Determinants of R&D - Competition and Market Power: Evidence from Pharmaceutical Industry

Abstract

We examine why firms undertake R&D and what decides the magnitude of R&D they do. We postulate based on previous literature, that the initial motivation for R&D and the extent of R&D is determined by the competition within an industry and market power of the respective firms. We extend the previous literature on industry level studies and studies looking at dominant firms in an industry to all firms within the industry. We develop empirical measures for market power and construct a simple model to explain the R&D activities of firms based on exogenous factors. Several studies have examined the impact of public policy, free cash flow, Tobin's Q, capital structure and corporate governance parameters on firm level R&D. We control for firm specific factors as per the previous literature. We test our model on a group of pharmaceutical companies. As predicted by the model, R&D is significantly related to competition and market power. The control parameters are in consonance with the previous literature. We discuss the policy implications of our model and estimate cut off values for Competition and market power above which R&D is likely to taper off.