The Price Effects of Differential Pricing and Parallel …130274/FULLTEXT01.pdf2 1. Introduction 1.1...
Transcript of The Price Effects of Differential Pricing and Parallel …130274/FULLTEXT01.pdf2 1. Introduction 1.1...
Departement of Economics University of Uppsala Master’s Thesis (D-Uppsats) Author: Mark Bohlund Supervisor: Sven-Åke Carlsson Spring Term (VT) 2005
The Price Effects of Differential Pricing and Parallel Trade in Pharmaceuticals
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1. Introduction..................................................................................................................................................... 2 1.1 Introduction................................................................................................................................................... 2 1.2 Purpose, Methodology and Disposition ........................................................................................................ 3
2. Pricing Theory................................................................................................................................................. 3 2.1. Monopoly Pricing ........................................................................................................................................ 4 2.2 Price Discrimination...................................................................................................................................... 5 2.3 Costs and Pricing in Research-intensive Industries....................................................................................... 7 2.4 Ramsey Pricing ..................................................................................................................................... 10 2.5 Conclusions................................................................................................................................................. 11
3. Industrial Location Theory: From Adam Smith to Cluster Theory................................................................... 11 4. Economic Theory on the Causes and Effects of Parallel Trade .................................................................. 12
4.1 Causes of Parallel Trade: Reasons Behind International Price Differentials .............................................. 13 4.2 Effects of Parallel Trade.............................................................................................................................. 13 4.3 Parallel Trade as a Mean to Fight Collusive Behaviour in a Market........................................................... 16 4.4 Costs of Parallel Trade ................................................................................................................................ 17 4.5 Theoretical Conclusions on Parallel Trade ................................................................................................. 17
5. Empirical Evidence. ...................................................................................................................................... 17 5. 1 The Pharmaceutical Industry...................................................................................................................... 18
5.1.1 The Location of the Pharmaceutical Industry ...................................................................................... 18 5.1.2 Costs of the Pharmaceutical Industry................................................................................................... 19 5.1.3 Profits of the Pharmaceutical Industry ................................................................................................ 20
5.2 The Pharmaceutical Market ........................................................................................................................ 20 5.2.1 Pricing Strategies for Pharmaceutical Products ................................................................................... 20 5.2.2 Regulation and Purchasing Strategies in Pharmaceutical Markets....................................................... 21
5.3 Evidence of Pharmaceutical Prices in International Markets ...................................................................... 22 5.4 Reasons for discrepancies between pharmaceutical prices and per capita income level............................. 23 5.5 Conclusions on International Price Differentials and the Opportunities for Parallel Trade ........................ 24
6. Evidence on the Effects of Parallel Trade: EU and Sweden ......................................................................... 25 6.1 The European Union ................................................................................................................................... 25 6.2 The Case of the Swedish Entry into the EU................................................................................................ 26 6.3 Evidence of Price Convergence Between Markets ..................................................................................... 27 6.4 Reactions from the Pharmaceutical Industry............................................................................................... 29 6.5 Conclusions from Parallel Trade within the EU.......................................................................................... 29
7. The Creation of a System of Differential pricing.......................................................................................... 30 7.1 Effects on Prices and Welfare ..................................................................................................................... 30 7.2 Requirements .............................................................................................................................................. 31 7.3 Efforts to Create Systems of Differential Pricing........................................................................................ 32
8. Conclusions on the Effects of Price Discrimination and Parallel Trade ....................................................... 33 8.1 Effect on prices in high-income markets..................................................................................................... 34 8.2 Effect on prices in Low-income markets .................................................................................................... 35 8.3 Effects on Research and Development........................................................................................................ 35 8.4 Areas of Regional Parallel Trade ................................................................................................................ 36
9 References..................................................................................................................................................... 36
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1. Introduction
1.1 Introduction The debate on parallel trade has much relevance as it puts at conflict two of the most urgent
and important issues of our modern-day society, namely the access to essential medicine in
developing countries and the right of intellectual property holders to get remuneration for
their innovations. The access to essential medicines can be a matter of life and death to many
third-world citizens and the opposition to parallel trade and generic drugs by multinational
pharmaceutical companies has often been seen as an expression of a cynic and inhuman
reasoning which puts financial profit before human lives. To counter this claim
pharmaceutical companies have repeatedly stressed the importance of upholding incentives
for pharmaceutical research and development (R&D) if we are to see new drugs and medical
progress in fighting diseases like AIDS and malaria. A number of governments, non-
governmental organisations, academics etc have entered the debate with a varying degree of
understanding of the aspects of the problem. When it comes to the academic debate, which
will be my focus in this essay, the question of differential pricing and parallel trade has been a
central topic. Differential pricing, and in particular Ramsey type pricing, has been presented
as a near ideal solution for solving the dilemma of access to medicine and incentives for R&D
spending. Differential pricing requires that markets are adequately segmented in order to
prevent arbitrage trading. Parallel trade in pharmaceuticals is a form of arbitrage trading and
has therefore taken a lot of flak from academics in favour of differential pricing between
markets. My aim with this thesis has been to account for the case presented by academics in
favour of differential pricing and opposed to parallel trade and then examine how well their
suppositions corresponds with empirical evidence in pharmaceutical markets across the world.
