Linking Competition to the Economic Incentives for Firms to Innovate: In the Context of the U.S. Pharmaceutical Industry

Jacob Berg Nielsen

Student thesis: Master thesis

Abstract

The main purpose of this research was to investigate the economic incentives for firms to innovate and to show how competitive forces might influence these incentives. It was predicted that the correlation followed an inverted U-shaped relationship. To do so it was necessary to take some initial steps before it was possible to investigate this correlation. First and foremost the objective was to raise the product evaluation of an innovation to higher level than on the product itself. Hence, the study sought to show if new product innovation influenced the firm as a whole – i.e. the overall expected firm performance. To do so it was vital to bridge economic innovation with the ideas of financial markets. By accepting the Efficient Market Hypothesis (EMH) in its semi-strong form and by relying on the Principle of the Conservation of Values, new information regarding product innovation must be reflected efficiently in a firm’s security prices as soon as this information becomes publicly available. If the connection is successful and efficient the expected firm performance in relation to new product innovation serves as valid approximation to the economic incentives for firms to innovate. The connection can be established via the event study methodology. Using the pharmaceutical industry as this study research context, the study successfully connected economic innovation with financial economics via an event study. The pharmaceutical industry was chosen because it possesses the necessary conditions to conduct an event study, and because the industry itself has gone through some interesting changes in relation to competitive implications. The event study showed that the expected firm performances (abnormal returns) from new innovations (drug approvals) were reflected somewhat efficiently in the firms’ security prices. The expected firm performance related to these product approvals consequently serves as a valid approximation to the economic incentives for firm to innovate. With a valid approximation, this study showed that increased competition, at least in more recent time periods, has a positive impact on the firms’ economic incentives to innovate, however, only up to a certain point. The study showed that excessive competition has an economic disincentive for firms to innovate once a certain threshold was met. In conclusion, the study showed that the economic incentives for firms to innovate and competition follow an inverted U-shaped relationship as predicted. These findings might prove to have practical implications from a shareholder perspective as well as to have implications to effective policy reforms.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2016
Number of pages117
SupervisorsJimmy Martínez-Correa