October  2020, 7(4): 317-333. doi: 10.3934/jdg.2020025

Real option value and poverty trap

1. 

Università di Urbino Carlo Bo, Dipartimento di Economia Società Politica - DESP, Via Saffi 42 61029 Urbino (PU), Italy

2. 

Università di Urbino Carlo Bo, Dipartimento di Economia Società Politica - DESP

*Corresponding author: Giuseppe Travaglini

Received  April 2020 Revised  June 2020 Published  August 2020

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.

Citation: Giorgio Calcagnini, Edgar J. Sanchez Carrera, Giuseppe Travaglini. Real option value and poverty trap. Journal of Dynamics & Games, 2020, 7 (4) : 317-333. doi: 10.3934/jdg.2020025
References:
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show all references

References:
[1]

E. Accinelli and E. S. Carrera, Strategic complementarities between innovative firms and skilled workers: The poverty trap and the policymaker's intervention, Structural Change and Economic Dynamics, 22 (2011), 30-40.  doi: 10.1016/j.strueco.2010.11.004.  Google Scholar

[2]

P. R. Agénor and J. Aizenman, Aid volatility and poverty traps, J. Develop. Econom., 91 (2010), 1-7.   Google Scholar

[3]

C. Altomonte, Economic determinants and institutional frameworks: FDI in economies in transition, Transnational Corporations, 9 (2000), 75-106.   Google Scholar

[4]

A. Assadzadeh and J. Pourqoly, The relationship between foreign direct investment, institutional quality and poverty: Case of MENA countries, J. Econom., 1 (2013), 161-165.   Google Scholar

[5]

C. Azariadis and A. Drazen, Threshold externalities in economic development, Quart. J. Econom., 2 (1990), 501-526.   Google Scholar

[6]

C. Azariadis, The economics of poverty traps; Part one: Complete markets, J. Econom. Growth, 4 (1996), 449-486.   Google Scholar

[7]

C. Azariadis and J. Stachurski, Poverty traps, Handbook of Economic Growth, 1 (2005), 295-384.  doi: 10.1016/S1574-0684(05)01005-1.  Google Scholar

[8]

C. Azariadis, The theory of poverty trap: What have we learned?, in Poverty Traps, 1, Princeton, Princeton University Press, 2006, 17–40. Google Scholar

[9]

A. Banerjee and A. Newman, Occupational choice and the process of development, J. Polit. Econ., 101 (1993), 274-298.   Google Scholar

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A. Banerjee and E. Duflo, Poor economics: A radical rethinking of the way to fight global poverty, 2$^{nd}$ edition, PublicAffairs, 2011. Google Scholar

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B. J. BarnettC. B. Barrett and J. R. Skees, Poverty traps and index-based risk transfer products, World Development, 36 (2008), 1766-1785.   Google Scholar

[12]

C. B. Barrett and B. M. Swallow, Fractal poverty traps, World Development, 34 (2006), 1-15.   Google Scholar

[13]

C. B. Barrett and M. R. Carter, The economics of poverty traps and persistent poverty: Empirical and policy implications, J. Develop. Stud., 49 (2013), 976-90.   Google Scholar

[14]

C. B. BarrettT. Garg and L. McBride, Well-being dynamics and poverty traps, Ann. Rev. Res. Econom., 8 (2016), 303-327.   Google Scholar

[15]

Y. Basnett, J. Engel, J. Kennan, C. Kingombe, I. Massa and D. W. te Velde, Increasing the effectiveness of aid for trade: The circumstances under which it works best, London: Overseas Develop. Instit., (2012), Working Paper 353. Google Scholar

[16]

S. Bowles, Institutional poverty traps, in Poverty Traps, 5 pp. 116-138, Princeton University Press, 2006. Google Scholar

[17]

C. Burnside and D. Dollar, Aid, policies, and growth, Amer. Econom. Rev., 90 (2009), 847-868.   Google Scholar

[18]

G. Calvo, Servicing the public debt: The role of expectations, Amer. Econom. Rev., 78 (1998), 647-661.   Google Scholar

[19]

M. R. CarterP. D. LittleT. Mogues and W. Negatu, Poverty traps and natural disasters in Ethiopia and Honduras, World Development, 35 (2007), 835-856.   Google Scholar

[20]

Y. Chen and M. Funke, Option value, policy uncertainty, and the foreign direct investment decision, HWWA Discussion Paper, 234 (2003). Google Scholar