I have found that although the theoretical case of a system of differential pricing clearly holds
a lot of advantages, there is no guarantee that a segmentation of markets would lead to
Ramsey type prices, i.e. prices inversely related to demand elasticity. Real life facts present
several obstacles for a system of differential pricing functioning well. Among other things, a
system of segmented markets requires pharmaceutical companies not exploiting the absence
of competition from parallel imports to set excessively high prices. It also requires
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governments and consumers in developed countries to accept considerably higher prices than
in developing countries. Developing countries would also have to agree on banning re-
exportation of drugs. An effort to create a system of differential pricing would therefore
require a set of commitments from all parties, which could be hard to achieve and uphold
practically. Maskus (2001) presents a compromise solution of allowing parallel trade among
countries of the same per capita income level, which would retain the positive impact of
parallel trade on competition but not impede different price levels in developed and
developing countries. Allowing parallel trade to but not from developing countries could also
allay their fears of pharmaceutical companies acting collusively in the absence of parallel
trade.
1.2 Purpose, Methodology and Disposition
This thesis is a literature study of the debate on parallel trade in pharmaceuticals. My aim has
been to clear up the confusion that the debate might confer on an reader unfamiliar with the
subject. Despite its importance parallel trade in pharmaceuticals hasn’t been extensively
treated in academic literature. The obvious reason for this is the lack of an empirical base as
empirical data on parallel trade is very limited. The reason for this, in turn, is that parallel
imported pharmaceutical aren’t separated from licensed imports when trade statistics are kept
(Maskus, 2001). Theoretical arguments can therefore seldom be challenged with empirical
data. Instead I have chosen to examine the explicit or implicit assumptions in the case for
differential pricing made by leading scholars in order to estimate what effects their proposed
reforms would have in real life. But I will also give an account of a rare study of the observed
effects of parallel trade, which is Ganslandt & Maskus study of parallel imports to Sweden
following the Swedish entry into the European Union in 1995. Before making my conclusions
I will also present some past efforts to create a system of differential pricing.
2. Pricing Theory In this section I will present some pricing models that are relevant to the subject. While much
of economic theory is built on the assumption of perfect competition, alternative market
models have also been treated in economic literature. The pharmaceutical industry is often
said to be monopolistic as new inventions are awarded patents which give them exclusive
rights to sell the product during a limited period of time. It can also be described as
monopolistic competition as the industry consists of a range of manufacturers each marketing
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a range of different products, all with their own specific brand name. For a customer or a
doctor writing a prescription for a patient it is often difficult to grasp what the available
options are, which mean that widely-known brands wield a degree of market power. I have
therefore chosen to present the model of monopoly and monopolistic competition in order to
give a background of the pricing strategies used in the pharmaceutical industry and their
effect on welfare. As the thesis has a global perspective I will in section 2.2 describe how a
company can act to increase profits by setting prices differently across markets, so called
price discrimination. In section 2.3 I will describe how economists have seen the dilemma of
recovering sunk costs, e.g. spending on R&D, in an economically efficient way.
2.1. Monopoly Pricing
A monopoly is when a single seller controls the entire market of a good. Unlike agents in a
competitive market he or she can therefore raise prices and still retain sales. The number of
customers lost by increasing prices is reflected by the elasticity of demand. There are varying
degrees of monopoly or market power depending on the amount of substitutes to the
company’s good. It is therefore often common to talk about monopolistic competition, which
is a hybrid form between a pure monopoly and perfect competition.
A strong monopolist will face an inelastic demand curve and will be able to raise prices
without losing too much business. In contrast, a weak monopolist will see more customers
turning to substitutes if he or she raises prices. The marginal revenue (MR) of a change in
price (P) will depend on the elasticity of demand and is expressed algebraically as follows;
MR= P + Q(δP/δQ)
The first term is the revenue from the last unit sold and the second term is the effect of a price
change on the revenue from the other units (Q) sold. The second term will, for a normal good,
be negative as an increase in price entails a decrease in sales for normal goods. A decision to
raise the price of a product is therefore normally a trade-off of the revenue lost by the
marginal buyer dropping out and the additional income from charging a higher price to the
remaining clients. The summation of these two factors will make the marginal revenue for the
monopolist. A monopolist will set a price which equates marginal cost and marginal revenue
to maximise profits. This is less economically efficient for society as a whole than perfect
competition as some consumers prepared to pay a price above marginal cost are withheld
consumption (Pindyck & Rubinfeld, 1995). This is the reason why there in many countries are
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regulatory authorities in place to assure that competition exists and is fair. But in some cases,
e.g. industries with large economies of scale it can be motivated to accept monopolies
(Bannock, Baxter & Davis, 1998). In other cases it can actually be motivated to create
monopolies. The awarding of patents is a way of creating monopolies in certain goods. I will
return to this issue later in section 2.3. The mirror image of a monopoly is a monopsony. The
latter is when a market has only one purchaser. A monopsonist faces a similar trade-off as a
monopolist as buying an additional unit will demand offering a higher price for all units
bought. A monopsony will therefore also lead to a lower level of production than is
economically efficient as a monopsonist will refrain from buying an additional unit even
though the marginal benefit from it exceeds its price.
