Can Competition Hurt Innovation?

A new NBER paper, “Starving (or Fattening) the Golden Goose?: Generic Entry and the Incentives for Early -Stage Pharmaceutical Innovation” (summarized here), asks whether competition from generic drugs disincentivizes research. The authors, Branstetter, Chatterjee and Higgins, find that this does broadly seem to be the case: drug development activity decreases after generic drugs are introduced. This result highlights the important tradeoff between research and consumption. When consumers pay for drugs, intellectual property (IP) policies play a large role in determining how much of that cost goes toward future drug development.

Pharmaceutical markets are risky: drug development takes 12 years from initial pre-trial preparation to bringing a drug to market, and between the complexity of the human body and the extended regulatory approval process only a small proportion of drugs make it all the way to market. Of the ones that do, a small minority make up the large majority of profits.

This riskiness means that policies play a critical role in getting pharmaceutical markets to work correctly: if companies do not have incentives that outweigh the risks, they will not invest in researching new drugs and bringing them to market.

Economic analysis can help us understand how companies see and react to such tradeoffs. The strength of the new paper lies in its extensive dataset that includes data about generic penetration and innovative activity by firm, market, and year. This allows the authors to examine individual markets over time and compare those markets with high penetration to those with low penetration, and how innovation changes in those markets over time. They also check certain types of markets that could be expected to have higher or lower competition generic drugs, and find that innovation in these markets behaves as would be expected under their hypothesis.

Although the authors find conclusively that generic competition limits innovation, they note that this is not necessarily a bad thing: it could have a variety of effects on human welfare in the real world. In particular, if decreased spending in areas with higher competition leads to more expenditures in domains with less generics, then science could advance further in those areas and help more people. However, if there are still significant scientific gains to be made in areas that already have heavy generic competition, then these incentives could be a significant loss for future medical progress.

The issue, ultimately, is the riskiness of pharmaceutical markets: we need to ensure that pharmaceutical companies that invest smartly in new research are able to survive not by getting lucky but by having a diversified drug portfolio and sufficient continued revenue from past successes. By driving down profits, competition can decrease innovation by diminishing potential rewards. While more research is necessary, Branstetter, Chatterjee and Higgins show that policymakers should be wary of adverse side effects when sacrificing pharmaceutical profits for consumer welfare.

(photo credit to e-Magine Art)