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

Billette de Villemeur, Etienne and Versaevel, Bruno (2019): One Lab, Two Firms, Many Possibilities: on R&D outsourcing in the biopharmaceutical industry.

Abstract

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 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 the sign and magnitude of an aggregate measure of direct (inter-firm) and indirect (through the external unit) technological externalities drives the distribution of industry profits, with higher returns to the external unit when involved in development (clinical trials) than in early-stage research (drug discovery). In the latter case, the delinkage of investment incentives from industry value, together with the ability of firms to transfer risks to the external unit, imply a vulnerability of early-stage investors’returns to negative shocks, and the likely abandonment of projects with economic and medical value. We also find that competition in the equity market makes a buyout by one of the two firms more profitable to a research biotech than to a clinical services unit, and can stimulate early-stage investments. However, this long-term incentive can be minimal, notably if the superior efficiency of outsourced operations originates from economies of scope that can hardly be exploited when a firm takes control of the external unit exclusively for itself. R&D outsourcing thus does not always qualify as a relevant pathway to address the declining productivity in innovation that has characterized the industry over several decades.

• Item Type: MPRA Paper
• Language: English
• Keywords: research; development; biotechnology; pharmaceuticals; externalities
• Subjects: C - Mathematical and Quantitative Methods > C7 - Game Theory and Bargaining Theory > C72 - Noncooperative Games; L - Industrial Organization > L1 - Market Structure, Firm Strategy, and Market Performance > L13 - Oligopoly and Other Imperfect Markets; O - Economic Development, Innovation, Technological Change, and Growth > O3 - Innovation ; Research and Development ; Technological Change ; Intellectual Property Rights > O31 - Innovation and Invention: Processes and Incentives

References

Allain, M-L., Henry, E. and Kyle, M.K., 2015, “Competition and the efficiency of markets for technology,” Management Science, 62(4), pp. 1000-1019.

Amir, R., Evstigneev, I. and Wooders, J., 2003, “Noncooperative versus cooperative R&D with endogenous spillover rates,” Games and Economic Behavior, 42(2), 183-207.

Argyres, N.S. and Liebeskind, J.P., 2002, “Governance inseparability and the evolution of US biotechnology industry,” Journal of Economic Behavior and Organization, 47(2), 197-219.

Arora A., Fosfuri, A. and Gambardella, A., 2001, “Markets for technology and their implications for corporate strategy,” Industrial and Corporate Change, 10(2), 419-451.

Arora, A., Gambardella, A., Pammolli, F. and Riccaboni, M., 2004a, “The nature and the extent of the market for technology in biopharmaceuticals,” in: Cesaroni, F., Gambardella, A. and Garcia-Fontes, W., editors, R&D, Innovation and Competitiveness in the European Chemical Industry, Ch. 7, Springer, 175-202.

Arora, A., Vogt, W.B. and Yoon, J., 2004b, “Does in-house R&D increase bargaining power? Evidence from the pharmaceutical industry”. Available at SSRN: http://ssrn.com/abstract=670304 or http://dx.doi.org/10.2139/ssrn.670304

Azoulay, P., 2004. Capturing knowledge within and across firm boundaries: Evidence from clinical development,” American Economic Review, 94(5), 1591-1612.

Bali, H., de Lima, B. and Yang, C., 2013, CROs (Contract Research Organisations) and other outsourced pharmaceutical support services: M&A drivers and trends. Available at http://resultshealthcare.com

Bernheim, B.D. and Whinston, M.D., 1986a, “Common agency,” Econometrica, 54(4), 923-942.

Bernheim, B.D. and Whinston, M.D., 1986b, “Menu auctions, resource allocation, and economic influence,” Quarterly Journal of Economics, 101(1), 1-32.

Bernheim, B.D. and Whinston, M.D., 1998, “Exclusive dealing,” Journal of Political Economy, 106(1), pp. 64-103.

Bernheim, B.D., Peleg, B. and Whinston, M.D., 1987, “Coalition-proof Nash equilibria: I Concepts,” Journal of Economic Theory, 42(1), 1-12.

Bhattacharya, S. and Guriev, S., 2006, “Patents vs. trade secrets: Knowledge licensing and spillover,” Journal of the European Economic Association, 4(6), 1112-1147.

