Keeping Your Options Open

Jean Guillaume Forand

No 82, 2011 Meeting Papers from Society for Economic Dynamics

Abstract: In standard models of experimentation, the costs of project development consist of (i) the direct cost of running trials as well as (ii) the implicit opportunity cost of leaving alternative projects idle. Another natural type of experimentation cost, the cost of holding on to the option of developing a currently inactive project, has not been studied. In a (multi-armed bandit) model of experimentation in which inactive projects have explicit maintenance costs and can be irreversibly discarded, I fully characterise the optimal experimentation policy and show that the decision-maker's incentive to actively manage its options has important implications for the order of project development. In the model, an experimenter searches for a success among a number of projects by choosing both those to develop now and those to maintain for (potential) future development. In the absence of maintenance costs, the optimal experimentation policy has a 'stay-with-the-winner' property: the projects that are more likely to succeed are developed first. Maintenance costs provide incentives to bring the option value of less promising projects forward, and under the optimal experimentation policy, projects that are less likely to succeed are sometimes developed first. A project development strategy of `going-with-the-loser' strikes a balance between the cost of discarding possibly valuable options and the cost of leaving them open.

Date: 2011
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Journal Article: Keeping your options open (2015)
Working Paper: Keeping Your Options Open (2010)
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