Market Conditions and the Nature of Innovation: Evidence from the Biotechnology Sector (formerly PHARMACEUTICAL PROFITS AND THE SOCIAL VALUE OF INNOVATION)

Firms must consider both the probability of development success and subsequent market profits when choosing to pursue incremental or breakthrough innovations. Previous research has examined how organizational factors impact these choices, with little consideration for the effect of changes in market conditions. A separate line of research has shown that downstream demand shocks spur additional product development, without attempting to classify the nature of the innovative output. We attempt to combine these literatures by developing a model of the innovative response to a downstream demand shock that distinguishes between innovative and breakthrough research. Under reasonable assumptions, our model predicts that a demand-increasing shock should result in a larger increase in incremental research. We empirically explore this prediction by examining the impact of the introduction of Medicare Part D on the development of new biotechnology products. We find clear evidence of an increase in new research and development efforts, with little evidence that these efforts are targeted at breakthrough innovations.