Considering real options in short-term decision making

Abstract

Option-like situations in non-financial markets, often referred to as real options, are usually discussed and analyzed in the context of investment decisions. In spite of the real options literature’s focus on investment decisions, option-like situations are also frequently encountered in operating decisions. For instance, decisions on the operating mode of a flexible machine in the presence of switching costs can be characterized as complex real options problems with multiple compound options. For an optimal long-term solution, short-term decision rules must consider the value of these options. In this paper we first show how a fully rational decision rule that takes the long-term consequences of short-term decisions into account can be derived within the real options framework. We contrast the outcomes of decisions according to this benchmark rule with the outcomes of decisions according to the traditional decision rule based on current contribution margin and illustrate our findings with a simulation analysis providing for a rich set of environments characterized by different levels of uncertainty and different switching costs. A major drawback of the options-based rule is the necessity to estimate option values at every decision point drawing on information from all future periods. We therefore analyze how a simplified options-based decision rule that looks ahead only one period performs against the benchmark rule. In an extension of the simulation analysis we find that the simplified decision rule serves as a good heuristic and improves decision-making similar to the benchmark rule while at the same time being much more likely to be implemented in practice.