Making enduring choices: Uncertainty and public policy

This paper provides an experimental test of the theory of investment under uncertainty and applies the theory to a group of policy decisions. Investment under uncertainty describes a class of problems, characterized by uncertainty that resolves itself over time, sunk costs that cannot be fully recovered, and the ability of the decision maker to wait without loss of strategic advantage. It also implies a “bad news principle,” under which decision makers are motivated by expected costs, but not expected benefits. The theory is illustrated as a two-period model for which the decision maker can either invest in the first period (and receive a known current return plus an uncertain future return) or defer until the second period when uncertainty is resolved. By foregoing current period benefits a “cost” that is sometimes referred to as an option value is incurred. Parameter values are specified and an experimental test, the results of which closely track the predictions of the theory, is described. Three cases, the structuring of contingent valuation questionnaires, the operalization of the precautionary principle in risk analysis, and the development of public policy to stimulate private investments (as for energy-saving products), are used to illustrate potential public policy applications.