Portfolio Management in New Drug Development - Innovation and Marketing in the Pharmaceutical Industry - page 111

Providing the appropriate incentives to the task at hand is also a challenge faced
by firms. Will a one-size-fits-all incentive system drive the right behaviors, versus
tailoring the incentives according to the nature of the project? Chao et al. ( 2011 ) use
principal-agent theory to determine that incentives depend on the interaction of
project complexity and desired type of innovation. An organization focused on
incremental innovation should set higher incentives for more complex projects.
However, an organization focused on radical innovation should set lower incentives
for more complex projects. This finding reconciles two differing schools of thought:
the first suggests that complex problems are difficult to solve and incentives should
be provided to enable managers to invest adequate effort; the second suggests that
incentives in fact result in lower performance for complex tasks. Chao et al. ( 2011 )
explain this dichotomy as arising due to the choice of incremental or radical innova-
tion (what they refer to as “search distance”). Empirical validation of these hypoth-
eses will provide useful insights to pharmaceutical firms in designing incentives in
light of projects of varying complexity and varying innovation goals.
Another critical incentive design issue is to motivate managers to kill the right
projects at the right time. Simester and Zhang ( 2010 ) argue that it is difficult to
reward decisions to kill projects simultaneously with rewards for success. Rewarding
success may mean that an agent persists with a project even if its prospects have
dimmed since its inception. Rewarding failure, on the other hand, undermines moti-
vation for persisting to find solutions to challenging projects, as it could be “argued”
that the project should be discontinued. Therefore, while a firm with a large project
portfolio may prefer to kill projects with low prospects, the fact that different man-
agers are responsible for different parts of the portfolio may jeopardize the efficient
updating of the portfolio over time.
Overall, there is further ground to explore the problem of incentives and the vari-
ous behaviors that result in the context of pharmaceutical portfolio management,
building upon the recent research in this area. We suggest that careful alignment is
required between how managers and scientists are compensated and the actions the
firm would want them to undertake, to preempt “moral hazard” issues.

3.5 Concluding Remarks and Open Questions

The literature on portfolio management is inherently interdisciplinary, with work
from decision theory, game theory, principal-agent mechanism design, empirical
data analysis, finance, simulation analysis, and statistical theory informing this cru-
cial topic. Extant literature has made significant contributions to the theory of port-
folio valuation and optimization, as well as characterizing the empirical findings
from actual practices at pharmaceutical firms. Yet, significant questions remain
open for further exploration which we now outline.
Research on portfolio valuation has focused on either market-based measures
(using stock market reactions to discrete events) or internal measures of value (NPV,
expected utility, IRR, etc). While there is a belief that both external and internal