2.2 Price Discrimination
Price discrimination is the practice of offering the same commodity to different buyers at
different prices. By doing this a seller can exploit the differences in the elasticity of demand
of consumer groups. The seller will charge a higher price in markets where buyers are
prepared to pay a high price and a lower price in a market were buyers are more price-
sensitive. By being able to charge certain customers a higher price without forfeiting sales to
other customers the seller will be able to gain a higher profit than by charging all customers a
uniform price. As figure 1 shows this is done by usurping part of the consumer surplus, but
also by reducing dead-weight losses. Price discrimination also benefits more price-sensitive
consumers who are offered the product at a price lower than under uniform pricing. The only
losers in the game are the less price-sensitive consumers who face a price higher than under
uniform pricing.
However some prerequisites are needed for price discrimination to function well.
Firstly, the seller must posses some degree of monopoly power in at least one of the markets
to be able to set prices independently. Secondly, there must be a difference in demand
elasticity between the markets to make any price discrimination worthwhile. Thirdly, there
must be a separation of markets so that trading between markets isn’t possible, as this would
lead to price convergence (Bannock, Baxter & Davis, 1998).
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Maskus (2001) illustrates the effect of price discrimination in segmented markets with the
following figure.
Figure 1.
Price
($)
80
D(a)
α β
45 A
35 MR(a)
29.4
22.5 B
MR(b)
D(b)
10 MC
80 179 219 317 500 Q (Thousands)
The line D(a) is the demand curve for a pharmaceutical product in country A, which is
assumed to be a high-income country where the inhabitants are able to pay for
pharmaceuticals. The line D(b) is the demand curve for a country B, which is assumed to be a
low-income country where the demand for pharmaceuticals is more elastic. For simplicity it is
assumed that demand in both markets would equal 500,000 units at a zero price. However the
maximum willingness is $80 per treatment in country A but only $35 in country B. The
demand curves may be written as Pa = $80 – 0.16 Qa and Pb = $35 – 0.07 Qb, where
quantities are in thousands. It is further assumed that the pharmaceutical company can supply
both markets at a constant marginal cost of $10 per treatment. We initially suppose that the
two markets are segmented by a restraint on parallel trading. In that case the manufacturer
would maximise profits by setting marginal cost equal to marginal revenue, shown by lines
MR(a) and MR(b) in the figure, in each market. This gives a market price of $45 in country A
and $22.5 in country B. This corresponds to 219,000 units being sold in country A and
179,000 units sold in country B. The consumer surplus in country A is represented by the
triangles α + β which make ((80 – 45) x 219,000)/2 which equals $ 3.8 million. The profit
made by the manufacturer is the mark-up (market price minus average cost) multiplied by the
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quantity sold. This makes (45-10) x 219,000 which equals $7.7 million. Correspondingly, the
consumer surplus in country B amounts to $1.1 million and the manufacturers profit to $2.2
million. Total consumer surplus would amount to $ 4.9 million and the total profit of the
manufacturer would be $9.9 million. The example clearly shows that a manufacturer is
prepared to supply a market as long as the price it can charge exceeds the marginal cost.
But if arbitrage trading, e.g. parallel trade, would lead to the complete integration of the two
markets, the manufacturer would be forced to set a uniform price that would maximise the
total profits from both markets. The uniform price would depend on the intercepts and
demand curves of the markets in question. In this example there would be two possibilities for
the manufacturer. By compounding the demand equations of the two markets we find that the
manufacturer could set a profit-maximising price of $29.4 which would mean that 317,000
units would be sold in country A and 80,000 unit sold in country B. The consumer surplus in
country A would increase by $4.2 million to $8 million but decrease in country B by $0.9
million to $0.2 million. The profit of the manufacturer would fall by $1.5 million in country A
and by $0.9 million in country B. The total profits would be $7.5 million, compared to profits
of $9.9 million when price discrimination could be used.
The other option for the manufacturer would be to stick to the profit-maximising price of $45
per treatment in country A. As nobody in country B would be prepared to pay this price, sales
in that market would be foregone completely. But as the profit level of $7.7 million would be
upheld in country A, this would be the preferred option of any profit-maximising
manufacturer. As the example shows parallel trade could result in some markets not being
supplied at all, because their maximum willingness to pay is inferior to profit-maximising
price levels in other more important markets (Maskus, 2001).
