One Lab, Two Firms, Many Possibilities: on R&D outsourcing in the biopharmaceutical industry

We draw from documented characteristics of the biopharmaceutical industry to construct a model where two firms can choose to outsource R&D to an external unit, and/or engage in internal R&D, before competing in a final market. We investigate the tension between internal and outsourced operations, the distribution of profits among market participants, and the incentives to coordinate outsourcing activities or to integrate R&D and production. Consistent with the empirical evidence, we find that: (i) internal and external operations are neither substitutes nor complements in general, as each firm’s in-house effort level can be reduced or stimulated by the external unit’s activities, depending on the nature of R&D returns; (ii) an aggregate measure of technological externalities drives the distribution of industry profits, with higher returns to the external unit for development (clinical trials) than for research (drug discovery); (iii) in the latter case, the delinkage of investment incentives from industry value, and the vulnerability of investors’ returns to negative shocks, both suggest the abandonment of projects with economic and medical value as a likely consequence of outsourcing; (iv) upstream entry is stimulated by the long-run perspective for founders of a research biotech, more than of a clinical services unit, to extract – or reappropriate – industry profits by selling the equity to a client firm.