Market Size in Innovation: Theory and Evidence from the Pharmaceutical Industry∗

Is innovation primarily determined by scientific constraints and motivated by past scientific discoveries? Or does innovation respond to profit incentives? In this paper, we develop a simple model linking innovation to potential market size, and show that under a variety of circumstances, a greater market size for a particular product, which implies greater profitability from sales, spurs faster innovation for this product. We provide evidence for this hypothesis from the pharmaceutical industry by looking at changes in the potential market size for various drug categories driven by U.S. demographic changes. We find that a 1 percent increase in the potential market size for a drug category leads to a 4 to 7.5 percent increase in the number of new drugs in that category. This result is generally robust to using different estimation strategies, adopting different classifications of drugs into various categories, and controlling for pre-existing trends.