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

  • Hsu, Jason C.
  • Schwartz, Eduardo S.
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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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    File URL: http://www.escholarship.org/uc/item/28j7c9r4.pdf;origin=repeccitec
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    Paper provided by Anderson Graduate School of Management, UCLA in its series University of California at Los Angeles, Anderson Graduate School of Management with number qt28j7c9r4.

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    Date of creation: 01 May 2003
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    Handle: RePEc:cdl:anderf:qt28j7c9r4
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    Web page: http://www.escholarship.org/repec/anderson_fin/

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    1. 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.
    2. Pindyck, Robert S, 1993. "A Note on Competitive Investment under Uncertainty," American Economic Review, American Economic Association, vol. 83(1), pages 273-77, March.
    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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