[21]

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[22]

P. Collier and D. Dollar, Can the world cut poverty in half? How policy reform and effective aid can meet intrenational development goals, World Development, 29 (2001), 1787-1802.   Google Scholar

[23]

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[24]

R. Cooper and A. John, Coordinating coordination failures in Keynesian models, Quart. J. Econom., 103 (1998), 441-463.  doi: 10.2307/1885539.  Google Scholar

[25]

L. Chauvet and P. Guillaumont, Aid and performance: A reassessment, J. Develop. Stud., 37 (2001), 6-92.   Google Scholar

[26]

L. Chauvet and P. Guillaumont, Aid, volatility and growth again: When aid volatility matters and when it does not, Rev. Develop. Econom., 13 (2009), 452-463.  doi: 10.1111/j.1467-9361.2009.00501.x.  Google Scholar

[27]

D. Chivers, Success, survive or escape? Aspirations and poverty traps, J. Econom. Behav. Organ., 143 (2017), 116-132.   Google Scholar

[28]

C. J. DalgaardH. Hansen and F. Tarp, On the empirics of foreign aid and growth, Econom. J., 114 (2004), 191-216.  doi: 10.1111/j.1468-0297.2004.00219.x.  Google Scholar

[29]

A. De Matteis, Relevance of poverty and governance for aid allocation, Rev. Develop. Finan., 3 (2013), 51-60.   Google Scholar

[30]

J. De Melo and L. Wagner, Aid for trade as finance for the poor, Development (No. 125), 2015. Google Scholar

[31]

D. Diamond and P. Dybvig, Bank Runs, Deposit Insurance, and Liquidity, J. Polit. Econ., 91 (1983), 401-419.   Google Scholar

[32]

A. Dixit, Investment and hysteresis, J. Econom. Perspective, 6 (1992), 107-132.  doi: 10.1257/jep.6.1.107.  Google Scholar

[33] A. Dixit and R. S. Pindyck, Investment under Uncertainty, Princeton University Press, New Jersey, 1994.   Google Scholar
[34]

S. Durlauf, A theory of persistent income inequality, J. Econom. Growth, 1 (1996), 75-93.   Google Scholar

[35]

S. Durlauf, Neighborhood effects, Handbook of Regional and Urban Economics, 4 (2003). Google Scholar

[36]

W. Easterly, Can foreign aid buy growth, Journal of Economic Perspectives, 17 (2003), 23-48.  doi: 10.1257/089533003769204344.  Google Scholar

[37]

W. EasterlyR. Levine and D. Roodman, Aid, policies and growth: Comment, Amer. Econom. Rev., 94 (2004), 774-780.  doi: 10.1257/0002828041464560.  Google Scholar

[38]

R. Echandi, J. Krajcovicova and C. Z. Qiang, The impact of investment policy in a changing global economy: A review of the literature, The World Bank, Policy Research Working Paper 7437, 2015. Google Scholar

[39]

M. Fujita, P. Krugman and A. J. Venables, The Spatial Economy; Cities, Regions and International Trade, Cambridge: MIT Press, 1999. doi: 10.7551/mitpress/6389.001.0001.  Google Scholar

[40]

A. D. Foster and M. R. Rosenzweig, Household division and rural economic growth, Rev. Econom. Stud., 69 (2002), 839-869.   Google Scholar

[41]

O. Galor and J. Zeira, Income distribution and macroeconomics, Rev. Econom. Stud., 60 (1993), 35-52.  doi: 10.2307/2297811.  Google Scholar

[42]

M. Ghatak, Theories of poverty traps and anti-poverty policies, World Bank Econom. Rev., (2015), 1–29. Google Scholar

[43]

R. Jenkins, Globalization, corporate social responsibility and poverty, International Affairs, 81 (2005), 525-540.  doi: 10.1111/j.1468-2346.2005.00467.x.  Google Scholar

[44]

S. Kosack, Effective aid: How democracy allows development aid to improve the quality of life, World Development, 31 (2003), 1-22.   Google Scholar

[45]

H. Hansen and F. Tarp, Aid and Growth Regressions, J. Develop. Econom., 64 (2001), 547-570.  doi: 10.1016/S0304-3878(00)00150-4.  Google Scholar

[46]

G. Holger and D. Greenaway, Foreign direct investment and intra-industry spillovers: A review of the literature, No. (2001), 37. Research Paper. Google Scholar