2.3 Costs and Pricing in Research-intensive Industries The evolution from an economy based on manufacturing into a more knowledge-based
economy has put new challenges to the field of economics. A faster pace of technological
development has lead to costs for R& D of new products making up an increasing share of
total costs. Economic theory states that the marginal benefit of the customer should be equal
to the marginal cost of the producer for a fully efficient, or “first best”, outcome.
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As Danzon & Towse (2003) state large R&D spending complicate pricing for several reasons.
The main reason for this is the introduction of a dynamic dimension into a normally static
perspective. Equating marginal benefits and marginal cost for effectiveness still holds but it is
also necessary that sunk cost of R&D are recovered to provide continued incentives for R&D
spending. The latter requires that a mark-up is added upon marginal cost in pricing. The first-
best solution in this case, would be to award new innovations with a fixed lump-sum transfer
and then distribute the new drug at a price equal to marginal cost (Maskus, 2001). This is of
course very difficult to arrange practically and efforts have therefore been concentrated to
finding a second-best outcome.
As Chard & Mellor (1989) points out the role of property rights, and intellectual property
rights in particular, can be said to be to maintain or extend the ability of market forces
towards their most valuable use. In the case of the pharmaceutical industry it could be argued
that patent rights are economically efficient as they direct surplus value from drug sales to
R&D activities at innovator firms rather than to monopolistic profits for “copy-cat”
producers. One could argue that the loss of consumer surplus could be weighed up by the
development of new and/or better drugs.
Scholars in the field of intellectual property like Liebeler (1986) and Young (1986) point to
the risk that “copy-cat” firms will free-ride on innovator and other firms investments in R&D,
branding and marketing and they therefore argues that parallel imports should be severely
restricted or completely banned. Such measures would encourage investments in innovation
and quality management of trademarks, which would be beneficial also to customers as it
decreases their search costs.
The way chosen out of this quandary has traditionally been the granting of patents to protect
innovative companies from “copy-cat” companies free-riding on their R&D. Patents are
barriers to entry that give companies a monopoly for a product during a limited period of
time. This enables them to set prices above marginal cost and recover their R&D spending.
This is of course not fully efficient as consumers are withheld consumption even though their
marginal benefit exceeds marginal cost. But patent protection is still viewed by most
economists as being the best practical approach to funding R&D.
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Danzon & Towse (2003) puts the conditions of pharmaceutical pricing algebraically as
follows. For R&D costs to be covered following conditions need to be fulfilled;
Pj≥ MCj and ∑(Pj – MCj) ≥ F
Where Pj is the price in a market j, MCj is the marginal cost of providing market j, this could
be cost of transporting, packaging etc. The second term expresses that the combined revenue
must both cover the marginal cost of the market and joint costs of R&D, including a normal,
risk-adjusted rate of return on capital (F).
Normally competition from therapeutic substitutes constrains the market power of
pharmaceuticals products. But, as Lu & Comanor (1998) point out and which I will return to
later in section 5.3 some products have so unique qualities that they leave companies virtually
unrestrained in there pricing abilities. This has led to accusations of exorbitant pricing against
pharmaceutical companies and motivated governments to impose price controls and other
regulation to guarantee “affordable” prices of vital pharmaceuticals.
For a monopolist the choice is between charging price-insensitive customers up to their ability
to pay or to expand sales to more price-sensitive customers. The sole solution to this dilemma
is price discrimination, as described in section 2.2. This is often difficult to exercise in an
individual country, as it is hard to separate different customer groups. But the possibility to
price discriminate between geographical markets is larger. As the geographical distance and
patent and license rules separate customer groups companies can set prices without having to
create artificial barriers between groups to prevent trading. Consequently they will be able to
reap all the potential revenue in high-income market by selling at a high price and at the same
time cater to more price-sensitive consumers in other markets by offering lower prices. The
effects of price discrimination are therefore harmful for price-insensitive consumers and
beneficial for producers and price-sensitive consumers. But as section 2.2 showed, the overall
effects of price discrimination on welfare should be positive.
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2.4 Ramsey Pricing
The problem of recovering joint sunk costs across different markets in an efficient way was
addressed by the British economist Frank Ramsey in the 1920s. The mainstay of Ramsey’s
theory is linking prices to the price-sensitivity of consumers or in other words the price-
elasticity of the market. Ramsey pricing is therefore based on both price discrimination and
monopoly pricing. The difference is that while the latter choices of action aim to maximise
the producer surplus Ramsey pricing aims at maximising the total amount of welfare. As
previously mentioned it is economically efficient to provide a customer with a good as long as
she or he is prepared to pay a price exceeding the marginal cost. But to recover sunk costs it is
necessary to have a mark-up i.e. set prices above marginal cost. But if the mark-up is too high
price-sensitive users will drop out of the market, even though they might be prepared to pay a
price above marginal cost and hence contribute to paying the joint sunk costs. This would
entail a loss of welfare or a so called dead-weight loss. This effect is also valid for more price-
insensitive consumers also but to a lesser degree and consequently with smaller dead-weight
losses.
