When choosing which new products to develop, companies must decide how much they want to innovate. Should they make an incremental improvement on an existing product? Or should they create something entirely new?

Dimitris Papanikolaou, a professor of finance at Kellogg, explored how this choice plays out in the pharmaceutical industry.

Some researchers argue that pharmaceutical firms these days are often making minor changes to existing medications instead of delivering innovative drugs. And, given the potential life-saving and life-improving power of new drugs, such a trend would have clear consequences for society.

“Breakthroughs are becoming less frequent,” Papanikolaou says.

To measure what is happening in the industry, he and coauthors developed a method to quantify a medication’s level of novelty and applied it to a database of more than 64,000 drugs. They found that more innovative therapies had a lower chance of being approved by the U.S. Food and Drug Administration (FDA). On the other hand, those that did pass this hurdle tended to be more effective and lucrative than so-called “me too” drugs, which are variations on existing medications.

Yet the researchers found that firms were eager to work on novel drugs—under the right financial circumstances. When pharmaceutical companies got a windfall, such as a sudden increase in profits, they were more likely to spend it on developing novel drugs than on incremental improvements. The reverse, of course, is also likely true, Papanikolaou says. Firms may be held back from pursuing innovative therapies because they lack the cash to turn their financially riskier ideas into reality.

“These financial frictions may be limiting innovation,” says Papanikolaou, who collaborated with Joshua Krieger of Harvard Business School and Danielle Li of MIT Sloan School of Management on the research. If society wants to encourage more novel drugs, he says, one solution would be to increase the supply of capital to these firms.

Read more at Kellogg Northwestern