Incorporating Knightian uncertainty into real options analysis: Using multiple-priors in the case of rail transit investment

Abstract

This paper revisits the real option investment problem from a ‘Knightian’ perspective of uncertainty. We examine the decision to invest in rail transit infrastructure (i.e., transport improvement) by treating population scale and the attitudes of decision-makers or social planners as sources of risk and ambiguity. An α-maxmin multiple-priors expected utility framework is developed to solve for the option value of rail transit investment under Knightian uncertainty. We find that the threshold for investment varies with the ambiguity attitudes (i.e., pessimism or optimism) of decision-makers regarding future population dynamics, and show that option value can in fact either increase or decrease with uncertainty subject to κ-ignorance and ambiguity. We also underline the effect of transport improvement on traffic congestion under various states of nature, and determine the specific population scale ranges for which investment is warranted under (1) risk and (2) Knightian uncertainty. These dynamics are illustrated in a numerical application adapted from a Chinese rail transit initiative specific to the Xiamen region.