Ramsey showed that the dead-weight losses can be minimised by charging price-insensitive
consumers a high price and more price-sensitive consumers a lower price. In an economist
prose this means that prices will be set higher in markets were the price elasticity is low and
vice versa. The economic theory Ramsey developed is known as inverse elasticity pricing or
simply Ramsey pricing (Danzon, 1998).
Making estimates of the demand elasticities of a market is a difficult task. As medicines or
other pharmaceuticals are often necessary for the survival or the well-being of the consumer,
their demand are normally less dependent of price than other goods, i.e. the demand is often
inelastic. However, in poorer countries where disposable income is limited the demand for
pharmaceuticals is often more elastic. People simply cannot afford medicines regardless of
their need of them (Danzon, 1998). Hence, Ramsey pricing would mean that prices for
pharmaceuticals will be set low in poor countries and higher in richer countries. This
coincides with widely held concepts of fairness by providing consumers in low-income
countries with access to medicines at lower prices than those charged in richer countries.
Ramsey pricing is therefore held out by scholars like Danzon and Maskus as a way to
reconcile the conflicting interests of medicines at affordable prices and incentives for R&D.
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This might appear to be an ideal solution to the issue of distributing the cost of R&D
spending. Unfortunately it doesn’t coincide with the short-term interest of individual
countries. Countries will have an incentive to shirk the costs of R&D and “free ride” on the
R&D expenditure of other countries. This can be done by using the monopsony power of
government purchasing agencies to force down pharmaceutical prices. As long as the price
offered exceeds the marginal cost it is rational for a pharmaceutical company to supply a
buyer. But if total revenue doesn’t cover the sunk costs of R&D pharmaceutical companies
will lose their incentive to engage in R&D. If the cost shirking occurs in a small market the
effect might be marginal, but with parallel trading the effects of this kind of “free-riding” can
spread to other, and possibly more important, markets (Danzon, 1998).
2.5 Conclusions I hope this section will have enlightened, or maybe refreshed, the reader’s knowledge of
monopolistic pricing models and price discrimination. As was stated above sunk costs
complicate economic theory in several ways. The clear-cut arguments of the virtues of trade
and pricing at marginal costs are no longer valid when it comes to products which require
large sunk costs. Historically the creation of monopolies by awarding exclusive rights to
innovators has been the way chosen to guarantee returns on R&D spending. But as we saw in
section 2.1 monopoly pricing entails dead-weight losses. As was shown in section 2.4 Ramsey
pricing can according to theory be used to minimise the dead-weight losses of monopoly
pricing, but it requires that markets are adequately separated. In section 5.3 I will present
some empirical evidence on how pharmaceutical companies set prices across markets.
3. Industrial Location Theory: From Adam Smith to Cluster Theory
The subject of the most economically efficient location of an industry has been a central part
of classic economic theory since the days of Adam Smith. Smith’s theory of absolute
advantages stated that an industry should ideally be located where the costs of resources such
as manpower are the lowest. Ricardo developed Smith’s thoughts by adding that it is the local
production costs relative to the production of other goods that matter. The most efficient
location of production for a given good would be determined by the relative prices demanded
by the different parties when trading. Eli Heckscher and Bertil Ohlin gave further substance to
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this theoretical line in their model of international trade. But industrial location theory was
established as a discipline of economics by the works of Alfred Weber in the early 20th
century. Weber highlighted the transport costs of resources and finished products as a vital
factor in the choice of location. The shift in the industrialised countries from labour- and
capital-intensive industry to more knowledge-intensive industries during the second half of
the 20th century has also shifted the focus of academics in industrial location theory. Modern
academic work has in particular concentrated on the phenomena of agglomeration, also
known as “clustering”, which is common in knowledge-intensive industries. This phenomena
is caused by economies of scale external to the individual firm. These can exist in the form of
labour pooling, i.e. a concentration of skilled labour demanded and attracted by an
agglomeration of companies in a certain industry. This can also occur for subcontractors and
other auxiliary services crucial to the industry. Other scholars emphasise socio-cultural
reasons for agglomeration, such as the creation of an dynamic environment of knowledge and
innovation. Regardless of its causes the phenomena of agglomeration leads to what Gunnar
Myrdal pointed out in 1958 “Within broad limits the power of attraction today of a centre has
its origin mainly in the historical accident that something once started there, and not in a
number of places were it equally well or better have started, and that the start met with
success”(Dicken, 1996). The phenomena of strong economics of scale working in a self-
reinforcing loop is known in economics as a “First-mover Advantage” (Bannock, Baxter &
Davis, 1998, , Krugman & Obstfeld, 2000). It has a strong conserving effect that makes it
difficult for new players to get a foothold and establish themselves in a mature industry.
