Ownership vs. Contract: How Vertical Integration Affects Investment Decisions in Pharmaceutical R&D

This paper explores the effect of vertical integration on investment behavior in the pharmaceutical industry. I study a detailed, project-level sample of 4057 drug candidates that were sponsored by 40 large pharmaceutical firms during the period 1984-2001. Of these projects, 447 were conducted through a contractual alliance with another, smaller company that had discovered the drug candidate. The existence of these two types of governance structures allows me to compare integrated and non-integrated projects within the same firm. Controlling for project and firm characteristics, I document that pharmaceutical firms are more selective in continuing their integrated projects than in continuing projects governed by contract. I hypothesize that this difference is caused by the rigidity of the contract that governs non-integrated projects, making them less flexible in adapting to changes in the firm’s situation. In line with this hypothesis, I document that although more frequently continued, non-integrated projects have a lower probability of success. Moreover, investment in non-integrated projects is less sensitive to the firm’s cash flow and to the existence of other projects in the firm