Option value is the value of being able to delay a decision. Within effective altruism, the idea has been used to argue for the importance of reducing existential risk, for deciding what choices effective altruists should make as a community, and for assessing the value of different careers. Option value may also be useful for looking at problems such as differential progress and climate change.

The idea of option value was adapted from finance, and is heavily used in environmental economics to measure the value of delaying an irreversible decision. It arises as a result of the uncertainty of future costs and benefits, the ability to gain information over time, and the ability to delay a decision. When done in the typical fashion, orthodox cost-benefit analysis ignores the second and last of those three conditions. In more sophisticated applications of cost-benefit analysis, however, consideration of option value allows for a better-optimized decision-making process.

A simple model

Dixit and Pindyck gave the simple example of a firm that has the option to invest in a factory that would produce one "widget" per year starting on the year of investment.^[1] The current price of the widget is $200. Next year the price of the widget will either rise to $300 or go down to $100 and will stay at that level permanently. The chance of either outcome happening is 50%. The cost of the investment is $1600 and the interest rate is 10%. We find that the net present value (NPV) is equal to:

$NPV = - 1600 + 200 + \infty \sum t = 1 \frac{0.5 \cdot 300 + 0.5 \cdot 100}{{1.1}^{t}} = $ 600.$

The NPV is positive and a traditional cost-benefit analysis suggests the firm should invest. A more complex analysis, however, considers not only whether or not to invest, but also considers whether the investment would be better made now, or in the future. In this case, we can consider the option of waiting until next year when the price changes. Our traditional analysis now indicates that in a year, we would invest only if the price rises to $300:

$NPV = 0.5 \cdot 0 + 0.5 \cdot [\frac{- 1600}{1.1} + \infty \sum t = 1 \frac{300}{{1.1}^{t}}] = $ 773.$

Even though we are now foregoing the current year sale at $200, we find that the NPV is higher if the firm delays the investment decision. Intuitively, we can understand that by ignoring the possibility of delaying the investment and of learning new information by waiting, the original NPV calculation boiled down to a "now or never" decision. In the second c...

Megan Phelan

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