Experimentation Levels and Social Welfare under FDA's Flexible Approval Standards

The FDA sets a uniform hypothesis test's approval standard at the end of Phase III clinical trials for new drugs. We study the impact of flexible approval standards on experimentation and social welfare when pharmaceutical companies (firms) are strategic, especially in terms of the level of experimentation for the new drug. We consider a Stackelberg game with the FDA and two firms in two distinct markets (diseases). The FDA sets the approval standards to maximize social welfare consisting of benefit/cost of approving an effective/ineffective drug, while each firm seeks to maximize its payoff, considering the experimentation cost and potential benefit of entering the market upon approval, which is modeled by an optimal stopping of a diffusion process. We analyze the properties of this Stackelberg game, which has a unique equilibrium under some natural assumptions, and provide comparative statics. Our results show that the shift from uniform to flexible approval standards will increase the approval standard of one market and decrease it for the other market. Consequently, the shift will be beneficial to one market and detrimental to the other. We characterize the conditions under which such a shift is advantageous or disadvantageous for firms conducting research on rare diseases