Supply Uncertainty, Option Price, and Indirect Benefit Estimation

Abstract

Both the original and many of the subsequent explanations of the concept of option price have been motivated by an assumption of an uncertain supply of the commodity involved.1 Consequently, it is surprising to find that all of the definitions of option price compare two states of the world which each have known (or certain) supply conditions. Paying the option price does not eliminate supply uncertainty, as it has been described. Rather it changes the individual's conditions of access to the good or service from a certainty of no access to a certainty of complete access. Risk enters the problem only because these analyses assume the individual does not know whether he (or she) will desire access at the time the payment must be made. Since the analysis is in terms of planned consumption, the reason for this demand uncertainty is sometimes explained by the fact that the consumption must take place in the future, when other factors influencing demand may have changed.2 Bishop (1982) appears to have been the first to draw attention to this omission of supply uncertainty and proposed a framework without demand uncertainty to demonstrate that there are conditions when option value (i.e., the difference between option price and the expected consumer surplus) would be unambiguously positive.3 While there have been a number of theo-