Risk aversion, NOT literal cash, explains pharma, BUT more cash means less aversion.

Technological innovation is a key engine for growth; hence, understanding the frictions that impede the development of new ideas is critical. Unlike investments in physical capital, investments in research and development (R&D) are characterized by considerable uncertainty. As a result, the forces that limit firms’ willingness to take risks may lead them to forgo innovative investments and focus instead on safer but more marginal projects.1 Our goal in this paper is to understand the extent to which firms’ risk aversion limits their investment in innovative projects. To do so, we focus on the pharmaceutical industry, an important setting in which these frictions are likely to be particularly salient.

Using detailed data on firms’ drug development decisions, we provide evidence suggesting that risk aversion keeps even large firms from investing in innovative projects. To arrive at this conclusion, we first develop a new measure of the molecular novelty of firms’ new drug candidates. Using this measure, we show that firms face a risk-reward trade-off when considering investments in novelty: novel drug candidates are less likely to be approved by the U.S. Food and Drug Administration (FDA), but they also appear to be more valuable investments ex ante. Specifically, early patents associated with novel drug molecules are more valuable than patents associated with more derivative molecules. Having established that novel drugs appear to be superior investments than me-too drugs raises the issue of why firms do not develop more novel drugs. Using variation based on the expansion of Medicare prescription drug coverage, we find that firms respond to plausibly exogenous increases in their net worth by developing riskier, more innovative drugs that are also more valuable on average. This result, which holds even for profitable, publicly traded firms, stands in contrast to the complete markets benchmark in which a firm’s willingness to take (diversifiable) risks is independent of its net worth. By contrast, our findings are consistent with a dynamic model of investment with costly external finance, in which firms favor conservative drug development strategies in order to manage the risk of their cash flows. A positive cash flow shock leads to more novel R&D not because the firm is literally cash constrained, but because the increase in firm’s net worth reduces its effective risk aversion.