Value of Alternate Imperfect Information Sources: Laser Biomedical Corp. is developing a new drug for the treatment
Question:
Value of Alternate Imperfect Information Sources: Laser Biomedical Corp. is developing a new drug for the treatment of high cholesterol. Based on the data gathered to date. Laser Biomedical estimates that there is a .65 probability that the drug is effective. To obtain approval to market the drug, the company needs to conduct a trial which will show that the product is effective. If the product is successful, the drug will have a net present value of $30 million before consideration of the testing costs.
The company can carry out two tests in its attempt to prove effectiveness of the drug. The final test requires the use of 1.500 patients. Half of the patients would receive a placebo (sugar pill), and the other half would receive the drug. A comparison of cholesterol levels between the two groups would indicate whether the drug was effective. This test will cost $2 million. If the drug is effective, this test will indicate effectiveness an estimated .7 of the time. If the drug is not effective, this test will indicate effectiveness an estimated .05 of the time. If this test does not indicate that the drug is effective. Laser Biomedical will repeat the test using 4,000 patients. The repeat will cost $6 million. If the drug is effective, the repeat test will indicate this with probability .95. If the drug is not effective, the repeat test will indicate this with probability 1.0. If the repeat test indicates that the product is not effective, all $6 million testing costs will be lost. An alternative is to conduct the trials using 5,000 patients. This test will cost $3 million. If the drug is effective, this test will indicate effectiveness .9 of the time. If the drug is not effective, this test will never indicate that the drug is effective. If this test indicates that the drug is not effective, the project will be abandoned and the test costs will be lost.
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