Biopharmaceutical R&D outsourcing: Short-term gain for long-term pain?

Research and development (R&D) outsourcing offers some obvious productivity benefits (e.g., access to new technology, variabilised costs, risk sharing, etc.). However, recent work in economics points to a productivity headwind at the level of the innovation ecosystem. The market for technologies with economies of scope and knowledge spillovers (those with the biggest impact on industry economics and social welfare) has structural features that allow customers to capture a disproportionate share of economic value and transfer a disproportionate share of economic risk to technology providers, even though the providers aim to maximise profit. This reduces the incentives to invest in new ventures that specialise in the most promising early-stage projects. Therefore, near-term gains from R&D outsourcing can be offset by slower innovation in the long run.

One lab, two firms, many possibilities: On R&D outsourcing in the biopharmaceutical industry.

We draw from documented characteristics of the biopharmaceutical industry to construct a model where two firms can choose to outsource R&D to an external unit, and/or engage in internal R&D, before competing in a final market. We investigate the distribution of profits among market participants, and the incentives to coordinate outsourcing activities or to integrate R&D and production. Consistent with the empirical evidence, we find that the sign and magnitude of an aggregate measure of direct (inter-firm) and indirect (through the external unit) technological externalities drives the distribution of industry profits, with higher returns to the external unit when involved in development (clinical trials) than in early-stage research (drug discovery). In the latter case, the delinkage of investment incentives from industry value, together with the ability of firms to transfer risks to the external unit, imply a vulnerability of early-stage investors' returns to negative shocks, and the likely abandonment of projects with economic and medical value. We also find that competition in the equity market makes a buyout by one of the two firms more profitable to a research biotech than to a clinical services unit, and can stimulate early-stage investments. However, this long-term incentive can be minimal, notably if the superior efficiency of outsourced operations originates from economies of scope that can hardly be exploited when a firm takes control of the external unit exclusively for itself. R&D outsourcing thus does not always qualify as a relevant pathway to address the declining productivity in innovation that has characterized the industry over several decades.