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Option Value and Flexibility: A General Theorem with Applications

  • Francois Salanie
  • Nicolas Treich

What is the effect of future information on today's actions? The answer may help understand, or justify, low investment in the presence of costs, a preference for holding liquid money, self-insurance or precautionary savings motives, environmental preservation and global warming abatement policies. Within a three-period model, Epstein (1980) showed that the effect of future information depends on a condition on an indirect value function. We provide the necessary and sufficient condition on the model's primitives. Furthermore, we derive a generic ambiguity result, and characterize all model specifications for which the question can be answered without ambiguity. These specifications include all classical models discussed in the literature. The paper also discusses the interpretation of the concept of flexibility in this literature.

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File URL: http://www2.toulouse.inra.fr/lerna/travaux/cahiers2009/09.12.288.pdf
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Paper provided by LERNA, University of Toulouse in its series LERNA Working Papers with number 09.12.288.

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Date of creation: May 2009
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Handle: RePEc:ler:wpaper:09.12.288
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  1. Arrow, Kenneth J & Fisher, Anthony C, 1974. "Environmental Preservation, Uncertainty, and Irreversibility," The Quarterly Journal of Economics, MIT Press, vol. 88(2), pages 312-19, May.
  2. Avinash Dixit, 1992. "Investment and Hysteresis," Journal of Economic Perspectives, American Economic Association, vol. 6(1), pages 107-132, Winter.
  3. Robert A. Jones & Joseph M. Ostroy, 1979. "Flexibilty and Uncertainty," UCLA Economics Working Papers 163, UCLA Department of Economics.
  4. Gollier & Jullien & Treich, 2000. "Scientific progress and irreversibility : an economic interpretation of the Precautionary principle," Working Papers 156240, Institut National de la Recherche Agronomique, France.
  5. Henry, Claude, 1974. "Investment Decisions Under Uncertainty: The "Irreversibility Effect."," American Economic Review, American Economic Association, vol. 64(6), pages 1006-12, December.
  6. Maler, Karl-Goran & Fisher, Anthony, 2006. "Environment, Uncertainty, and Option Values," Handbook of Environmental Economics, in: K. G. Mäler & J. R. Vincent (ed.), Handbook of Environmental Economics, edition 1, volume 2, chapter 13, pages 571-620 Elsevier.
  7. EECKHOUDT, Louis & GOLLIER, Christian & TREICH, Nicolas, . "Optimal consumption and the timing of the resolution of uncertainty," CORE Discussion Papers RP -1792, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
  8. Kolstad, Charles D., 1996. "Fundamental irreversibilities in stock externalities," Journal of Public Economics, Elsevier, vol. 60(2), pages 221-233, May.
  9. Baker, Erin, 2005. "Uncertainty and learning in a strategic environment: global climate change," Resource and Energy Economics, Elsevier, vol. 27(1), pages 19-40, January.
  10. Kousky, Carolyn & Luttmer, Erzo F. P. & Zeckhauser, Richard, 2006. "Private Investment and Government Protection," Working Paper Series rwp06-017, Harvard University, John F. Kennedy School of Government.
  11. Epstein, Larry G, 1980. "Decision Making and the Temporal Resolution of Uncertainty," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 21(2), pages 269-83, June.
  12. Fisher, Anthony C. & Hanemann, W. Michael, 1987. "Quasi-option value: Some misconceptions dispelled," Journal of Environmental Economics and Management, Elsevier, vol. 14(2), pages 183-190, June.
  13. Rothschild, Michael & Stiglitz, Joseph E., 1970. "Increasing risk: I. A definition," Journal of Economic Theory, Elsevier, vol. 2(3), pages 225-243, September.
  14. 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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