EVALUATING IRREVERSIBLE INVESTMENTS Introduction In the realm of resource economics, we address a critical question: What are theimplications of irreversibility for resource allocation? Irreversibility becomes particularly pertinent when natural environments, with insitu resources, appreciate in value relative to extractive resources over time. The Dynamics of Technical Change Technical change is asymmetric: it increases the capacity to produce ordinarygoods and services but not natural environments. As consumer preferences tend to favor environmental preservation, the relativevalue of in situ resources may rise. Irreversible investments may necessitate conservative project investment criteria. Irreversible Development of Natural Environments A model based on Arrow's analysis of irreversible capital accumulation revealsthat if the net benefits of development, net of environmental costs, are anticipatedto decline over time, development is optimally cut off before that period. If expected net benefits are always declining, either no development ordevelopment at the initial point in time may be appropriate. The Impact of Changing Expectations While the model assumes that expectations about benefits from development donot change over time, in reality, people learn and adapt. Expectations may evolve as new information becomes available. The timing of a project can significantly affect its expected benefits. Investment Under Uncertainty and Irreversibility The concept of option value arises when considering the value of retaining theoption to consume in the future.
Option value can be identified with a risk premium over and above expectedconsumer surplus. Preservation decisions can involve risks, such as the risk of flood or powerfailure. Risk-Neutral Decision-Making There's a debate about whether social choices should display aversion to risk ornot. Risk may be pooled in government projects, and when returns are spread overmany individuals, so are the risks. The existence of an option value of preserving the environment depends on theasymmetry of alternatives, especially when one is irreversible. The Role of Information Better information can improve decision-making but comes with a cost. The cost can be in the form of direct research expenditures or the opportunitycost of waiting for information to accrue. The value of information is defined as the difference between the expected valueof the optimal decision with new information and the expected value without it. Option Value as the Value of Information An alternative concept of option value is defined as the value of informationconditional on retaining the option to make an irreversible decision in the future. The value of information is compared to the cost of acquiring it, either directresearch costs or the opportunity cost of waiting. The concept of option value is essential for decision-making in scenariosinvolving irreversible investments and changing information. Conclusion Evaluating irreversible investments in natural environments requires consideringchanging expectations, risk, and the value of information. Option value plays a crucial role in decision-making when development isirreversible and benefits and costs may evolve over time.