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What's the Option?

  • Author(s): Traeger, Christian
  • et al.
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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