Technical Uncertainty in Real Options with Learning

Abstract

In this article, we introduce a new approach to incorporate technical uncertainty into irreversible investment. The agent is allowed to make a one time investment, after which she receives a stream of output from a reserver. She is exposed to both price uncertainty as well as uncertainty in the amount of available resources in the reserves. She does, however, learn about the reserve levels through time. To model the technical uncertainty and learning simultaneously, we adopt a continuous time Markov chain model and investigate the incremental value that learning has prior to investment. Moreover, we demonstrate how in principle the technical uncertainty and learning parameters may be estimated.