When choosing which new products to develop, companies must decide how much they want to innovate. Should they make an incremental improvement on an existing product? Or should they create something entirely new?
Dimitris Papanikolaou, a professor of finance at Kellogg, explored how this choice plays out in the pharmaceutical industry.
Some researchers argue that pharmaceutical firms these days are often making minor changes to existing medications instead of delivering innovative drugs. And, given the potential life-saving and life-improving power of new drugs, such a trend would have clear consequences for society.
“Breakthroughs are becoming less frequent,” Papanikolaou says.
To measure what is happening in the industry, he and coauthors developed a method to quantify a medication’s level of novelty and applied it to a database of more than 64,000 drugs. They found that more innovative therapies had a lower chance of being approved by the U.S. Food and Drug Administration (FDA). On the other hand, those that did pass this hurdle tended to be more effective and lucrative than so-called “me too” drugs, which are variations on existing medications.
Yet the researchers found that firms were eager to work on novel drugs—under the right financial circumstances. When pharmaceutical companies got a windfall, such as a sudden increase in profits, they were more likely to spend it on developing novel drugs than on incremental improvements. The reverse, of course, is also likely true, Papanikolaou says. Firms may be held back from pursuing innovative therapies because they lack the cash to turn their financially riskier ideas into reality.
“These financial frictions may be limiting innovation,” says Papanikolaou, who collaborated with Joshua Krieger of Harvard Business School and Danielle Li of MIT Sloan School of Management on the research. If society wants to encourage more novel drugs, he says, one solution would be to increase the supply of capital to these firms.
A Yardstick for Drug Innovation
Papanikolaou and his coauthors tackled the issue by first considering how to define innovation. In the past, researchers often measured novelty by counting, say, the number of new drugs or patents a firm produced. But these methods didn’t capture whether the therapies were innovative or “me too” drugs.
Instead, Papanikolaou and colleagues examined the chemical structures of individual drugs that were being developed. In general, molecules that are chemically similar tend to have similar functions. So to measure novelty, the researchers used recent advances in bioinformatics to compare each medication in a large drug database to every drug developed before it. The algorithm, which was developed by researchers at the University of California, Riverside, returned a score that captured the chemical similarity between each pair of drugs. The team then identified the maximum similarity score for that medication—that is, how similar it was to its closest “neighbor.” The lower the score, the more innovative the drug.
The team found that from 1999 to 2014, the average novelty of drugs declined. This trend was partly due to the fact that the number of existing medications grew. But even when the researchers compared each drug only to those developed during the previous five years, the pattern persisted.
Papanikolaou cautions that this doesn’t necessarily mean all areas of innovation are declining in the pharmaceutical industry. The researchers’ method of measuring novelty worked only on small-molecule drugs; more complex “biologic” drugs—consisting of molecules such as proteins or sugars—were excluded from the analysis. While these biologic medications occupy a small fraction of the marketplace, they are a major source of innovation, he says.
A Failure or a Blockbuster?
Next, the researchers investigated the risks and rewards of developing novel drugs.
They found that, on average, an innovative drug was less likely to pass regulatory hurdles. A drug with a novelty score that was one standard deviation higher than another medication for the same disease produced around the same time had a 29 percent lower chance of FDA approval.
“If you’re trying something that hasn’t been tried before, you’re more likely to fail,” Papanikolaou says.
But innovative drugs that did get approved performed better on several measures.
A one standard deviation increase in novelty was linked to a 33 percent rise in the likelihood of being categorized as highly important by Haute Autorité de Santé, a French healthcare organization that evaluates medical products and issues treatment guidelines. It was also associated with 10–33 percent more citations for patents related to the drug. Revenue generated from the medication was approximately 15–35 percent higher. And the firm’s stock value increased by 2–8 percent more upon announcement of FDA approval.
The results suggest that while novel drugs may be less likely to get through the approval process, they have more upside potential for the company and for patients.
“If you want to have a blockbuster drug, that’s the way,” Papanikolaou says.
An Influx of Cash
Still, questions about firms’ attitudes toward novel drugs remained. Given the risk of failure, did companies view innovative products as a worthwhile investment?
Ideally, the researchers would have performed a controlled experiment to find out whether firms responded to an influx of money by developing novel versus me-too drugs.
“We would randomly drop helicopters of cash on firms,” Papanikolaou says. Unfortunately, “that cannot be done.”
Instead, the team took advantage of a natural experiment. In 2006, the U.S. government rolled out Medicare Part D, which increased insurance coverage of prescription drugs for older patients. So pharmaceutical companies that already manufactured medications for this age group were likely to become more profitable. “That’s almost the same as me giving out money,” Papanikolaou says.
This natural experiment wasn’t perfect, however. Ideally, all other factors in the firms’ environment would remain the same. But Medicare Part D had another side effect. It increased the incentive for companies to develop more drugs for the elderly so that they could cash in on the benefits of the new regulations. If the researchers simply compared drug-development trends between firms whose drugs were mostly used by the elderly to other firms during this time, it would be unclear whether changes were due to the increase in profits or the new incentives.
Papanikolaou and his colleagues devised a way to get around this confounding factor. At some firms, the patents on drugs were about to expire, so any additional profit from Medicare Part D would be short-lived. At other firms, the patents still had a lot of life left in them, so those firms would likely benefit financially from the regulations for a long time. By comparing companies with differing patent expiration dates—among the firms with prescription drugs for older patients—the researchers could isolate the effects of profits on drug development.
Financing Potential Blockbuster Drugs
The team found that firms that reaped more profits tended to develop more drugs—and those medications were more likely to be novel. Additionally, many were targeted at younger patients, not the elderly. This confirmed that the increase in innovative drugs was not caused just by the greater incentives for drugs for older customers.
“This can only be due to cash-flow shock,” Papanikolaou says.
The typical financial advice for a company with a good idea but not enough cash on hand is that it should raise money—say, by taking out a loan or issuing shares. But the study suggests that even large pharmaceutical firms may have trouble doing this.
“Good ideas may not always be able to be financed,” he says.
Papanikolaou notes a couple important caveats. One is that the study assumes that firm managers make drug-development decisions to further best interests of shareholders—rather than prioritizing their own pet projects or careers. The other is that novel drugs may not necessarily be better for society. It is possible that me-too drugs benefit patients more because they lower prices and increase competition.
But regardless of how innovative drugs affect society, it appears that pharmaceutical companies consider them worthwhile investments—when they have extra cash on hand.
“Firms seem to perceive them as more valuable,” Papanikolaou says.
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