4. Economic Theory on the Causes and Effects of Parallel Trade
In this section I will attempt to summarise what economic theory states as the reasons for and
effects of parallel trade. I will commence by citing some reasons for international price
differentials between pharmaceuticals markets as they give opportunities for arbitrage trading.
Then I will give an account of the case that a group of scholars led by Danzon has made that
parallel trade has negative effects both on the access to affordable drugs in developing
countries and on the incentives for R&D spending. They therefore call for a ban on parallel
trade in pharmaceuticals. To counter this claim I will subsequently present some views that
hold parallel trade as an important function in combating collusive behaviour in monopolistic
markets. Finally I will give an account for the transport and other costs of parallel trade.
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4.1 Causes of Parallel Trade: Reasons Behind International Price Differentials
Parallel trade is like all kinds of trade basically an arbitrage between two markets. For trade to
come about and be profitable it is necessary that prices differ between the two markets.
Parallel trade in itself is a proof of international price differentials in pharmaceuticals. But
what causes these price differentials? Bale (1998) lists the following reasons for real price
differentials between countries;
• Differences in patent duration. The expiry of a patent normally entails increased price
pressure due to the entry of generic substitutes. If a product goes off-patent earlier in one
country than in others, competition may force the price of the product to fall in relation to
corresponding prices in other countries. This opens up an opportunity for parallel trading.
• Differences in inflation and/or exchange rates may lead to diverging real
prices of products, as prices are generally relatively inflexible or “sticky”. Wholesalers or
retailers may choose to keep prices unchanged despite currency fluctuations to, for
example increase profit margins or, conversely, maintain their customer base.
• Differences in prices attributable to national price regulation. I will return to this in section
5.2.2.
• Differences in per capita income and consumption preferences mean differences in
demand and prices between countries.
• Pharmaceutical companies may chose to set prices differently as part of a marketing
strategy.
• Pharmaceutical companies may chose to offer discounts or donations to less developed
countries through agreements with governments, UN institutions or private volunteer
organisations.
4.2 Effects of Parallel Trade As I mentioned in the introduction parallel trade is hard to measure as it isn’t separated from
licensed imports when trade statistics are kept. This is probably also a reason behind the fact
that the academic literature on parallel trade is relatively meagre and dominated by a few
scholars. A possible reason for this could be that it might be hard to question a set of views
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established by leading scholars without having some kind of empirical backing. Danzon
(1998) has made the following analysis of the causes and effects of parallel trade.
Trade is enabled by the possibility of buying an article abroad and having it transported to you
at a total cost lower than the price charged in the domestic market. In this way trade normally
leads to inefficient producers pricing themselves out of the market and therefore improves
overall efficiency. This has been the foundation of trade theory since the days of Ricardo.
However, a requisite for this to hold is that prices reflect true costs. In Danzon (1998),
Danzon & Towse (2003), Ganslandt & Maskus (2001) and Maskus (2001) it is argued that the
lower prices of pharmaceuticals in general reflect more aggressive regulation rather than
efficiency in production, lack of patent protection or price discriminating by drug
manufacturers because of lower per capita income. Danzon (1998) therefore argues that
parallel trade in pharmaceuticals doesn’t yield the normal efficiency gains attributed to trade.
Instead it dissolves the segmentation of markets that price discrimination and Ramsey pricing
are build upon and lead to prices converging between high and low income markets. In
response to losing market shares to parallel traders, manufacturers will raise prices in low-
income markets and lower prices in high-income markets to make parallel trade unprofitable.
Even a small amount of parallel trade can lead to a large shift in price if a manufacturer
decides to set a significantly lower price in order to deter additional parallel trade (Danzon
1998).
When it comes to consumers in the low-income market, they will lose welfare as they will
face higher prices. A number of them will drop out of the market which will create the losses
of total welfare described in section 2.1 of monopoly pricing. Consumers in the high-income
market will benefit from cheaper prices of pharmaceuticals. But they will also have to bear an
increased burden of paying R&D as pharmaceutical companies will have lost revenue from
low-income markets and will be increasingly dependent on them for recovering the costs of
developing new drugs. As for producers, they will lose revenue as sales will drop in high-
income markets as customers turn to cheaper parallel imports instead. Increased sales in low-
income countries will only compensate these losses partially as prices are lower there.
