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What's the Option?

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  • Traeger, Christian

Abstract

Global warming, alterations of ecosystems, and sunk investmentsall imply irreversible changes with uncertain future costs and benefits. Twoconcepts measure how this combination of uncertainty and irreversibilitychanges the value of preserving an ecosystem or postponing an investment.First, the environmental and resource economics literature developed theArrow-Fisher-Hanemann-Henry quasi-option value. Second, the real optionsliterature developed the Dixit-Pindyck option value. This paper clarifiesthe precise differences between the two approaches in a simple two periodmodel. We explain that the quasi-option value captures the value of learningconditional on preservation, while the Dixit-Pindyck option value capturesthe net value of preservation under learning. We show how either of the twoconcepts alters the common net present value decision rule. We illustratesimilarities, differences, and the decision rules in two instructive examples.

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Bibliographic Info

Paper provided by Department of Agricultural & Resource Economics, UC Berkeley in its series Department of Agricultural & Resource Economics, UC Berkeley, Working Paper Series with number qt41v56658.

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Date of creation: 01 Jan 2013
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Handle: RePEc:cdl:agrebk:qt41v56658

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Keywords: Social and Behavioral Sciences; irreversibility; option; quasi-option value; benefit cost analysis; uncertainty;

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  1. Henry, Claude, 1974. "Investment Decisions Under Uncertainty: The "Irreversibility Effect."," American Economic Review, American Economic Association, vol. 64(6), pages 1006-12, December.
  2. Fisher, Anthony C., 2000. "Investment under uncertainty and option value in environmental economics," Resource and Energy Economics, Elsevier, vol. 22(3), pages 197-204, July.
  3. Hanemann, W. Michael, 1989. "Information and the concept of option value," Journal of Environmental Economics and Management, Elsevier, vol. 16(1), pages 23-37, January.
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