Paying off the Competition: Market Power and Innovation Incentives
How does a firm’s market power in existing products affect its incentives to innovate? We explore this fundamental question using granular project-level and firm-level data from the pharmaceutical industry, focusing on a particular mechanism through which incumbent firms maintain their market power: “reverse payment” or “pay-for-delay” agreements to delay the market entry of competitors. We first show that when firms are unfettered in their use of “pay-for-delay” agreements, they reduce their innovation activities in response to the potential entry of direct competitors. We then examine a legal ruling that subjected these agreements to antitrust litigation, thereby reducing the incentive to enter them. After the ruling, incumbent firms increased their net innovation activities in response to competitive entry. These effects center on firms with products that are more directly affected by competition. However, at the product therapeutic area level, we find a reduction in innovation by new entrants after the ruling in response to increased competition. Overall, these results are consistent with firms having reduced incentives to innovate when they are able to maintain their market power, highlighting a specific channel through which this occurs.
We thank Jan Bena (discussant), Chirantan Chatterjee, Greg Glass, Matt Higgins, Josh Krieger, Howard Kung (discussant), Filippo Mezzanotti, Myles Shaver, and participants at the Minnesota Corporate Finance Conference and SFS Cavalcade North America for helpful comments and suggestions. We also thank Matt Higgins for providing data. We thank Xuan Xie, Anushka Ray, Paula Fenstad, and Paul Freed for research assistance. Any errors are our own. Research support from the MIT Laboratory for Financial Engineering is gratefully acknowledged. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.