The regeneration decision: a sequential two-option approach

Real option theory has for some decades been used in forest economics to analyse problems that involve irreversible and stochastic decisions. One of these problems is when to harvest a stand and with what species to regenerate. This problem is analysed here, assuming that the value development of both the present and the next stand is stochastic and that the regeneration species must be chosen. The latter decision is assumed asymmetric, as natural regeneration can be exchanged for a planted regeneration but not vice versa. Consequently, the decision can be postponed for some time if natural regeneration is foreseen, making a species change possible if favoured by the value development or if regeneration of the present species proves unsuccessful. This is an extension of the traditional two-option problem, by involving several stochastic elements that are nested in another option problem: when to harvest a stand. Thus the decision on when to harvest a stand depends on its present value as well as on the value of the future stand, both values evolving stochastically. The problem is formulated as a sequential two-option problem and solved numerically.