Endogenous Productivity of Demand-Induced R&D: Evidence from Pharmaceuticals

This paper examines trends in the productivity of the pharmaceutical sector over the past three decades. Motivated by Ricardo’s insight regarding demand-driven productivity in settings of scarce resources, we examine the industry’s aggregate R&D production function. Using exogenous demand shocks to instrument investments, we find that demand growth explains roughly half of R&D growth, and amongst this demand-induced R&D the industry’s returns to scale have been very stable while total factor productivity has declined significantly. Evidence based on these estimates is in line with Ricardo’s prediction that productivity and rents are endogenous to demand.