The theory of irreversible investment predicts that development of an oil field should take place when a unique ‘price trigger' is passed. At the start of the 1990/91 Gulf War, however, oil prices promptly doubled, only to fall back to their previous level when peace returned six months later. To incorporate such large but ‘transitory' price hikes, we evaluate the profitability of an oil field contingent on war and peace and calculate separate triggers in each case. For plausible parameter values, we find that the switch between these development triggers is about 3/4 of the price hike caused by the war. The price hike is therefore equivalent to a permanent price increase of only a quarter of its size.
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Miller et al. (1996) studied this question.
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