Bhattacharya, S. and Guriev, S., 2013, “Control rights over intellectual property,” Journal of Industrial Economics, 61(3), 564-591.

Billette de Villemeur, E. and Versaevel, B., 2003, “From private to public common agency,” Journal of Economic Theory, 111(2), pp. 305-309.

Bloom, N., Schankerman, M. and Van Reenen, J., 2013, “Identifying technology spillovers and product market rivalry,” Econometrica, 81(4), 1347-1393.

Ceccagnoli, M., Higgins, M. and Palermo, V., 2014, “Behind the scenes: sources of complementarity in R&D,” Journal of Economics and Management Strategy, 23(1), 125-148.

Cockburn, I.M. and Lerner, J, 2009, “The cost of capital for early- stage biotechnology ventures,” Congressional Briefing. Available at: http://buchpedersen.com/wp-content/uploads/2016/02/TheCost-of-Capital-for-Early-Stage-Biotechnology-VenturesCockburnLerner.pdf

Cockburn, I.M. and Henderson, R.M., 2001, “Scale and scope in drug development: Unpacking the advantages of size in pharmaceutical research,” Journal of Health Economics, 20(6), 1033-57.

Cohen,W. M., Nelson, R.R. andWalsh, J.P., 2000, “Protecting their intellectual assets: Appropriability conditions and why US manufacturing firms patent (or not),” National Bureau of Economic Research.

Comanor, W. and Scherer, F.M., 2013, “Mergers and innovation in the pharmaceutical industry,” Journal of Health Economics, 32(1), 106-113.

d’Aspremont, C. and Jacquemin, A., 1988, “Cooperative and noncooperative R&D in duopoly with spillovers,” American Economic Review, 78(5), 1133-1137.

Danzon, P., Nicholson, S. and Sousa Pereira, N., 2005, “Productivity in pharmaceutical-biotechnology R&D: the role of experience and alliances,” Journal of Health Economics, 24(2), 317-339.

Danzon, P., Epstein, A. and Nicholson. S., 2007, “Mergers and acquisitions in the pharmaceutical and biotech industries,” Managerial and Decision Economics, 28(4-5), 307-328.

Danzon, A. and Grabowski, H., 2012, “Mergers, acquisitions, and alliances,” in: Danzon, P. and Nicholson, S., editors, The Economics of the Biopharmaceutical Industry, Ch. 18, Oxford University Press, 552-577.

DiMasi, J.A., Hansen, R.W., Grabowski, H.G., and Lasagna, L., 1991, “Cost of innovation in the pharmaceutical industry,” Journal of Health Economics, 10(2),107-142.

DiMasi, J.A., Hansen, R.W., and Grabowski, H.G., 2003, “The price of innovation: new estimates of drug development costs,” Journal of Health Economics, 22(2), 151-185.

DiMasi, J.A., Hansen, R.W., and Grabowski, H.G., 2016, “Innovation in the pharmaceutical industry: New estimates of R&D costs,” Journal of Health Economics, 47(C), 20-33.

Folta, T.B., 1998, “Governance and uncertainty: The trade-off between administrative control and commitment,” Strategic Management Journal, 19(11), 1007-28.

Galambos, L. and Sturchio, J.L., 1998, “Pharmaceutical firms and the transition to biotechnology: A study in strategic innovation,” Business History Review, 72(2), 250-278.

Getz, K.A., 2007, “CRO shifts in the outsourcing market,” Applied Clinical Trials, 16(5), 35-38.

Golec, J. and Vernon, J.A., 2009, “Financial risk of the biotech industry versus the pharmaceutical industry,” Applied Economics and Health Policy, 7(3), 155-65.

Guedj, I., 2005, “Ownership vs. contract: how vertical integration affects investment decisions in pharmaceutical R&D,” McCombs Research Paper Series, No. FIN-01-06.

Hagedoorn, J. and Wang, N., 2012, “Is there complementarity or substitutability between internal and external R&D strategies?,” Research Policy, 41(6), 1072-1083.

