Environment, Uncertainty, and Option Values
In: Handbook of Environmental Economics
AbstractWe analyze in this chapter decision-making when costs and benefits of an action are uncertain, that is, when future preferences are uncertain. We begin, in Section 2, with the classical analysis by Krutilla et al. (1972) of whether the expected consumer's surplus is a correct measure of the net benefits from the action. It turns out that for one individual, the correct measure is the expected consumer's surplus corrected with one term representing the covariance between the state-contingent consumer's surplus and the state-contingent marginal utility of wealth and a second term representing risk aversion. This corrected measure is what Krutilla et al. (1972) called the option value. Thus the difference between option value and expected consumer's surplus is determined by the covariance between preferences and consumer's surplus and risk aversion. The sign of this difference will therefore depend on these factors. We apply this result to a number of cases in order to derive additional useful results. First we look at the aggregate (over a set of individuals) option value and establish a general result. We then apply this result to the allocation of risk in the context of both public and private goods.In Section 3, we introduce relevant dynamic elements to the general problem of decisions under uncertainty. We analyze actions that may have irreversible effects, but where the decision-maker can improve her information about the true future preferences. This problem was first studied by Arrow and Fisher (1974) and Henry (1974), who showed (as we do in Section 3.2) that when the decision-maker has to choose between two actions, of which one is irreversible, and future benefits are uncertain in the first time period, maximizing expected value will result in a biased result: the irreversible action will be chosen too often. However, this result is based on assumptions of linearity. In order to study the problem without this restriction, we rely on Epstein's (1980) framework, which we present in some detail. The result is that convexity (concavity) assumptions are essential to establish the direction of the bias. We also use Epstein's framework to look at issues such as uncertainty about cost of restoration and uncertainty about irreversibility.All of the results to this point are for models with just two time periods. In Section 4, we analyze the many-period case, adopting a somewhat different analytical framework: stochastic dynamic programming, as presented in Dixit and Pindyck (1994). Additional results in continuous time are developed, drawing on the theory of stochastic processes. We look in particular at the "optimal stopping problem," a useful and important special case, and present an empirical application due to Conrad (1997): when, if ever, to cut an old-growth forest that also yields benefits in its natural state.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
This chapter was published in:
This item is provided by Elsevier in its series Handbook of Environmental Economics with number 2-13.
Contact details of provider:
Web page: http://www.elsevier.com/wps/find/bookseriesdescription.cws_home/BS_HE/description
Find related papers by JEL classification:
- Q50 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - General
You can help add them by filling out this form.
CitEc Project, subscribe to its RSS feed for this item.
- Francois Salanie & Nicolas Treich, 2009.
"Option Value and Flexibility: A General Theorem with Applications,"
LERNA Working Papers
09.12.288, LERNA, University of Toulouse.
- Salanié, François & Treich, Nicolas, 2009. "Option Value and Flexibility: A General Theorem with Applications," TSE Working Papers 09-002, Toulouse School of Economics (TSE).
- Muhammad Rafiq, . "Estimating the Value of Statistical Life in Pakistan," Working papers 18, The South Asian Network for Development and Environmental Economics.
- Giuseppe Attanasi & Aldo Montesano, 2010.
"Testing Value vs Waiting Value in Environmental Decisions under Uncertainty,"
LERNA Working Papers
10.01.307, LERNA, University of Toulouse.
- Attanasi, Giuseppe & Montesano, Aldo, 2010. "Testing Value vs Waiting Value in Environmental Decisions under Uncertainty," TSE Working Papers 10-154, Toulouse School of Economics (TSE).
- Lobb, Alexandra E., 2011. "Risk and Uncertainty in Environmental Economics: From Theory to Policy," 2011 Conference (55th), February 8-11, 2011, Melbourne, Australia 100580, Australian Agricultural and Resource Economics Society.
- Xepapadeas, Anastasios, 2005. "Economic growth and the environment," Handbook of Environmental Economics, in: K. G. Mäler & J. R. Vincent (ed.), Handbook of Environmental Economics, edition 1, volume 3, chapter 23, pages 1219-1271 Elsevier.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Zhang, Lei).
If references are entirely missing, you can add them using this form.