1. Pioneers, Imitators, and Generics – A Simulation Model of Schumpeterian Competition The authors develop a computer simulation model of R&D competition in new product introductions and apply it to the pharmaceutical industry There are two qualitatively different types of R&D strategies in the model: “pioneering” and “imitative” Pioneering R&D involves the development of a new family of products with the potential for very significant therapeutic advances and commercial success: risky but potentially very rewarding Imitative R&D involves investigating a known family of products to produce incremental improvements: less risky but less rewarding A third type of strategy that involves no innovation is “generic competition,” which the authors consider but do not endogenize

2. The Goal: Policy Impacts The parameters are based on data for the U.S. pharmaceutical industry during the 1970s The authors examine the sensitivity of innovation levels to the rate of generic competition, regulatory review times, and patent lives They are particularly interested in how changes in government policy influence the rate of innovation and the relative positions of the different types of firms

3. General Description of the Model Competition centers around investments in R&D projects The firms in the model can be characterized as collections of ongoing projects in various stages of the life cycle: discovery, development, market life, removal from the market Each year, the firm must make various decisions about its portfolio of R&D projects: whether to continue funding each one, start new ones, exit the industry, etc. Completed R&D projects receive random qualities that determine commercial potential, and the path of sales follows a life cycle pattern (rising initially, then stable, then declining) The pattern of sales if subject to change as a result of imitative entry

4. General Description, cont. The earnings from successful R&D projects are used to fund future R&D Firms engaged in pioneering R&D plow back a target percentage of their total earnings into R&D, subject to several constraints Firms engaged in imitative R&D base their R&D expenditures on expected and realized earnings from R&D They assume firms specialize and either pursue pioneering R&D or imitative R&D

5. R&D and Profits Pioneering and imitative R&D have similar features, but the expected value of R&D costs and market sales are greater for pioneers A pioneering strategy requires a discovery phase that imitators do not have to perform Consequently, the R&D process is longer and more costly for pioneering firms Pioneering R&D has a lower probability of success Pioneering firms face a more highly skewed distribution of market sales

6. R&D Competition Across Market Classes All competition takes place in the context of particular industry submarkets The allocation of R&D budgets across submarkets is important They assume the probability that a pioneering firm launches a product in any particular submarket is equal across submarkets However, any submarket that has a major product breakthrough (a blockbuster) is assumed to have a temporary depletion of the stock of opportunities which prevents that class from having another such winner in the immediately subsequent years Imitators target their R&D allocations to submarkets with recent market successes; their new product launches are a lagged stochastic function of the market introduction pattern of the pioneers An imitator’s payoff is a function of the sales of the pioneer it is imitating and the number of competing imitative products entering the submarket Pioneers new product introductions are more market expanding and less redistributive than imitator’s R&D

7. R&D Expenditure Functions Pioneering firms plow back a percentage of their net revenues into R&D, subject to constraints on the growth of R&D and the funding of ongoing projects The pioneers operate with a target R&D expenditure to revenue ratio They use the earnings targeted for R&D first to fund ongoing projects and then to initiate new projects A constraint on R&D growth is incorporated to avoid unrealistically sharp increases in R&D from large increases in net revenues If funds allocated for R&D are less than the amount needed for ongoing projects, no new projects are begun. Up to a point, existing projects continue to receive funding When the number of new blockbusters increases, imitators increase their targeted R&D to earnings ratio subject to constraints on R&D growth If the retained earnings targeted for R&D drops below 50% of what is necessary to fund ongoing projects, the firm stops all R&D activity

8. Policy Experiments They perform several policy experiments; change patent life, for example, and observe the effects on pioneering R&D, imitation, etc. In these experiments, they assume the target R&D to sales ratios do not change when the policy changes The experiments incorporate parameter estimates for R&D costs, technical and commercial success probabilities, sales revenue distributions, and other parameters that match the pharmaceutical industry during the 1970’s The main policy variables analyzed are regulatory review times, patent life, and the degree of sales loss to generics after patent expiration

9. Base Case Parameters and Modifications Based on the 1970’s: 1. The average discovery phase is three years, development takes eight years 2. Only pioneering firms need discovery, so imitators have a longer effective patent life (11 years compared to 8) 3. After patent expiration, 5% of the sales are lost to generics in the first year and 10% in all subsequent years of market life They compare this to more modern times, where the average expected loss to generics would be 50% after patent expiration The impact depends critically on the patent life; with a short patent life, rapid generic entry is particularly damaging to pioneering firms The 1984 Act extended the patent life for pioneers; they also consider this effect, looking at increases of three and six years They also consider reductions in regulatory review times, which increase positive cash flow earlier in the life cycle than patent extensions

10. Simulation Experiments They assume the industry initially consists of twenty equal sized firms Ten are pioneers; ten are imitators In year 1, each firm is already a going concern and owns a portfolio of drugs developed and marketed over the preceding 20 to 30 year period It is also performing R&D for projects in various stages of the development process Each firm earns $57 million in the first period and spends 28% of this on R&D. Given the projects in progress, there is an expected value of 6 pioneering products and 15 imitative ones each year

11. After 50 Years After 50 years have elapsed (average results from 10 simulations), industry net revenue has approximately doubled The average market share of the pioneers is significantly larger than that of the imitators (56% compared to 44%) Imitators have more product introductions, but they have smaller average sales than pioneers Pioneers have higher R&D The market share of the top four firms rises from 20% to 42%

12. Changes in Generic Competition Consider moving from the base case of 10% sales loss after patent expiration to 50% The assumptions on effective patent life for pioneers and imitators, 8 and 11 years, are retained The rate of innovation and other performance variables are highly sensitive to this assumed increase in the degree of generic competition Industry revenues and R&D are reduced by approximately 30% and new product introductions by 20% If generics hurt pioneers more than imitators (60% loss for pioneers, 40% for imitators), then the revenues and R&D of pioneers fall more relative to that of imitators

13. Changes in Effective Patent Life The 1984 Act encouraged generic entry but also extended patent lives for innovators To consider this effect, they maintain the assumption of a 50% post-expiration sales loss to generics They assume that patent lives increase by three years for pioneers and imitators As a result, industry R&D and net revenues increase by over 20% relative to the case without patent extensions Approximately 75% of the loss from enhanced generic competition is restored by the three-year increase in patent life. These benefits are subject to diminishing returns; a six year increase in patent life has a very small marginal effect relative to the three year increase. This is because the gains come late in the product’s life cycle when revenues are already low

14. Changes in Regulatory Clearance Times They consider reducing regulatory clearance times by one and two years They find that innovation levels are very sensitive to this change A one-year reduction increases revenues and R&D by approximately 30% There is a slight tendency for pioneers to benefit more than imitators There are diminishing returns in moving from one to two years, but these are not as severe as in the case of patent extensions The stimulative effects on innovation of a one-year reduction in regulatory approval times is equivalent to a five or six year patent extension If a firm is able to increase its cash flow early in the life cycle, it is able to initiate new projects sooner, realize returns on them sooner, start more new projects, etc. The cumulative effect is substantial Even if reductions in regulatory times are accompanied by equal reductions in patent life, there is still a substantial positive effect (regulation has no benefit in this model; it is a pure cost)

15. Robustness They consider the sensitivity of their results to changes in the number of firms participating in the industry, the extent to which new product sales are market expanding vs. redistributive, and the richness of technological opportunities Reducing the number of firms had no effect If business stealing rises then revenues and product introductions fall (this could be endogenized. If more products are introduced then business stealing would rise – they are competing in similar markets) Improving technological opportunities raises revenues and innovation They do not allow for entry into the industry