Environmental Resources: Dynamics, Irreversibility and Option Value

Abstract

This chapter begins with a short discussion of the evolution of environmental economics, with links to theories of externalities and public goods and a focus on pollution. The focus then shifts to a less-studied aspect: the economics of natural environments. The idea that the environment from which commercially valuable resources are taken may have value in its natural state motivates a discussion of how this affects a benefit/cost analysis of the resource development project. This in turn leads to the concept of irreversibility, joined to uncertainty concerning evaluation of the environmental services that would be lost in perpetuity, or at least in the very long run if the resource development project goes forward. Examples are given to motivate the realism and potential importance of this approach. A theoretical discussion of investment under uncertainty and irreversibility is presented, verbally and graphically, which leads to the concept of option value (real, not financial), in turn given an analytical treatment, including an example of how to compute. The potential empirical importance of option value is illustrated in an application to a forested area in Thailand, in which each of four zones can be either preserved, developed, or given an intermediate level of development, in each of three periods. The states are distinguished by appropriate uses but subject to an irreversibility constraint, formulated as a decision tree of feasible sequences. For example, commercial agriculture can follow preservation but not vice versa. Results of an exercise using illustrative values show that option value, though small in relation to total use values, can tip the balance in a major way, with the largest zone optimally developed in what might be called the traditional analysis but preserved when option value is taken into account.