What's the Option?
Global warming, alterations of ecosystems, and sunk investments all imply irreversible changes with uncertain future costs and benefits. Two concepts measure how this combination of uncertainty and irreversibility changes the value of preserving an ecosystem or postponing an investment. First, the environmental and resource economics literature developed the Arrow-Fisher-Hanemann-Henry quasi-option value. Second, the real options literature developed the Dixit-Pindyck option value. This paper clarifies the precise differences between the two approaches in a simple two period model. We explain that the quasi-option value captures the value of learning conditional on preservation, while the Dixit-Pindyck option value captures the net value of preservation under learning. We show how either of the two concepts alters the common net present value decision rule. We illustrate similarities, differences, and the decision rules in two instructive examples.
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- Henry, Claude, 1974. "Investment Decisions Under Uncertainty: The "Irreversibility Effect."," American Economic Review, American Economic Association, vol. 64(6), pages 1006-12, December.
- 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.
- 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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