Real option value and poverty trap

Abstract

In recent years concerns about poverty traps have risen to the forefront of policy. Accordingly, the decision on investing or waiting in specific sectors or locations of poor countries is in part assigned to the government of that country. We study the optimal timing of a foreign direct investment (FDI) where the returns are stochastic and the cost irreversible. A model of real option value compares the benefits and costs of a risky FDI with those of a riskless official development assistance (ODA). Once FDIs take place, the local government can shift ODAs towards different sectors or locations to hinder poverty. We show that with uncertainty and irreversibility, the policy decision has an opportunity value that must be included as a part of the full value of the FDI. This option value is highly sensitive to uncertainty over the future returns, so that changing actual economic conditions in poor countries can have a large impact on the poverty trap. Simulations show that this option value can be significant to explain the prevalence of hysteresis, that is the tendency of a poor country to persist in poverty.