Irreversibility and Uncertainty in Species Valuation

This paper incorporates an option value into deforestation policy analysis. Similar to an option value in finance, the option value here reflects the advantage to delaying irreversible species extinction until more information about the uncertain value of species is known. The return from species is modeled as a stochastic flow of benefits which ceases if policy makers choose to deforest. Deforestation produces known profits from wood, and agriculture or ranching. Model variations include using geometric Brownian motion and a Poisson jump process to model the variation in species values, and the effect of considering whether "harvesting" of species can occur during deforestation. The model demonstrates that uncertainty over the value of species should encourage forest protection beyond what present discounted value comparisons (traditional cost-benefit analysis) would imply. Data from studies of Brazil's Amazonia region are used to provide numerical examples of the differences between traditional cost-benefit methods and the option-theoretic approach described here. *This paper is a rewritten version of a B.S. thesis completed in the spring of 1994 at the Massachusetts Institute of Technology. The author thanks the Center for Energy and Environmental Policy Research, the National Science Foundation, and the Undergraduate Research Opportunities Program at MIT for financial support. My thanks to Dr. Robert Pindyck for extensive advice as well as Alex Chisholm, Raul Acevedo, Amy Weaver, and Alex Pfaff for their comments and assistance.