A relatively newcomer to the socio-economic impact assessment scene, the real options model addresses some of the conceptual and methodological limitations of other estimation methods.
First we need to understand the rationale behind the real options model. Perhaps the easiest way is to use a very simple example, let’s examine the case of a company or a research experiment station deciding to invest in the research and development necessary to create a maize variety that is resistant to drought for arid areas in Latin America. For argument’s sake let’s assume that the whole process from blue sky research to product delivery it takes 15 years or so.
The decision maker has the option of investing now or it can wait to obtain more information about other traits or even other crops that may be of greater value in the future for that region. If some of those investments in R&D can be considered irreversible (meaning sunk, lost forever without any possibility of recovery) then the firm faces an opportunity cost for investing now rather than later. Note that this implies that we may have reversible and irreversible costs and benefits to consider in this analysis!
This analysis is complicated because in most investment decisions that may have a pay-off over time (fifteen years as in this example) we face a lot of uncertainty in terms of outcomes, cash flows, and the possibility of success, amongst the many things that determine the outcome of our investment. Taking into consideration these situations, the opportunity cost, or in other words, the value of the option, can be quite large. Here I am talking about the difference between “wait and see” and “now or never” investment approaches that consider not only the uncertainty related to investments, but also the fact that some decisions are reversible and others are irreversible.
The procedure is to first identify and quantify reversible and irreversible benefits and costs, that may be private or public (external to the assessed) as seen in the Figure above. Although there are many approaches to estimate a real options model, the alternative proposed by Justus Wesseler and colleagues in their 2007 paper is quite practical. In their approach, they derive a decision making rule where they compare social irreversible costs (a.k.a. MISTICs – Maximum Incremental Social Tolerable Irreversible Costs) to the sum of social reversible benefits and social irreversible benefits. Social reversible benefits are weighted by a coefficient called a hurdle rate. The hurdle rate is estimated from historical or survey data. The coefficient captures uncertainty, irreversibility and flexibility of decision making processes governing productive practices. The hurdle rate can be estimated using different models, but an often used model is that of a Brownian motion modelling a specific type of trend over time. The analyst then estimates the value of MISTICs and contrasts to those values of reversible and irreversible costs.
- Kilkuwe, Enoch; Wesseler, Justus, Falck-Zepeda, José. “Introducing a genetically modified banana in Uganda : Social benefits, costs, and consumer perceptions.” 2008. IFPRI Discussion Paper 767. Washington, D.C. International Food Policy Research Institute (IFPRI). http://www.ifpri.org/pubs/dp/ifpridp00767.asp
- Wesseler, Justus, Sara Scatasta, Eleonora Nillesen (2007): The Maximum Incremental Social Tolerable Irreversible Costs (MISTICs) and other Benefits and Costs of Introducing Transgenic Maize in the EU-15. Pedobiologia 51(3): 261-269. http://edepot.wur.nl/39371
- Demont, M.; Wesseler, J.H.H.; Tollens, E. (2005) Irreversible costs and benefits of transgenic crops: what are they? In: Proceedings of the Frontis workshop on Environmental Costs and Benefits of Transgenic Crops, Wageningen, The Netherlands 1-4 June 2003 / Wesseler, J.H.H., . – Dordrecht : Springer, (Wageningen UR Frontis Series 7) Frontis workshop on Environmental Costs and Benefits of Transgenic Crops http://edepot.wur.nl/43728
- Beckmann, V.; Soregaroli, C.; Wesseler, J.H.H. (2009) Ex-Ante regulation and ex-post liability under uncertainty and irreversibility: governing the coexistence of gm crops Economics 2009 . – p. 1 – 39.Berlin : Economics-ejournal, (53 53). http://edepot.wur.nl/45781