Overcoming inefficiencies in the development of personalized medicine

Abstract

The pharmaceutical industry faces a radical change in its business model. Whereas one-size-fits-all blockbuster drugs dominated in the past, today technological breakthroughs like the decoding of the human genome allow pharmaceutical firms to develop more customized products. This so-called personalized medicine can only work if a product tandem of specialized drug and companion diagnostic test exists, making new product development processes interdependent. We consider a pharmaceutical firm and a diagnostic firm that develop such a product tandem for personalized medicine. We show that the dependence on each other and the diagnostic firm’s option to postpone R&D activities lead to systematic inefficiencies in the development of personalized medicine. In practice, revenue-sharing and cost-sharing contracts are used to address such inefficiencies by better balancing and aligning the financial interests of drug and diagnostic manufacturers. We show that simple revenue-sharing and cost-sharing contracts can often, but not always, solve problems related to postponed or reduced investment, and we characterize settings where the pharmaceutical firm prefers revenue sharing over cost sharing. To account for different existing market structures, we compare the pharmaceutical firm’s contract preferences under regulated and free pharmaceutical pricing.