Real Options and the WTP / WTA Disparity Jinhua

We present a real options model of an agent's decision to purchase or sell a good under conditions of uncertainty, irreversibility, and learning over time. Her WTP and WTA contain both the intrinsic value of the good and an option value associated with delaying the decision until more information is available. Consequently, the standard Hicksian equivalence between WTP/WTA and compensating and equivalent variation no longer holds. This helps to explain the WTP/WTA disparity often observed in laboratory experiments and surveys because subjects may have limited learning time and opportunities, thus generating option values. In contrast, the disparity may decrease or disappear entirely in real markets since agents are free to choose when to stop gathering information, thereby reducing or eliminating the option values. We also discuss experimental evidence that supports the option value hypothesis. (JEL: D60, D83, C90) Hicksian welfare theory forms the basis of modern welfare analysis. This theory is static and therefore the relationship between standard welfare measures such as willingness to pay (WTP) or willingness to accept (WTA) and the passage of time has not received much attention. However, in many market decisions where it takes time to gather information, timing of the transaction is an integral part of the decision. For example, an art collector considering selling a painting may want to gather information about the painting's market value before deciding to o er it for sale. Likewise, a consumer considering the purchase of a new style of blue jeans might want to learn more about current styles and substitutes before actually making the purchase, especially if the store has a limited return policy. Thus, timing may play a key role in market transactions by allowing agents to acquire information about the good, such as the prevailing market prices (including substitutes), and to solidify their own preferences for the good. Consequently, the time at which WTP or WTA is formed may a ect their magnitude. If there are nontrivial transaction costs associated with reversing the decision and the agent has some uncertainty about the value of the good, she may prefer to delay the decision in order to obtain additional information about the good's value. This information helps the agent to reduce the likelihood of having to reverse her trade (thus incurring the associated transaction cost) later on. As Arrow and Fisher (1974), Henry (1974), Epstein (1980) and Dixit and Pindyck (1994) have demonstrated, this role of future information means that there is a bene t, called quasi-option value (QOV), associated with waiting to make a decision. Thus, to make a purchase on the rst day that the new styles are in the stores, the jeans shopper will be willing to pay less than she might if she waited and gathered further information. Alternatively, for the art collector to sell the painting to the rst bidder and forego further learning, she will demand a higher price in QOV is distinct from the option value concept introduced by Weisbrod (1964). The Weisbrod option value is fundamentally a risk aversion premium. Quasi-option value, on the other hand, measures a conditional value of information and exists even for risk neutral agents. See Hanemann (1989) for additional discussion of QOV.