Market size, product recalls, and pharmaceutical innovation

We examine the causal effect of market size on pharmaceutical innovation in a context where observed revenues are endogenous equilibrium outcomes jointly determined by demand, competition, and innovation. To address this endogeneity, we use major drug recalls as a novel instrument for expected market rewards, relying on their sharp and unanticipated nature at the therapeutic-class level. Combining U.S. sales, recall, and clinical trial data at the relevant submarket level, we estimate the effect of market size on innovation within a control-function IV Poisson framework that addresses both idiosyncratic and heterogeneity-driven endogeneity. The identifying variation comes from recall-driven contractions in class-level revenues that persist beyond the recall year. We find that a 10\% increase in market size leads to approximately a 6% increase in clinical trial activity, an elasticity at the upper range of existing estimates. Importantly, when innovation is restricted to trials that result in marketed products, the estimated elasticity falls substantially. This finding suggests that standard measures of innovation effort overstate the responsiveness of commercially successful innovation to market-size incentives and underscores the importance of distinguishing between innovation effort and realized outcomes for both empirical measurement and policy design.