Economically Optimal Timing of Insect Control in Processing Facilities: A Real Option Approach SULING DUAN, DOCTORAL RESEARCH ASSISTANT BRIAN D. ADAM, PROFESSOR OKLAHOMA STATE UNIVERSITY
Insect Control is an Economic Compromise Cents per bushel 14 Cost of Insect Damage Cost of Control 12 10 8 6 4 2 0 1 2 3 Treatments 4
Research Question When, and how often, should insects be treated in a processing facility? Objective is to balance costs of insect infestation/damage and costs of treatment
Problem: uncertainty in estimating costs Sources of insect damage uncertainty: o Weather uncertainty (affects insect population and activity) o Insect immigration uncertainty o Uncertainty of insects entering food o How much economic damage do insects cause, if they do enter food? (recalls, etc.)
Insect population without treatment Red Flour Beetles in a Flour Mill: no treatment 900 800 First Floor 600 Second Floor 500 400 Third Floor 300 Fourth Floor 200 Fifth Floor 100 0 1 11 21 31 41 51 61 71 81 91 101 111 121 131 141 151 161 171 181 191 201 211 221 231 241 251 261 271 281 291 301 311 321 331 341 351 361 Insect Number 700 Days
Tradeoff There is a risk of treating too early or too late Too early need more treatments (costly) Too late greater insect damage (costly)
Examples of varying treatment dates Red Flour Beetles: Fumigation after 90 days 900 700 First Floor 600 Second Floor 500 Third Floor 400 Fourth Floor 300 Fifth Floor 200 100 0 1 11 21 31 41 51 61 71 81 91 101 111 121 131 141 151 161 171 181 191 201 211 221 231 241 251 261 271 281 291 301 311 321 331 341 351 361 Insect Number 800 Days
Red Flour Beetles: Fumigation after 180 days 900 800 First Floor 600 Second Floor 500 Third Floor 400 300 Fourth Floor 200 Fifth Floor 100 0 1 11 21 31 41 51 61 71 81 91 101 111 121 131 141 151 161 171 181 191 201 211 221 231 241 251 261 271 281 291 301 311 321 331 341 351 361 Insect Number 700 Days
Red Flour Beetles: Fumigation after 300 days 900 800 600 First Floor 500 Second Floor 400 Third Floor 300 Fourth Floor Fifth Floor 200 100 0 1 10 19 28 37 46 55 64 73 82 91 100 109 118 127 136 145 154 163 172 181 190 199 208 217 226 235 244 253 262 271 280 289 298 307 316 325 334 343 352 361 Insect Number 700 Days
Research Question Since fumigating too early increases the frequency of fumigation and fumigation cost, and fumigating too late increases the potential insect damage cost: What is the optimal time to fumigate to balance these two offsetting costs? There is risk in waiting, and risk in not waiting what is the cost of that risk? Traditional approaches do not consider $ value of risk
Real Option Approach Measures risk in dollar terms Borrows from finance theory (worth paying a little now to protect against large loss) Examples: Insurance Options on futures contracts How much would I be willing to pay now to make a better decision later?
Real Option a simple real-life example Should I choose to carry an umbrella today? That would be inconvenient, but I will be prepared if it rains.
Umbrella Example no rain It s OK rain Get wet no rain Inconvenient Not carry Carry rain Inconvenient, but STAY DRY
An economic example Option to wait to invest in a project Investment cost = $600 $1,000 Possible outcomes: $1,000 or $0 one year later, each with 50% probability Expected revenue = $500 Don t invest (expected loss = $100) $0
An economic example What if we can delay the investment until the uncertainty is resolved (say 1 year)? How much would that option be worth? (Suppose I want to build a factory to build electric cars, but the profitability of the factory depends on battery technology. I could buy the land for the factory, which leaves open the possibility of building the factor if the technology advances sufficiently)
Investment cost = $600 Decide Year 1 Invest $600, $1,000 Expect to receive $500 $0 Expected return = -$100 Wait Until Uncertainty Becomes Resolved
Investment cost = $600 Wait Year 1 Decide Year 2 $1,000 $0 Good Outcome Invest $600, Receive $1,000, Net $400 Bad Outcome Invest $0, Receive $0 Waiting is worth up to $400 (expected return from waiting = $200) Wait Until Uncertainty Becomes Resolved
Objective for this research: Determine optimal time to treat for insects Traditional approach: Treat when economic benefit = economic cost (loss from insect damage avoided = treatment cost) Traditional approach ignores uncertainty
Uncertainty in this problem Waiting to treat might cost more insect damage Treating now might incur more treatment costs later
Timing Option The value of the option to wait to treat is: max,0 : cost avoided by treating (return from treating) : treatment cost : discount rate
Timing Option
Option Value Option value = Intrinsic Value + Time Value = Net Value of Treating + Value of Waiting
Timing Option Simulation: Insect Growth simulated with Flour Mill Model by Flinn et al. 3rd floor Data: 2010-2011 900 800 700 600 500 400 300 200 100 0 1 20 39 58 77 96 115 134 153 172 191 210 229 248 267 286 305 324 343 362 Weather Red Flour Beetles, 3rd Floor, 2010-2011 Insect Number/kg Days
100000 Intrinsic Value (V) 80000 60000 40000 20000 0 1 17 33 49 65 81 97 113 129 145 161 177 193 209 225 241 257 273 289 305 321 337 353 $ T Optimal Results Days 157 7000 6000 5000 4000 3000 2000 1000 0 Value of the Option (F(V)) 1 18 35 52 69 86 103 120 137 154 171 188 205 222 239 256 273 290 307 324 341 358 $ Treatment Cost $937 Option Value (F(V)) $6,466 Insect Number 526 Days
0 5000 10000 15000 20000 25000 30000 35000 1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81 86 91 96 101 106 111 116 121 126 131 136 141 146 151 156 $ T Time Value (V) -5000 0 5000 10000 15000 20000 25000 30000 35000 1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81 86 91 96 101 106 111 116 121 126 131 136 141 146 151 156 Intrinsic value
$ 800 600 400 Optimal treatment time without considering risk Value of waiting = value of treating(time value = 0) Value of Treatment minus Treatment Cost 200 0-200 -400 Option Value (F(V)) Net Value of treating immediately Time Value (V) value of waiting Value of treating immediately Optimal treatment time taking into account risk Time -600-800
Red Flour Beetles: Fumigation after 180 days 900 Option approach 800 600 500 First Floor Traditional approach Second Floor Third Floor 400 300 Fourth Floor 200 Fifth Floor 100 0 1 11 21 31 41 51 61 71 81 91 101 111 121 131 141 151 161 171 181 191 201 211 221 231 241 251 261 271 281 291 301 311 321 331 341 351 361 Insect Number 700 Days
What s the bottom line? 1) 2) 3) 4) A real option approach takes into account uncertainty the decision-maker faces It puts a dollar value on the option to wait In this specific example, a real option approach recommends delaying treatment longer than static economic analysis that doesn t consider risk Extended work with collaborators will include more detailed insect growth and damage cost estimates Questions? Comments?
Thank You! Questions?
Figure. Diagram for option to wait to treat insect for rice mill in one location Weather uncertainty: Indoor Temperature Humidity Outdoor temperature Insect growth and adult insect death Insect population uncertainty Immigration uncertainty: Insects moving from other location Insects immigrating from outside Sanitation conditions Facility layout Uncertainty of insects entry into food Option to wait to treat Effect of waiting to treat Product recall from insect infestation (-) Product rejection from insect infestation (-) Postpone treatment cost (+) Decision Model What s the trigger value? Effect of treating Reduced insect damage (+) Treatment cost (-)