Going as far as you can with economies of scale

Chapter 7: Innovation and Technological Change: The Future Is Now

3. Add the resulting values for each scenario.

115

The expected development cost equals $58.5 million.

Starting your research by developing both drugs at the same time can lower your expected development cost because partway through the process, you can decide to abandon one drug because its development costs are too high. If both drugs are developed in parallel, you have a 49-percent chance (0.7 × 0.7) that the development cost of each drug equals $75 million. This is the probability of the worst-case scenario occurring for both drugs. You have a 9-percent chance (0.3 × 0.3) chance that the development cost of each drug equals $20 million. This is your best-case scenario occurring for both drugs. Finally, you have a 42-percent chance that one of the two drugs has the best case scenario — a $20 million development cost. This is the situation where one drug’s development represents the best-case scenario and the other drug’s development represents the worst-case scenario (0.3 × 0.7 + 0.7 × 0.3).

Because you ultimately complete the development of only one drug — remember, both drugs are for the same condition — you’ll choose the cheapest drug to develop. Thus, you have a 51-percent chance — the 9-percent chance of best-case for both drugs, plus the 42-percent chance of best-case for one of the two drugs — that the development cost equals $20 million. Note how 51 percent is better than the 30 percent chance of the best-case scenario’s $20 million development cost if you develop only one drug.

Now comes a critical step. If the actual development cost of each drug can be determined with certainty after $C have been spent, and only the drug with the lowest development cost is developed after that point, the expected development cost equals

In the example, you know that you can determine the actual development cost for each drug after spending $8 million. (This value varies from situation to situation and must be determined in advance, usually by past experience.) Thus, your expected development cost of parallel efforts equals

In this situation, your parallel efforts have lowered the expected development cost by $3.55 million from the initial $58.5 million to $54.95 million.