Hagedoorn, J. and Hesen, G., 2007, “Contract law and the governance of inter-firm technology partnerships: An analysis of different modes of partnering and their contractual implications,” Journal of Management Studies, 44(3), 342-366.

Henderson, R.M. and Cockburn, I.M., 1996, “Scale, scope and spillovers: the determinants of research productivity in drug discovery,” RAND Journal of Economics 27(1), 32-59.

Hernandez-Villafuerte, K., Sussex, J., Robin, E., Guthrie, S. and Wooding, S., 2017, “Economies of scale and scope in publicly funded biomedical and health research: evidence from the literature,” Health Research Policy and Systems 15(1), 1-17.

Henriques, I., 1990, “Cooperative and noncooperative R&D in duopoly with spillovers: Comment,” American Economic Review, 80(3), 638-640.

Higgins, M.J., 2007, “The allocation of control rights in pharmaceutical alliances,” Journal of Corporate Finance, 13(1), 58-75.

Higgins, M.J. and Rodriguez, D., 2006, “The outsourcing of R&D through acquisitions in the pharmaceutical industry,” Journal of Financial Economics, 80(2), 351-383.

Ho, S.J., 2009, “Information leakage in innovation outsourcing,” R&D Management, 39(5), 431-443.

Hoos, A., 2016, “Development of immuno-oncology drugs – from CTLA4 to PD1 to the next generations,” Nature Reviews Drug Discovery, 15, 235-247.

Keith, J.A., Bigger, L.A., Phyllis A.A., Maes, A.E. and Daems, R., 2013, “Delivering the promise of the Decade of Vaccines: Opportunities and challenges in the development of high quality new vaccines,” Vaccines, 31(S), B184-B193.

Lai, E., Riezman, R. andWang, P., 2009, “Outsourcing of innovation,” Economic Theory, 38(3), 485-515.

Laussel, D. and Le Breton, M., 2001, “Conflict and cooperation: The structure of equilibrium payoffs in common agency,” Journal of Economic Theory, 100(1), 93-128.

Lerner, J. and Merges, R.P., 1998, “The control of technology alliances: An empirical analysis of the biotechnology industry,” Journal of Industrial Economics, 46(2), 125-156.

Macher, J.T. and Boerner, Ch. S., 2006, “Experience and scale and scope Economies: Trade-offs and performance in development,” Strategic Management Journal, 27(9), 845-865.

Majewski, S., 2004, “How do consortia organize collaborative R&D?: Evidence from the national cooperative research act,” Discussion Paper 483, Harvard Law School.

Martimort, D., 2007, “Multi-Contracting Mechanism Design,” in: Blundell, R., NeweyW. and Person, T., editors, Advances in Economic Theory Proceedings of the World Congress of the Econometric Society, Cambridge University Press.

Mestre-Ferrandiz, J.M., Sussex, J. and Towse, A., 2012, The R&D Cost of a New Medicine. London: Office of Health Economics.

Motta, M., 1992, “Cooperative R&D and vertical product differentiation, International Journal of Industrial Organization, 10(4), 643-661.

Munos, B. 2009, “Lessons from 60 years of pharmaceutical innovation,”Nature Reviews Drug Discovery, 8, 959-968.

Pammolli, F., Magazzini, L. and Riccaboni, M., 2011, “The productivity crisis in pharmaceutical R&D,”Nature Revue Drug Discovery, 10(6), 428-438.

Pisano, G.P., 1991, “The governance of innovation: vertical integration and collaborative arrangements in the biotechnology industry,” Research Policy, 20(3), 237-249.

Pisano, G.P., 2006a, Science Business: The Promise, the Reality and the Future of Biotech, Harvard Business School Press.

Pisano, G.P., 2006b, “Can science be a business? Lessons from biotech,” Harvard Business Review, 84(10), 114-124.

Pisano, G.P., 2010, “The evolution of science-based business: Innovating how we innovate,” Industrial and Corporate Change, 19(2), 465-482.

Pisano, G.P., 2015, “Big pharma needs to get busy in the lab: Blanket generalizations about biotech firms being more efficient are unfounded,” TheWall Street Journal, March 19. Available at: www.wsj.com/articles/gary-pisano-big-pharma-needs-to-get-busy-in-the-lab-1426805547.

