Real Option Value and Path Dependence in Oncology Innovation

Drug innovation relies on cumulative, path-dependent, incremental research and development (R&D). In oncology, path-dependence may not be along a single dimension, such as steadily improving efficacy or survival against a given endpoint in the same population, but innovation builds on itself. The next innovation may use a recently developed drug in a new way - e.g., a new line of therapy, or a new indication in a different population, or in combination with other drugs. Of course, in some cases, innovation on a current drug can be the development of a next generation drug. Yet, few have studied how path-dependence impacts the decisions of oncology pharmaceutical producers, consumers, and insurers/payers. This study illustrates how real options can be used to value the effects of path-dependence, that is, the additional value that incremental innovation adds when the innovation is a first step along a path to a major innovation. We show how rational pharmaceutical producers and consumers recognize the additional real option value. However, today, many payers, particularly European governments, may use some form of drug evaluation method that ignores this option value. Observers may wonder how closely the US will follow Europe in its development of comparative-effectiveness research (CER). The American Recovery and Reinvestment Act of 2009 authorizes $1.1 billion to study CER. Previous attempts to measure or compare the value of medicines typically focus only on the direct effect on the initial setting for which the drug receives regulatory approval, and, hence, they ignore real option value. If CER were interpreted this way, its widespread use could reduce oncology R&D, and reduce intermediate innovations that could have led to breakthrough innovations more rapidly and simply. When a particular drug has option value, but payers who set the terms of exchange do not account for that value, the resulting mix of R&D spending will be suboptimal from a social economic welfare perspective.