9781118041581

We observe that the biogenetic (G) approach requires a greater initial

investment and is significantly riskier than the biochemical (C) alternative. In

the worst case, the firm will write off the R&D effort, earning no commercial

profit and therefore losing its $20 million investment. The biochemical

approach is also uncertain but far less risky. A commercially viable drug is guar-

anteed. Even in its worst case, the firm makes a $40 million net profit.

Straightforward calculations show that

,

whereas

,

where E() denotes expected profit. Of the two methods, the company should

pursue the biochemical approach.

The firm’s decision analysis should not end here. It has a considerably wider

range of options than first appears. Resources permitting, the firm might do

well to hedge its bet by pursuing bothR&D programs simultaneously. Depending

on the results, the firm can decide which method to commercialize.

The decision tree in Figure 12.3 depicts the simultaneous R&D option. The

tree lists four distinct possible R&D outcomes: one, both, or neither effort may be

E(G)(.2)(200) 20 $20 million

E(C)(.7)(90)(.3)(50)  10 $68 million

512 Chapter 12 Decision Making under Uncertainty

FIGURE 12.3

Simultaneous R&D

Investments

By investing in both

R&D methods,

the company earns

an expected profit

of $72.4 million.

72.4

170

Biogenetic

Biochemical

$170

$60

170

Biogenetic

Biochemical

$170

$20

Both programs

succeed

Only biogenetic

succeeds

Only biochemical succeeds

Neither program succeeds

.56

.24

$60

$20

Simultaneous

development

.14

.06

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