Basically instead of having a random event popping up asking you to kill the dragon and then the dragon cave magically appears on the map, the dragon is already there and interacts with it's environment.

Agreed. I like the idea of things already in the world forcing the player to make decisions and undertake quests of their own volition. Good suggestion.

I like this suggestion provided the Dragon doesn't roam.  Powerful Mobs will need to stay in a region of the map or the player will be destroyed before they are capable of putting up a fight. 

This could be enhanced if an inn provides rumors of nearby threats/opportunities and the Dragon protects an important end-game resource.

Presumably there are other ways around that though.  If I had to guess, I would think that a large army would probably not be tremendously effective against a roaming dragon since 1) that dragon can fly around and hit whatever part of the army it wants to, 2) there are only so many soldiers that can get within weapons range and effectively attempt to hit the dragon without also hitting their fellow soldiers and 3) that dragon would be so intimidating, probably only a few select elite units (whatever your "knights" are) would even be willing to go near the thing.

More useful in this situation would be a good group of heros who combine to take down the dragon, or a powerful combatant channeller.

I guess the point I'm trying to make is that a lot of these things only are unbalancing as long as there is only one way to counteract them and one way to have power.  Since one of the goals of elemental is to prevent that "blobbing" effect that makes the game only interesting for the 1st third or so, I think there will be enough different ways to manifest strength (armies, heros, combatant channeler, magic focused channeler, ect) that having every player tech to a powerful military will not be a problem.

The problem you are talking about here isn't having people tech for the most powerful weapons at the end of the tech tree though.  The problem is that there is no opportunity cost for doing so.  With the Civ tech tree everyone developed along pretty much the same path research wise.  You might change up the order a bit, but at the end of the day you all had to develop pretty much the same technology in order to advance very far, so teching to the end of the tree was quite viable.  In elemental you can't really research it all in order to advance (more branches, and they don't really intertwine the way Civ's tech tree does), so if you rush the warfare tech tree then you are stunting your civ, magic, questing and diplomacy techs.  That is a very real opportunity cost just within the research system itself.  Not to mention the problems of a relatively weak economy.  Now you've got access to great weapons, but your richer and more populous opponent (who didn't focuse on the military tree but was a bit more balanced) has four times your numbers and the industry to equip all of them with decent, if substantially lower grade, equipment.

I think the basic idea here is very sound, although it will be tough to implement, I think. I would like to see the following:

1) Keep the current system of random quests being offered to the player.

2) Have some quests offered to the player based on the buildings the player builds (this has been mentioned frequently, ie: I build a tavern, I can now visit that Tavern and get quests or engage in other actions) and the overall gameplay situation (ie: some quests generated by wars, treaties, etc). I think this will be fairly each to implement.

3) Have some special dynamic quests such as the Dragon or whatever.This would be amazingly cool, but possibly hard to implement.

4) Allow the player to call for heroes to go questing, similar to Majesty. These heroes would then independently go questing, use the player's cities and buildings for resupply, etc.