Abstract
This chapter presents “The pharmaceutical R&D financing” game in which the Institution lowers the decision threshold and must respond to a pharmaceutical industry Threat. Firms claim that the capital market fails to provide funds for pharmaceutical Research and Development (R&D); it is a risky investment and returns are long-term. Hence, firms finance R&D through internal funds generated by above marginal cost pricing of drugs. If institutions use monopsonist power to bargain down prices, there will be insufficient funds to finance the R&D that society requires. The population will be worse off. This claim leads to the following paradox: Why should the health budget finance pharmaceutical R&D without a formal contractual arrangement if firms and pharma-economists are claiming that the capital markets are unwilling to take on this risk, even with the protection of legally enforceable contracts? The Game is structured as a choice by firms between the two strategies to raise funds: Lobby (approach the Institution to increase prices) or Borrow (go to the capital market). I conclude that there is no incentive for the Institution to finance pharmaceutical R&D through higher prices, unless a contract is negotiated. However, in this case, if institutions are more risk adverse than banks, this strategy (Lobby with Contract) will be more expensive for firms than approaching the capital market. The practice by firms of financing most of their investment in R&D from internal funds is more likely to be the result of these internal funds being imperfectly priced by institutions, not failure in the capital market.
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Notes
- 1.
Whether the authors convey Reinhardt’s intent is unclear to me.
- 2.
For example, the previous quotation from the Congressional Budget Office Report notes that internal funds are a cheaper source of funds than the capital market because this market requires compensation for the additional risk they bear in relation to the firm because the firm has more information about the drug being developed. However, the authors do not clarify why the providers of these internal funds, purchasers and public research funding organisations, do not require this compensation. This is the case even though the authors identify higher drug prices as a source of these funds.
- 3.
There are ways to improve the health of groups of patient groups using technologies not currently financed. However, the additional cost of financing these technologies will require services to be displaced and health effects lost. The net effect of the loss from displacement and gain for the patient group will be to reduce the population’s health because the new technologies are less cost-effective than the least cost-effective of existing technologies.
- 4.
A discussion of two ways that the pharma-economic literature and Pharma characterise and quantify risk and additional sources of variation in firm profits is presented in Pekarsky (2012, Appendix 8).
- 5.
This problem uses the terms “investment” for the Institution and “loan” for the funding from the Capital Market. The use of the term “investment” highlights that there is an expected dividend if the R&D is successful. The use of the term “loan” suggests a schedule of repayments of the capital with an agreed interest payment. It is unrealistic to assume that the Capital Market will have no capital returned from its loan in the event of a failed R&D; this would mean the Firm becomes bankrupt. However, this device, assuming that there is no return to the Capital Market on its loan if R&D is unsuccessful, allows the claimed riskiness of this loan to be characterized and also simplifies the math. The critical issue is that the Firm enters a formal agreement with the Capital Market that ensures an agreed payment if it is successful and there is no such agreement with the Institution and the dividend is instead a future drug, which the Institution needs to pay for.
- 6.
In fact the evidence suggests that the Firm will invest <33 % into R&D for new drugs (see Vernon’s Equation (International Trade Administration 2004 p. 29). Reinhardt also makes this point, although indicates the percentage of revenue rather than economic rent that goes to R&D (Reinhardt 2007 pp. 41–43). The implications of relaxing this assumption are considered in the discussion.
- 7.
The Institution and Firm can of course enter a bargaining process. However, the key issue is that the public domain decision threshold combined with the requirement for the Institution to agree to reimburse the new drug if its price per effect is less than or equal to the threshold means that the profit maximizing offer price. If it cannot offer the drug at this price then it will be able to assess the impact of this constraint via the backward induction process. This situation is illustrated in Game 1, Chap. 8.
- 8.
This situation analogous to impact of sunk R&D costs on the firm’s decision to manufacture a new drug. Vernon et al noted that the sunk costs of R&D are “irrelevant from a firm’s decision-making perspective.” By the time a drug gets to market (Vernon et al. 2006).
- 9.
This is a critical issue in the understanding of backward induction as a solution method. See Watson (2002).
- 10.
For example Vernon et al. (2006) See footnote 7.
- 11.
This is an equality because the Bank is risk neutral. See the consumer equivalent in Jehle and Reny (2001) p. 105.
- 12.
More risk averse than the Bank and not a risk taker.
- 13.
A mistake is an error made by a player, possibly a result of the complexities of a strategy. For example see Watson (2002) p. 27. The idea of irrationality could suggest that the player is acting in a way that is not consistent with their objectives. The idea of players acting rationally is significant in game theory because it is the assumption that allows players to select their own strategy based on the expected response by the other player. There could still be strategic uncertainty in the other player’s response, even if all players act rationally. It is unusual in Game Theory to assume that there is only one definition of rationality, but some concepts of rationality dominate. (See Watson 2002 and Grüne-Yanoff and Schweinzer 2008) Games however can incorporate the idea of mistakes and in Evolutionary Game Theory mistakes can play a significant role in achieving an evolutionary stable equilibrium. See Samuelson (2002).
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Pekarsky, B.A.K. (2015). The “Pharmaceutical R&D Financing” Game. In: The New Drug Reimbursement Game. Adis, Cham. https://doi.org/10.1007/978-3-319-08903-4_9
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