Robinson, D.T. and Stuart, T.E., 2000, “The allocation of control in biotechnology strategic alliances,” Organization ScienceWinter Conference. Available at: https://faculty.fuqua.duke.edu/oswc/2000/papers/thursday/TobyStuart.pdf

Robinson, D.T. and Stuart, T.E., 2007, “Financial contracting in biotech strategic alliances,” Journal of Law and Economics, 50(3), 559-595.

Rothaermel, F.T., 2001, “Incumbent’s advantage through exploiting complementary assets via inter-firm cooperation,” Strategic Management Journal, 22(6-7), 687-699.

Rydzewski, R.M., 2008, Real World Drug Discovery: A Chemist’s Guide to Biotech and Pharmaceutical Research, Amsterdam: Elsevier.

Sancheti, S., Thomas, H., van den Heuvel, R. and Verhaeghe, A.J, 2018, R&D 2030: Reinvent innovation and become an R&D front-runner by 2030, KPMG International. Available at: https://assets.kpmg.com/content/dam/kpmg/xx/pdf/2018/11/r-and-d-2030-thriving-on-disruption-series.pdf

Scannell, J.W., Blanckley, A., Boldon, H. and Warrington, B., 2012, “Diagnosing the decline in pharmaceutical R&D efficiency”, Nature Reviews Drug Discovery, 11, 191-200.

Scherer, F.M., 2001, “The link between gross profitability and pharmaceutical R&D spending,” Health Affairs, 20(5), pp. 216-220.

Scherer, F.M., 2010, “Pharmaceutical innovation,” in: Hall, B.H. and Rosenberg, N., editors, Handbook of The Economics of Innovation, Vol. 1, Ch. 12, pp. 539-574.

Scherer, F.M., 2011, “R&D costs and productivity in biopharmaceuticals,” Faculty Research Working Paper Series, Harvard Kennedy School, RWP11-046.

Schuhmacher, A., Gassmann, O. and Hinder, M., 2016, “Changing R&D models in research-based pharmaceutical companies,” Journal of Translational Medecine, 14(1), pp. 105-115.

Shuchman, M., 2007, “Commercializing Clinical Trials Risks and Benefits of the CRO Boom,” New England Journal of Medicine, 357(14), 1365-1368.

Spulber, D.F., 2013, “How do competitive pressures affect incentives to innovate when there is a market for inventions?,” Journal of Political Economy, 121(6), 1007-1054.

Stuart, T.E., Hoang H. and Ralph C.H., 1999, “Interorganizational endorsements and the performance of entrepreneurial ventures,” Administrative Science Quarterly, 44(2), pp. 315-349.

Symeonidis, G., 2003, “Comparing Bertrand and Cournot equilibria in a differentiated duopoly with product R&D,” International Journal of Industrial Organization, 21(1), 39-55.

Tang, J., Shalabi, A. and Hubbard-Lucey, M., 2018, “Comprehensive analysis of the clinical immunooncology landscape,” Annals of Oncology, 29, pp. 84-91.

Taylor, K., Shah, S. and Stockbridge, M., 2016, Balancing the R&D Equation: Measuring the Return from Pharmaceutical Innovation, Deloitte Centre for Health Solutions. Available at: https://www2.deloitte.com/content/dam/Deloitte/uk/Documents/life-sciences-health-care/deloitte-uk-measuring-the-return-pharma-report-2016.pdf

Thakor, R. T., Anaya, N., Zhang, Y., Vilanilam, C., Siah, K. W., Wong, C. H., and Lo, A. W., 2017, “Just how good an investment is the biopharmaceutical sector?,” Nature Biotechnology, 35(12), pp. 1149-1157.

Topkis, D., 1995, “Comparative statics of the firm,” Journal of Economic Theory, 67(2), 370-401.

Vencatachellum, D. and Versaevel, B., 2009, “R&D delegation in a duopoly with spillovers,” The B.E. Journal of Economic Analysis & Policy, 9(1) (Contributions), Article 55.

Wilson, E., Wallach, M., and Willoughby, R., 2016, CRO Industry Primer, Credit Suisse. Available at: https://research-doc.credit-suisse.com