[47]

G. Holger and D. Greenaway., Much ado about nothing? Do domestic firms really benefit from foreign direct investment?, The World Bank Research Observer 19.2, (2004), 171–197. Google Scholar

[48]

M. Ikegami, M. R. Carter, C. B. Barrett and S. Janzen, Poverty traps and the social protection paradox", NBER Chapters, in The Economics of Poverty Traps National Bureau of in The Economics of Poverty Traps, University of Chicago Press. Google Scholar

[49]

A. Kraay and D. McKenzie, Do Poverty Traps Exist? Assessing the Evidence, J. Econom. Perspectives, 28 (2014), 127-148.  doi: 10.1257/jep.28.3.127.  Google Scholar

[50]

P. Krugman, Increasing returns and economic geography, J. Polit. Econ., 99 (1991), 483-499.  doi: 10.1086/261763.  Google Scholar

[51]

M. Katz and C. Shapiro, Technology adoption in the presence of network externalities, J. Polit. Econ., 94 (1986), 822-841.  doi: 10.1086/261409.  Google Scholar

[52]

P. T. Leeson, Escaping poverty: Foreign aid, private property, and economic development, The Journal of Private Enterprise, 23 (2008), 39-64.   Google Scholar

[53]

E. M. Liu and J. K. Huang, Risk preferences and pesticide use by cotton farmers in China, J. Develop. Econom., 103 (2013), 202-215.   Google Scholar

[54]

G. C. Loury, Intergenerational transfers and the distribution of earnings, Econometrica, 49 (1981), 843-867.  doi: 10.2307/1912506.  Google Scholar

[55]

R. E. Lucas Jr., On the Mechanics of Economic Development, J. Monetary Econom., 22 (1988), 3-42.  doi: 10.1016/0022-0531(77)90108-9.  Google Scholar

[56]

K. Matsuyama, Poverty traps, in The New Palgrave Dictionary of Economics, New York: Palgrave Macmillan, 2008. Google Scholar

[57]

R. McDonald and D. Siegel, The value of waiting to invest, Quart. J. Econom., 101 (1986), 707-728.  doi: 10.2307/1884175.  Google Scholar

[58]

D. Moyo, Dead Aid: Why Aid is not Working and How there is a Better Way for Africa, Macmillan, 2009. Google Scholar

[59]

M. Obstfeld, Rational and Self-Fulfilling Balance-of-Payments Crises, Amer. Econom. Rev., 76 (1986), 72-81.   Google Scholar

[60]

M. Obstfeld, Models of currency crises with self-fulfilling features, Eur. Econom. Rev., 40 (1996), 1037-1047.  doi: 10.1016/0014-2921(95)00111-5.  Google Scholar

[61]

OECD/WTO, Aid for trade at a glance 2011: Showing results, WTO, Geneva/OECD Publishing, Paris, 2011. Google Scholar

[62]

OECD, Development co-operation report, Paris: OECD, 2018. doi: 10.1787/dcr-2018-en.  Google Scholar

[63]

R. Pindyck, Irreversibility, uncertainty and investment, J. Econom. Lit., 29 (1991), 1110-1148.   Google Scholar

[64]

V. Polterovich, Institutional Trap, in The New Palgrave Dictionary of Economics, London, Palgrave Macmillan, 2008. doi: 10.1057/978-1-349-95121-5_2717-1.  Google Scholar

[65]

R. G. Rajan and A. Subramanian, Aid, Dutch disease, and manufacturing growth, J. Develop. Econom., 94 (2011), 106-118.   Google Scholar

[66]

P. Rivoli and E. Salorio, Foreign direct investment and investment under uncertainty, J. Internat. Bus. Stud., 27 (1996), 335-357.  doi: 10.1057/palgrave.jibs.8490138.  Google Scholar

[67]

P. M. Romer, Increasing returns and long-run growth, J. Polit. Econ., 94 (1986), 1002-1037.   Google Scholar

[68]

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Figure 1.  Source: [62] DAC statistics
Figure 2.  Source: UNCTAD (2014). Inward and outward foreign direct investment flows, annual, 1970-2012
Figure 3.  Source: Own elaboration. Values of Waiting and Investing
Figure 4.  Source: Own elaboration. Real option value for $ \sigma = 0.2 $ and $ 0.3. $
Figure 5.  Source: Own elaboration. Real option value for $ \alpha = 0.06 $ and $ 0.08. $
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