Option value: improving resource allocation efficiency

Abstract

Measuring consumer benefits associated with a policy or a project in a world where prices and outcomes are known with certainty is, at least in theory, straightforward. Changes in consumer surplus provide an appropriate measure of a policy's contribution to consumer welfare. But, in a world where prices and outcomes are uncertain, there is a strong case for concluding that measuring expected consumer surplus alone is inadequate (Bishop, 1982), and in many natural resource situations, uncertainty is the rule rather than the exception. Option value is the adjustment, if any, that is made to expected consumer surplus when there is uncertainty about the demand or supply of an environmental asset. The concept of option value is based on Weisbrod's (1964) argument that consumers, uncertain about their future demands for a commodity, would be willing to pay something above expected consumer surplus to maintain an option to consume the commodity in the future. As we have noted, this additional ""payment"" is option value. While Weisbrod's argument suggests that option value is positive, this need not be the case. A variety of authors have proven that option value can take either sign, depending on the specific circumstances, and especially on the type of uncertainty involved. We begin with an overview of the origin of option value in economics and its relevance to decision making under uncertainty. The next chapter considers compensation tests and identifies an ex ante compensation test as being appropriate for uncertain situations. Option value is then located within a total value framework that includes use values and existence values. Uncertainty in both demand and supply is then shown to provide justification for considering option value as an adjustment that individuals make to allow for uncertainty. However, we will show that there are few situations where the sign of option value can be unambiguously established in theory. The final chapters of the publication describe how option value can be measured and incorporated into cost-benefit analysis.