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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.

Suggested Citation

  • Traeger, Christian, 2013. "What's the Option?," Department of Agricultural & Resource Economics, UC Berkeley, Working Paper Series qt41v56658, Department of Agricultural & Resource Economics, UC Berkeley.
    • Handle: RePEc:cdl:agrebk:qt41v56658
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    References listed on IDEAS

    as
    1. Avinash K. Dixit & Robert S. Pindyck, 1994. "Investment under Uncertainty," Economics Books, Princeton University Press, edition 1, number 5474.
    2. 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.
    3. Henry, Claude, 1974. "Investment Decisions Under Uncertainty: The "Irreversibility Effect."," American Economic Review, American Economic Association, vol. 64(6), pages 1006-1012, December.
    4. 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.
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    Keywords

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