How does a firm’s market power in existing products affect its incentives to innovate? We explore this fundamental question using granular project- and firm-level data from the pharmaceutical industry, focusing on a particular mechanism through which incumbent firms maintain their market power: “reverse payment” or “pay-for-delay” agreements to delay the market entry of competitors. We first show that when firms are unfettered in their use of “pay-for-delay” agreements, they reduce their innovation activities in response to the potential entry of direct competitors. We then examine a legal ruling that subjected these agreements to antitrust litigation, thereby reducing the incentive to enter into them. After the ruling, incumbent firms increased their net innovation activities in response to competitive entry. We provide evidence that this innovation is of higher “quality”—it has greater scientific and commercial value. These effects are centered on firms with products that are more directly affected by competition. However, at the level of product therapeutic area, we find a reduction in innovation by new entrants after the ruling in response to increased competition. Overall, these results are consistent with firms having reduced incentives to innovate when they are able to maintain their market power, highlighting a specific channel through which this occurs.
