Market Heterogeneity and Drug Innovation
market size effect
Health and Medical Administration
The Induced Innovation Hypothesis (IIH) describes the causal effect of market size (i.e., product demand) on innovation output - larger value markets offer larger profit potential which leads to higher rates of new product entry. Empirical literature has supported the IIH but the estimated effects of market size on pharmaceutical innovation are curious in two respects: they are much higher than predicted and they vary across innovation measures (e.g., new molecules, new non-generic drugs, new patents). I propose and investigate an extended Induced Innovation Hypothesis (eIIH) which posits how non-size characteristics of markets or "market heterogeneity" (e.g., compositional structure, R&D riskiness) together with aggregate market size can influence the introduction rate of new drugs and associated outputs. My empirical approach exploits a panel dataset constructed from publicly available data from the U.S. Food and Drug Administration, Agency for Healthcare Research and Quality, and World Health Organization that links market size and heterogeneity measures with innovation counts associated with New Drug Application (NDA) approvals. Consistent with previously reported estimates, I find that a 1% increase in market size produces a 2%-6% increase in innovation entry under a traditional IIH setup. However, in closer alignment with theoretical predictions, controlling for market population characteristics such as disease severity, physiology types, and treatment preferences lowers the estimated effect of market size to the 1%-4% range. These results appear reasonably robust across different innovation count measures with significance levels sensitive to specification and variable construction choices. Thus, initial evidence suggests that an extended IIH can provide a more informative model of induced drug innovation than the traditional IIH. It also suggests how policy levers might be more effectively used to direct pharmaceutical innovation toward under-served as well as un-served markets.