Academic journal article Contemporary Economic Policy

The Optimal Time to License a Biotech "Lemon"

Academic journal article Contemporary Economic Policy

The Optimal Time to License a Biotech "Lemon"

Article excerpt

I. INTRODUCTION

The optimal time to license an irreversible technology is affected by uncertainty and the externalities created by its adoption. A new genetically modified (GM) wheat variety developed by Monsanto is an example of an irreversible technology that will cause both environmental and market externalities. (1) The policy decision to license GM wheat varieties, which confronts governments in Canada and the United States, needs to account for the uncertainty, externalities, and irreversibility of the technology. One way to do this is through the use of real option theory.

There are two externalities, which may result from the government decision to license GM wheat varieties. These are (1) the spread of the new variety into non-GM crop fields imposing additional herbicide costs on nonadopters (Downey and Beckie, 2002), and (2) the potential loss in aggregate producer market returns because of consumer resistance to GM wheat varieties. The environmental externality is related to the control of the unwanted spread of the GM wheat genetics.(2) Because the GM wheat variety is resistant to a common herbicide Roundup, controlling the unwanted spread of the GM wheat genetics will result in additional herbicide costs for both adopters and nonadopters. From a market perspective many consumers have misgivings about purchasing GM foods. There is concern that the consumption of GM wheat could have long-term adverse impacts on human health (this article not evaluate the assertion that GM wheat may be harmful to human health). These concerns have been expressed in the form of consumer demand for product labeling and, in the case of some countries, an outright ban on the production and importation of GM varieties.

Because GM and non-GM wheat varieties are not visually distinguishable from one another, the presence of GM wheat can adversely affect the demand for non-GM wheat varieties. Without segregation, the introduction of GM wheat will create a "lemon" market for all wheat. A lemon market, as described by Akerlof (1970), exists when there is insufficient information to distinguish between products with different consumer values in the market place. Therefore, all products will be valued at the lower market price, which results in only lower quality products (i.e., the lemons) being offered for sale.

Once a GM wheat variety is licensed and grown by some farmers it will be nearly impossible to reclaim all of the novel genes from the environment. Small quantities of the variety will eventually diffuse throughout the grain production and marketing system. This diffusion process makes the decision to license GM wheat irreversible. (3) Thus, the external costs will persist even if GM wheat is no longer commercially produced.

There is a well-developed literature pertaining to the value of an option to invest in an irreversible project under uncertainty (McDonald and Siegel, 1986; Pindyck, 1991; Dixit and Pindyck, 1994). From an empirical standpoint, the real option value approach has been used to evaluate the impact of uncertainty on investments in the agriculture sector (Purvis et al., 1995; Winter-Nelson and Amegbeto, 1998; Carey and Zilberman, 2002). In the case of GM wheat, the real option value is the relevant measure of social desirability because of the uncertainty over the future costs and benefits of the wheat technology, and because the introduction of the variety is irreversible. In addition, the real options framework is appropriate because it explicitly considers the flexibility in the timing of the optimal licensing decision.

A GM wheat variety developed by Monsanto is currently under evaluation in the Canadian crop regulatory system. (4) On first blush (ignoring the potential environmental and market externalities) large potential gains appear to be achievable through the adoption of GM wheat varaities (due to increased yields and lower herbicide costs). Capitalized rents earned from this new technology, due to a higher yield and lower weed control costs, are in the range of U. …

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