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Unformatted text preview: HEALTH ECONOMICS Handout 12 Innovation Incentives to Innovate: Innovation is not costless. It requires some expenditures be devoted to research and development. These expenditures could be quite large. Genentech invested 30.9% of sales to R&D. Firms are willing to devote such sums to R&D because they expect it will pay off in the future. Hence R&D can be viewed as an investment. The value of future cash flows: (This is just for your information, net present value will not be covered on the exams but as a general rule you should understand the concepts.) When thinking of making an investment (R&D), firms must weigh expenses in the shortrun vs. potential gains in the long run. When doing so firms recognize that a dollar today is worth more than a dollar tomorrow (Because the dollar today could be invested to return more than a dollar tomorrow.) The degree to which a dollar today is more valuable than a dollar tomorrow depends on the interest rate. We will ignore issues surrounding what the appropriate interest rate is. They involve the nature of the risk of the investment. Instead lets assume there is an interest rate (annual constant over time), r. 1 dollar today is worth the same as 1+r dollars in one year. 1 dollar today is worth the same as (1+r) 2 dollars in two years. Similarly, 1 dollar next year is worth 1/(1+r) today (which will be less than 1). Likewise 1 dollar in 2 years would be worth 1/(1+r) 2 . In general the formula for converting dollars received at some specified period in the future (future value, FV) to dollars today (present value, PV) is: PV=FV/(1+r) n . Where n denotes the number of years in the future. If future returns occur over many years then the present value is the sum of the present value associated with each years cash flow. PV= n [FV n /(1+r) n ] As the above formula illustrates, the more years one receives payment the better: (You should prefer getting 10 dollars for 10 years as opposed to for 5 years). If one includes the investment costs in the future cash flows (making some of them negative), the firm should invest if the present value is positive. This will tend to be the case if the future cash flows are large and are received for a long period of time. 1 ==> Policies which increase the PV of R&D (by increasing the associated FV or the number of periods future returns are earned) encourage investment. 2 Policies to encourage investment: First lets assume if some innovation is made the social present value of is $25 ignoring research costs. Assume the research costs are $1/firm and the probability that at least 1 firm will make the discovery increases with the number of firms competing to make the...
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This note was uploaded on 04/09/2008 for the course HMP 661 taught by Professor Michaelchernew during the Winter '06 term at University of Michigan.
 Winter '06
 MichaelChernew

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