© 2001 The People-To-People Health Foundation, Inc.

Health Affairs

September, 2001 - October, 2001

LENGTH: 611 words

TITLE: Probing The Link Between Gross Profitability And R&D Spending ;
Focusing on the link between R&D and current profits might obscure its more
fundamental link with future expected profits.

AUTHOR: Frank R. Lichtenberg

TEXT:
In his paper F.M. Scherer examines the relationship between pharmaceutical profits and
research and development (R&D) investment using time-series industry-level data. He
finds an apparently highly significant positive correlation between the two variables (both
measured as deviations from trend). While I (and I believe most economists) would
expect there to be a link between profitability and R&D investment, it is a link different
from the one that Scherer examines. I fear that his analysis captures only part of the
nexus of profits and R&D, but not the most important part.

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.
Evidenceindicates 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.

NOTE

REFERENCE:
[n1.] 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).

Jn

LOAD-DATE: October 1, 2001