2011 Discussion Papers
School of Economics Discussion Paper 11/07
A General Equilibrium Model of Environmental Option Values
Iain Fraser and Katsuyuki Shibayama
University of Kent
In this paper we consider the option value of the environment employing a stochastic general equilibrium growth model. In our model, as in existing studies, because of irreversibility, the environment has significant real option value. However, unlike the existing literature, the value of the environment is endogenously determined in our general equilibrium setting. In our model, the elasticity of substitution between the environment and consumption not only has quantitative effects but also qualitative effects on the option value of the environment and the optimal allocation of land. We also show that the volatility of the exogenous shock process has quantitatively significant effects on the size of the option value which has important implications for the practical estimation of environmental option values.
JEL Classification: Q38; G13; O13
Keywords: Real option; environment; general equilibrium; elasticity of substitution; generalized isoelastic preference