Alternative Land Use Policies: Real Options with Costly Reversibility

This paper adopts a real options framework to evaluate the cost-effectiveness of four types of subsidies that aim to encourage a socially desirable land use under return uncertainties and costly reversibility of land use change. We first present a land conversion model to show how the subsidies that are expected net present value (ENPV) equivalent can change a representative farmer’s optimal land conversion rules differently for converting land into an alternative use as well as converting out of it. This is because these subsidies affect the land conversion costs, land return level and uncertainty differently. Then in the context of encouraging energy crop production, we compare the probabilities of inducing the representative farmer to convert land from a current crop to an energy crop across four subsidies for the same, fixed 30-year expected government budget. Results of Monte Carlo simulations show that the insurance subsidy results in the highest probability of land being converted to the energy crop, followed by the constant subsidy. Although the cost-sharing subsidy and the variable subsidy encourage land conversion to the energy crop, they also reduce the incentive to retain land in it. Over time, these two subsidies have little effect on the probability of land converting into energy crops compared to the no-subsidy baseline. Combining the establishment cost-sharing subsidy with other annual subsidies has no added effect over single subsidies in inducing land conversion to the energy crop