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

67 Pages Posted: 31 Dec 2007 Last revised: 3 Jan 2017

See all articles by Jason C. Hsu

Jason C. Hsu

Rayliant Global Advisors; Research Affiliates, LLC; University of California, Los Angeles - Anderson School of Business

Eduardo S. Schwartz

Simon Fraser University (SFU); University of California, Los Angeles (UCLA) - Finance Area; National Bureau of Economic Research (NBER)

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Date Written: November 2, 2010

Abstract

We develop a real options model of R&D valuation that takes into account the uncertainty in the quality (or efficacy) 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 five dimensions: expected cost to the sponsor, probability of development success, consumer surplus generated, expected number of successful vaccinations and 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). Moreover, we find that a hybrid subsidy plan constructed from a purchase commitment combined with a sponsor research cost-sharing subsidy is the most effective.

Keywords: real option, incentive design, R&D valuation

JEL Classification: E61, G13, H20, H43

Suggested Citation

Hsu, Jason C. and Schwartz, Eduardo S., A Model of R&D Valuation and the Design of Research Incentives (November 2, 2010). Insurance: Mathematics and Economics, Vol. 43, No. 3, pp. 350-367, 2008. Available at SSRN: https://ssrn.com/abstract=1079609

Jason C. Hsu (Contact Author)

Rayliant Global Advisors ( email )

Hong Kong

Research Affiliates, LLC ( email )

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Newport Beach, CA 92660
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HOME PAGE: http://www.jasonhsu.org

University of California, Los Angeles - Anderson School of Business

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Los Angeles, CA 90095-1481
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Eduardo S. Schwartz

Simon Fraser University (SFU) ( email )

8888 University Drive
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Canada

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-1953 (Phone)
310-206-5455 (Fax)

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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