One tactic the pharmaceutical industry might try to adopt to keep its revenue up is that of
‘market skimming’. This is one frequently used by firms in the high-tech industry. It consist
of launching a new product at a high-price to cater to the most price-insensitive clients and
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then successively lower prices in order to expand sales to more price-sensitive customers. A
pharmaceutical company might adopt this kind of tactic by delaying the introduction of drugs
in markets where they cannot sell at the price level that is profit maximising in other larger
markets. The threat of parallel trade could thus effectively leads to certain markets being
denied new drugs for an unknown period of time. But a more long-term solution to counter
parallel trade is to adopt uniform pricing. As was shown in the example in section 2.2 above
the distributive effect of uniform pricing would be to transfer welfare from consumers in
poorer countries to consumers in richer countries. Ultimately, as the example in section 2.2
showed it could lead to some markets not being supplied at all. According to Maskus (2001)
small, least-developed countries would almost certainly not be served by pharmaceutical
companies in the case of a global uniform price of certain products. Danzon (1998) reaches
the same conclusion. But uniform pricing will also reduce revenue for producers. The
reduction in expected revenue for new pharmaceutical products will mean less incentives for
them to spend money on R&D. Hence some medicines may not be developed that consumers
would have been willing to pay for had differential pricing been possible. Thus Danzon
(1998) concludes that in the long run also consumers in high-price countries will be worse off.
Although Danzon’s theoretical analysis may appear to be infallible a crucial requisite for it to
hold is that pharmaceutical companies would actually use Ramsey pricing if markets were
adequately segmented from each other. Other scholars like Malueg & Schwartz (1994),
Maskus (2001) and Scherer & Watal (2001) also give support for the case that pharmaceutical
companies would use price discrimination if it was possible. This would, in general, lead to
higher prices than under uniform pricing for consumers in large markets with inelastic
demand and the opposite in smaller markets with elastic demand, that is consumers would
face lower-than-uniform prices. But one should keep in mind that pharmaceutical firms have
no incentive to adopt Ramsey pricing if they can earn higher profits by raising prices further,
as Maskus (2001) points out. According to Danzon & Towse (2003) profit-maximising
pricing structures are so similar to the welfare maximising Ramsey pricing structures that the
outcomes should be similar. But this is not undisputed as we will see in the next section.
Moreover, in some countries government agencies account for a large part of purchased
volumes. As I describe in section 5.2 they are likely to use their monopsony power to bargain
for prices, and ignore the negative externalities this would have on R&D spending. As long as
the price offered exceeds marginal cost a pharmaceutical firm would be rational to accept the
16
offered price (Maskus 2001). These are two reasons that prices might differ from Ramsey
prices. I will present some others later in section 5.4.
4.3 Parallel Trade as a Mean to Fight Collusive Behaviour in a Market Import barriers are often used to reduce competition in a market: Often, it is the “Infant
Industry”-argument that is claimed, that a newly-started industry needs temporary protection
from established foreign competitors in order to give it time to become efficient. But it has
proved difficult to remove these import barriers once they have been put in place. Either the
industry in question never becomes efficient enough to compete on equal terms or they
fiercely protect the fat margins they make under protection by applying pressure on or even
bribing the public officials in charge of trade policy. The country would then be stuck in a
situation where consumers lose welfare by paying unnecessarily high prices for certain goods
(Krugman & Obstfeld, 2000). A ban on parallel imports could in a similar way be used to
increase the market power of certain actors. Abbott (1998) takes the example of the Australian
book market where foreign book publishers took advantage of restrictions on parallel trade to
charge significantly higher prices for books exported to the Australian market compared with
books exported to other markets. According to Abbot (1998) parallel imports are often an
effective policing function on abusive price setting of patent products. Maskus (2001) also
highlights the risk for colluding behaviour as a result of trade barrier, e.g. a ban on parallel
imports of pharmaceuticals. This could weaken price competition in pharmaceutical products
and might lead to that efficiency gains might be lost. Many developing countries are therefore
concerned that restricting parallel trade would invite collusive behaviour and abusive price
setting in their markets by foreign companies (Abbot, 1998 & Maskus, 2001). They thereby
completely dismiss the case of Danzon and other scholars, who claim that developing
countries have everything to lose from parallel trade.
In contrast, academics specialised in intellectual property like Chard & Mellor (1989) claim
that restrictions on parallel trade might be pro-competitive if they encourage investment in
inter-brand competition and through providing incentives to build markets. They base their
analysis on the view that parallel trade is a way to free ride on the official licensees’
investment in building up a local market through quality branding, advertising, discounting
and by providing post-sale services (Chard & Mellor, 1989, Liebeler, 1986, Maskus, 2001 and
Young, 1986). If parallel trade weakens the incentives for these kind of efforts it could be
claimed that parallel trade leads to efficiency losses. Unfortunately there are no available data
17
or empirical studies that may be used to determine the effects of parallel imports free-riding
on the marketing efforts of authorised distributors (Maskus, 2001).
4.4 Costs of Parallel Trade As Maskus (2001) points out transport, repackaging and administrative costs of parallel
trading are essentially non-productive activities and mean a loss of welfare. If as we assume
pharmaceuticals are produced in the high income markets and then exported to low-income
markets only to be re-imported back in to the high-income markets, as the case was in
Danzon‘s scenario, there will be no efficiency gains from the trade. On the contrary the
transport costs and administrative handling of parallel traded drugs will be an economic waste
that will reduce total welfare. From a welfare perspective it is therefore worth noting that a
price reduction caused by potential competition from parallel importers would be more
efficient than actual competition as no real resources would be spent on transport,
repackaging and other administrative costs connected with parallel trading (Ganslandt &
Maskus, 2004).
