Developing Novel Drugs

Abstract

We provide evidence that risk aversion leads pharmaceutical firms to underinvest in radical and
novel innovation. We do so by introducing a new measure of novelty: a drug candidate is novel
if it is molecularly distinct from prior candidates. Using our measure, we show that firms face a
risk-reward tradeoff when investing in novel drugs: while novel drug candidates are less likely to
be approved by the FDA, they are based on patents with higher indicators of value. Consistent
with a simple model of costly external finance, a plausibly exogenous positive shock to firms’ net
worth leads the development of novel (and riskier) drug candidates. This pattern suggests that
even large public firms behave as though they are risk averse, reducing their willingness to invest
in potentially valuable radical innovation.

Keywords: Drug Development, Innovation, Research & Development

JEL Classification: O31, O32, O34, G32, L25, D22