dangers that they believe they cannot avoid, and hence they either underestimate the chances of such a danger's occurrence (Akerlof and Dickens, 1982) or assume that the probability of its happening is so low that it is not worth worrying about (Slovic et al., 1977). Second, when an accident does occur, there is a tendency to overestimate the chances of the event's occurring again in the future, a phenomenon characterized as availability (see Kahneman et al., 1984). People frequently estimate the chances of an event's occurring in the future by the ease with which they can imagine it. In addition, the immediacy of a personal experience can focus attention on the potential for loss in a way that statistical data may not. Given the difficulties of calling people's attention to potential hazards, consideration of the several alternative strategies discussed below is in order. Broadening the Time Horizon If individuals treat the probability of an accident as so small that they do not concern themselves with the consequences, then broadening the relevant time horizon of hazard information may induce people to protect themselves. For example, if residents fail to buy insurance in a 100-year flood-plain, knowing that the probability of at least one flood during the next 25 years is .22 might induce them to pay attention to the potential consequences and to avail themselves of protective mechanisms. People's reluctance to wear seat belts voluntarily might also be due to the extremely small probability of incurring a fatal accident on a single automo