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

• Proposes a novel real option framework for rail transit investment under Knightian uncertainty.
• Uses κ-ignorance and multiple-priors to identify optimal investment conditions.
• Proposes solutions for congestion relief under uncertain urban population growth.
• Option value and investment thresholds vary with the ambiguity attitudes of decision-makers.
• Conducts a numerical application to illustrate the impact of pessimism or optimism on investment.

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.