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FROM THE FIELD

Probing The Link Between Gross Profitability And R&D Spending

Scherer examines the contemporaneous relationship between pharmaceutical profits and R&D investment, but many economists would not hypothesize a contemporaneous relationship. Two assumptions that economists often make are (1) that there are "perfect capital markets," so that a company can easily issue debt or equity to finance its investments, and (2) that company managers attempt to maximize shareholders’ wealth. Under these assumptions, R&D should depend only on expected future profits, not on current profits. If a company has a good investment opportunity and can communicate it to outside investors, low current profitability will not inhibit investment. The fact that biotech startups today can "burn" tens of millions-of dollars in R&D before they ever earn a dollar of revenue suggests that capital markets are not too imperfect now, although that was not always the case. It also seems unlikely that "big pharma" firms such as Pfizer and Glaxo SmithKline are constrained in their liquidity.

Sensitivity of investment to current profits might be due to failure of the second, rather than the first, assumption. According to Michael Jensen’s agency-cost model of free cash flow, managers sometimes prefer to waste resources on unprofitable investments. When profits are high, R&D spending will be high, but it may be too high.

Thus, on theoretical grounds, R&D should not necessarily depend on current profits. If there is a connection, that could arise for more than one reason, with ambiguous policy implications.

One might accept the idea that R&D ought to depend as much or more on expected future profits as it does on current profits but be skeptical about testing this empirically, because of the perceived difficulty of measuring expected future profits. But according to the "market efficiency hypothesis," for which there is considerable support, the stock market value of a firm equals the expected present discounted value of its future profits. In a recent paper I investigated the effect of both market value and current profits on pharmaceutical R&D investment at the firm level.¹ I found that R&D depended on both variables but that market value does a slightly better job of explaining R&D fluctuations and that the estimated effect of current profits declines by about a third when market value is accounted for.

I think that it is potentially misleading to focus on the link between R&D and current profitability, as this may obscure the more fundamental link between R&D and expected future profits. The latter link implies that policies that threaten to diminish future profits will reduce R&D investment today, even if they do not affect current profits. Evidence indicates that the threat of Clinton health care reform in 1992–93 reduced the growth rate of pharmaceutical R&D spending, although it had no immediate impact on profits.

Scherer’s paper is useful because it draws attention to the link between profits and investment, but R&D is much more forward looking, and the link more dynamic and complex, than allowed for by his analysis.

Editor's Notes

 
Frank Lichtenberg is the Courtney C. Brown Professor of Business at Columbia University in New York City. Health Affairs invited his comments on the preceding paper by F.M. Scherer.

NOTE

Top NOTE

 

1. F.R. Lichtenberg, "Public Policy and Innovation in the U.S. Pharmaceutical Industry," in Entrepreneurship and Public Policy, ed. D. Holtz-Eakin (Boston: MIT Press, forthcoming).

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