BIG pharma is key. Their models omit developmental setbacks.

Using our measure of novelty, we first show that, contrary to the popular view, large firms are more likely to develop novel drug candidates than smaller firms: novel drugs constitute 56% of large firms’ development pipelines, compared to 47% for smaller firms. This result stands in contrast with leading models of endogenous innovation and firm size (Akcigit and Kerr 2018), in which small firms are more likely to engage in radical innovation. We argue that standard models of endogenous growth typically ignore the significant uncertainty inherent in pursuing radical innovations, which combined with costs of external finance may lead firms to behave as if they are risk averse, even though the underlying risks may be diversifiable from the perspective of firm shareholders. In this world, drug development decisions become sensitive to firms’ net worth: larger firms are willing to take more risks and develop novel drugs because they are better able to weather setbacks in the drug development process. The rest of the paper examines this idea in more detail.