Price regulation, capital market imperfections, and strategic R&D investment behavior in the pharmaceutical industry: Consequences for innovation

The research in this thesis focuses on the pharmaceutical R&D investment decision. The two primary hypotheses I test are that: (1) capital market imperfections in the market for pharmaceutical R&D finance impart a lower cost of capital to internal funds relative to external debt and equity, and (2) pharmaceutical price regulation diminishes the incentives to invest in R&D. This thesis is separated into a theoretical chapter, four empirical chapters, and three empirical appendices. Chapter Two develops a q-model framework for analyzing the determinants of pharmaceutical R&D investment. Chapters Three and Four empirically test the capital market imperfections hypothesis using a variety of statistical methods. Chapter Five builds upon the work in Chapters Three and Four and tests the hypothesis that pharmaceutical price regulation diminishes incentives to invest in R&D. Finally, Chapter Six employs a computer simulation model of pharmaceutical innovation and competition to study how price regulation in the U.S. could affect R&D investment and innovation. My findings reveal that cash flows are an important determinant of pharmaceutical R&D investment. This was the case independent of the sample of firms considered, the time period studied, and the model specification estimated. My results indicate that a $100 decrease (increase) in firm cash flows will result in a $6-$38 decrease (increase) in firm R&D investment. Evidence was also uncovered suggesting that pharmaceutical price regulation exerts a substantially negative influence on firm R&D investment intensity. This result was robust to multiple model specifications. The computer simulation experiments undertaken in Chapter Six obtained results consistent with those reported in Chapter Five. However, given the vastly different methodology employed, numerous other results and discoveries were also obtained. Throughout the course of the aforementioned research I investigated several other related issues as well. For example, within the context of my general R&D investment model, I considered the issue of simultaneity and causality. I also explored in greater depth the precise nature of the relationship between pharmaceutical price regulation and pre-tax pharmaceutical profitability, and estimated that pharmaceutical price-cost margins in the U.S. are, on average, approximately four times higher than non-U.S. pharmaceutical price-cost margins.