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A Model of R&D Valuation and the Design of Research Incentives


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  • Jason C. Hsu
  • Eduardo S. Schwartz
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    We develop a real options model of R&D valuation, which takes into account the uncertainty in the quality of the research output, the time and cost to completion, and the market demand for the R&D output. The model is then applied to study the problem of pharmaceutical under-investment in R&D for vaccines to treat diseases affecting the developing regions of the world. To address this issue, world organizations and private foundations are willing to sponsor vaccine R&D, but there is no consensus on how to administer the sponsorship effectively. Different research incentive contracts are examined using our valuation model. Their effectiveness is measured in the following four dimensions: cost to the sponsor, the probability of development success, the consumer surplus generated and the expected cost per person successfully vaccinated. We find that, in general, purchase commitment plans (pull subsidies) are more effective than cost subsidy plans (push subsidies), while extending patent protection is completely ineffective. Specifically, we find that a hybrid subsidy constructed from a purchase commitment combined with a sponsor co-payment feature produces the best results in all four dimensions of the effectiveness measure.

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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10041.

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    Date of creation: Oct 2003
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    Publication status: published as Hsu, Jason C. and Eduardo S. Schwartz. "A Model of R&D Valuation and the Design of Research Incentives." Insurance: Mathematics and Economics 43, 3 (December 2008): 350-67.
    Handle: RePEc:nbr:nberwo:10041

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    1. Michael Kremer, 2000. "Creating Markets for New Vaccines Part II: Design Issues," NBER Working Papers 7717, National Bureau of Economic Research, Inc.
    2. Brennan, Michael J & Schwartz, Eduardo S, 1985. "Evaluating Natural Resource Investments," The Journal of Business, University of Chicago Press, vol. 58(2), pages 135-57, April.
    3. Ernst R. Berndt, 2002. "Pharmaceuticals in U.S. Health Care: Determinants of Quantity and Price," Journal of Economic Perspectives, American Economic Association, vol. 16(4), pages 45-66, Fall.
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    Cited by:
    1. Angel Leon & Diego PiƱeiro, 2004. "Valuation Of A Biotech Company: A Real Options Approach," Working Papers wp2004_0420, CEMFI.


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