We analyze firms’ decisions to invest in incremental and radical innovation, focusing specifically on pharmaceutical research. We develop a new measure of drug novelty that is based on the chemical similarity between new drug candidates and existing drugs. We show that drug candidates that we identify as ex-ante novel are riskier investments, in the sense that they are subsequently less likely to be approved by the FDA.
However, conditional on approval, novel candidates are, on average, more valuable—they are more clinically effective; have higher patent citations; lead to more revenue and to higher stock market value. Using variation in the expansion of Medicare prescription drug coverage, we show that firms respond to a plausibly exogenous cash flow shock by developing more molecularly novel drug compounds, as opposed to more so-called “me-too” drugs. This pattern suggests that, on the margin, firms perceive novel drugs to be more valuable ex-ante investments, but that financial frictions may hinder their willingness to invest in these riskier candidates. Over the past 40 years, the greatest gains in life expectancy in developed countries have come from the development of new therapies to treat conditions such as heart disease, cancer, and vascular disease.
At the same time, the development of new–and often incremental–drug therapies has played a large role in driving up health care costs, with critics frequently questioning the true innovativeness of expensive new treatments (Naci, Carter, and Mossialos, 2015). This paper contributes to our understanding of drug investment decisions by developing a measure of drug novelty and subsequently exploring the economic tradeoffs involved in the decision to develop novel drugs.
Measuring the amount of innovation in the pharmaceutical industry is challenging. Indeed, critics argue that “pharmaceutical research and development turns out mostly minor variations on existing drugs, and most new drugs are not superior on clinical measures,” making it difficult to use simple drug counts as a measure of innovation (Light and Lexchin, 2012). To overcome this challenge, we construct a new measure of drug novelty for small molecule drugs, which is based on the molecular similarity of the drug with prior drug candidates.3 Thus, our first contribution is to develop a new measure of pharmaceutical innovation.
We define a novel drug candidate as one that is molecularly distinct from previously tested candidates. Specifically, we build upon research in modern pharmaceutical chemistry to compute a pair-wise chemical distance (similarity) between a given drug candidate and any prior candidates in our data. This similarity metric is known as a “Tanimoto score” or “Jaccard coefficient,” and captures the extent to which two molecules share common chemical substructures. We aggregate these pairwise distance scores to identify the maximum similarity of a new drug candidate to all prior candidates. Drugs that are sufficiently different to their closest counterparts are novel according to our measure. Since our metric is based on molecular properties observed at the time of a drug candidate’s initial development, it improves upon existing novelty measures by not conflating ex-ante measures of novelty with ex-post measures of success such as receiving priority FDA review.
In the United States, the sharpest decline in death rates from the period 1981 to 2001 come from the reduction in the incidence of heart disease. See Life Tables for the United States Social Security Area 1900-2100. https://www.ssa.gov/oact/NOTES/as120/LifeTables_Body.html See also Lichtenberg (2013), which estimates explicit mortality improvements associated with pharmaceuticals. One of the more vocal critics is Marcia Angell, a former editor of the New England Journal of Medicine. She argues that pharmaceutical firms increasingly concentrate their research on variations of top-selling drugs already on the market, sometimes called “me-too” drugs.
She concludes: “There is very little innovative research in the modern pharmaceutical industry, despite its claims to the contrary.” http://bostonreview. net/angell-big-pharma-bad-medicine. Indeed, empirical evidence appears to be consistent with this view; Naci et al. (2015) survey a variety of studies that show a declining clinical benefit of new drugs. Small molecule drugs, synthesized using chemical methods, constitute over 80% of modern drug candidates (Ralf Otto, Alberto Santagostino, and Ulf Schrader, 2014). We will discuss larger drugs based on biological products in Section 3.6.
Our novelty measure based on molecular similarity has sensible properties. Pairs of drug candidates classified as more similar are more likely to perform the same function—that is, they share the same indication (disease) or target-action (mechanism). Further, drugs we classify as more novel are more likely to be the first therapy of its kind. In terms of secular trends, our novelty measure indicates a decline in the innovativeness of small molecule drugs: both the number, as well as the proportion, of novel drug candidates has declined over the 1999 to 2014 period. Across our sample of drug candidates, over 15% of newly developed candidates have a similarity score of over 0.8, meaning that they share more than 80% of their chemical substructures with a previously developed drug.
