Optimal co-development contracts for companion diagnostics

The market for companion diagnostics is expected to be a US$10.07 billion by 2026. Companion diagnostics have the potential to make expensive drugs cost-effective by identifying patients who would benefit from them. We consider the contract design problem between a pharmaceutical company which owns a drug that is effective for a particular subset of the patient population and a biotech company which owns some technology that could facilitate the development of a companion diagnostic. We obtain theoretical and practical results. We determine when both parties enter such a contract and fully characterize the optimal solutions in closed-form. We find sufficient conditions under which the optimal contract exhibits a particular structure. We show that the first-best can be achieved in some cases and identify sufficient conditions under which the biotech company would not work alone but participates in the project with the pharmaceutical company's subsidy. We find that heuristics based on practical preferences could be costly to the pharmaceutical company and hence the principal should use the second-best solution; and contract type depends heavily on the biotech company's workforce level, unit cost of workforce and information level.