The Cost of Us Pharmaceutical Price Reductions: A Financial Simulation Model of R&D Decisions

36 Pages Posted: 8 Mar 2005

See all articles by Thomas A. Abbott

Thomas A. Abbott


John A. Vernon

University of North Carolina (UNC) at Chapel Hill; National Bureau of Economic Research (NBER)

Date Written: February 2005


Previous empirical studies that have examined the links between pharmaceutical price controls, profits, cash flows, and investment in research and development (R&D) have been largely based on retrospective statistical analyses of firm- and/or industry-level data. These studies, which have contributed numerous insights and findings to the literature, relied upon ad hoc reduced-form model specifications. In the current paper we take a very different approach: a prospective micro-simulation approach. Using Monte Carlo techniques we model how future price controls in the U.S. will impact early-stage product development decisions in the pharmaceutical industry. This is done within the context of a net present value (NPV) framework that appropriately reflects the uncertainty associated with R&D project technical success, development costs, and future revenues. Using partial-information estimators calibrated with the most contemporary clinical and economic data available, we demonstrate how pharmaceutical price controls will significantly diminish the incentives to undertake early-stage R&D investment. For example, we estimate that cutting prices by 40 to 50 percent in the U.S. will lead to between 30 to 60 percent fewer R&D projects being undertaken (in early-stage development). Given the recent legislative efforts to control prescription drug prices in the U.S., and the likelihood that price controls will prevail as a result, it is important to better understand the firm response to such a regulatory change.

Suggested Citation

Abbott, Thomas A. and Vernon, John A., The Cost of Us Pharmaceutical Price Reductions: A Financial Simulation Model of R&D Decisions (February 2005). NBER Working Paper No. w11114, Available at SSRN:

Thomas A. Abbott

Thomson-Medstat ( email )

777 E. Eisenhower Parkway
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United States

John A. Vernon (Contact Author)

University of North Carolina (UNC) at Chapel Hill ( email )

102 Ridge Road
Chapel Hill, NC NC 27514
United States

National Bureau of Economic Research (NBER)

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United States

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