We next examine the economic characteristics of novel drugs, in order to better understand the tradeoffs that firms face when deciding how to allocate their R&D resources. We begin by exploring how the novelty of a drug candidate relates to its (private and social) return from an investment standpoint. Since measuring a drug’s value is challenging, we rely on several metrics. First, we examine drug effectiveness as measured by the French healthcare system’s assessments of clinical value-added, following Kyle and Williams (2017).
Since this measure is only available for a subset of approved drugs, we also examine the relationship between molecular novelty and the number of citations to a drug’s underlying patents, which the innovation literature has long argued is related to estimates of economic and scientific value (see, e.g. Hall, Jaffe, and Trajtenberg, 2005). We also use drug revenues as a more direct proxy for economic value. However, since mark-ups may vary systematically between novel and “me-too” drugs—that is, drugs that are extremely similar to existing drugs—we also rely on estimates of their contribution to firm stock market values. Specifically, we follow Kogan, Papanikolaou, Seru, and Stoffman (2017) and examine the relationship between a drug’s molecular novelty and the change its firm’s market valuation following either FDA approval or the granting of its key underlying patents.
Conditional on being approved by the FDA, novel drugs are on average more valuable. Specifically, relative to drugs entering development in the same quarter that treat the same disease (indication), a one-standard deviation increase in our measure of novelty is associated with a 33 percent increase in the likelihood that a drug is classified as “highly important” by the French healthcare system; a 10 to 33 percent increase in the number of citations for associated patents; a 15 to 35 percent increase in drug revenues; and a 2 to 8 percent increase in firm valuations. 4To benchmark what this means, we note that the chemical structures for Mevacor and Zocor, depicted in Figure 1, share an 82% overlap.
However, novel drugs are also riskier investments, in that they are less likely to receive regulatory approval. Relative to comparable drugs, a one-standard deviation increase in novelty is associated with a 29 percent decrease in the likelihood that it is approved by the FDA. Thus, novel drugs are less likely to be approved by the FDA, but conditional on approval, they are on average more valuable.
To assess how firms view this tradeoff between risk and reward at the margin, we next examine how they respond to a positive shock to their (current or expected future) cashflows. Specifically, if firms that experience a cashflow shock develop more novel—rather than molecularly derivative—drugs, then this pattern would suggest that firms value novelty more on the margin.
Here, we note that we are implicitly assuming that treated firms have a similar set of drug development opportunities as control firms, and, moreover, that financial frictions limit firms’ ability to develop new drug candidates. Indeed, if firms face no financing frictions, then, holding investment opportunities constant, cashflow shocks should not impact their development decisions. However, both theory and existing empirical evidence suggest that a firm’s cost of internal capital can be lower than its cost of external funds.5 In this case, an increase in cashflows may lead firms to develop more or different drugs by increasing the amount of internal funds that can be used towards drug development decisions. Even if this increase in cashflows occurs with some delay, firms might choose to respond today, either because it increases the firm’s net worth, and hence its effective risk aversion (see, e.g. Froot, Scharfstein, and Stein, 1993), or because this anticipated increase in profitability relaxes constraints today.
We construct shocks to expected firm cashflows using the introduction of Medicare Part D, which expanded US prescription drug coverage for the elderly. This policy change differentially increased profits for firms with more drugs that target conditions common among the elderly (Friedman, 2009). However, variation in the share of elderly customers alone does not necessarily enable us to identify the impact of increased cashflows. This is because the expansion of Medicare impacts not only the profitability of the firm’s existing assets.
For a theoretical argument, see Myers and Majluf (1984). Consistent with theory, several studies have documented that financing frictions play a role in firm investment and hiring decisions. Recent work on this topic examines the response of physical investment (for instance, Lin and Paravisini, 2013; Almeida, Campello, Laranjeira, and Weisbenner, 2011; Frydman, Hilt, and Zhou, 2015); employment decisions (Benmelech, Bergman, and Seru, 2011; Chodorow-Reich, 2014; Duygan-Bump, Levkov, and Montoriol-Garriga, 2015; Benmelech, Frydman, and Papanikolaou, 2017); and investments in R&D (see e.g. Bond, Harhoff, and van Reenen, 2005; Brown, Fazzari, and Petersen, 2009; Hall and Lerner, 2010; Nanda and Nicholas, 2014; Kerr and Nanda, 2015). These frictions may be particularly severe in the case of R&D: Howell (2017) shows that even relatively modest subsidies to R&D can have a dramatic impact on ex-post outcomes.
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