4.5 Theoretical Conclusions on Parallel Trade I hope this section will have informed the reader on the main current of academic literature on
parallel trade, which is that of Danzon et al. According to them parallel trade undermines the
market segmentation that makes price discrimination such as Ramsey pricing possible. But as
we saw it is not undisputed that segmented markets will lead to a Ramsey-pricing structure. In
the coming sections I will examine how the different theoretical lines of argument correspond
with real circumstances.
5. Empirical Evidence.
In this chapter I will at first, in section 5.1, present some essential facts of the pharmaceutical
industry such as location, costs and spending on R&D. In section 5.2 I will describe how the
pharmaceutical market functions; what strategies manufacturers use when launching new
drugs, the incidence of regulation in pharmaceutical markets and the purchasing behaviour of
large players. In section 5.3 I will turn to the international markets and examine
pharmaceuticals price differentials across countries. As we’ll see the correlation between
pharmaceutical price levels and per capita income is far from perfect. In section 5.4 I will
18
account for some reasons for the deviations between pharmaceutical price levels and per
capita income.
5. 1 The Pharmaceutical Industry
5.1.1 The Location of the Pharmaceutical Industry
This section builds in much on the industrial location theory presented in section 3. It might
be of use to separate the location of production and the location of research and development
(R&D) as they are dependent of different factors for their cost-effectiveness. However it is
common in the pharmaceutical industry to keep production and R&D together as mutual
learning can give opportunities for improvements in both production and R&D. Therefore I
will treat the two as one collected unit. The pharmaceutical industry can be seen as
independent of transport cost as both its inputs and finished goods have an extremely high
value to weight ratio. It has therefore no need to be located close to the source of any
materials used in the production as transportation costs are negligible. This is equally true for
transporting the finished goods to the market but there are other reasons for choosing to locate
close to potential or existing markets. The development of new medicines and chemical
entities is often pursued in close interaction with their intended consumers. This gives
opportunities to draw expertise from the treatment and observation of patients suffering from
illnesses that new drugs are intended to treat. Pharmaceutical products at an advanced stage of
development are tested on patients, so called phase-II clinical testing, before launched on the
market (Schweitzer, 1997). It is therefore often crucial for a pharmaceutical company to be
located close to a critical mass of people suffering from the illness the company is hoping to
provide a treatment for with its products. For reasons of profitability it is also crucial that the
intended consumers have the means to pay for new drugs. This is the reason why much of
R&D spending is allocated to treat life-style diseases as obesity and high cholesterol levels
rather than far more mortal illnesses like malaria and AIDS. Hence, it follows that the
pharmaceutical industry will be prone to locate in countries were consumers have the ability
to pay for pharmaceutical treatment.
As the pharmaceutical industry is intensive in high-skilled labour it is prone to locate close to
universities and other research facilities specialised in medicine, biology and other fields
relevant to the industry. As a knowledge-based and innovative industry there should also be
considerable external economies of scale to take advantage of by choosing to locate at an
19
agglomeration of other pharmaceutical companies and, publicly or privately-funded, research
facilities (Schweitzer 1997). This ought to lead to the risk that Myrdal pointed out, that the
location of the industry might be decided by historical rather than present condition. It is
therefore not surprising that the pharmaceutical industry is concentrated to a few regions in
the richer countries. It is at these places that the joint global sunk costs of R&D are spent and
to where the revenue of pharmaceutical are collected. It is of course possible to recuperate the
sunk costs of R&D in the home market, provided it is large enough. But to renounce revenue
from buyers abroad prepared to pay a price above marginal cost would be contrary to profit-
maximising, which is the raison d’être of private companies. The absolute majority of all
pharmaceuticals are therefore sold in several markets. The marketing of products in different
countries can give the company the opportunity to price discriminate as shown in section 2.2.
5.1.2 Costs of the Pharmaceutical Industry
As I stated earlier the greater part of the costs of the pharmaceutical industry are those of
R&D spending. The Pharmaceutical Industry spends a higher percentage of sales on R&D
than most industries – roughly 21% of sales compared to less than 4% for US industry overall.
It is estimated that the average cost of developing a new drug in the US or the EU is estimated
to be between approximately $300 million and $500 million but that it in some cases can be
substantially higher (Danzon, 1998). These large costs mean that a pharmaceutical company
needs to be of a certain size to shoulder the costs of developing new products. In addition, a
pharmaceutical company needs to spread risks across a number of research projects, as most
projects don’t generate any profits. Danzon & Towse (2003) refer to evidence that new
chemical entities launched during the 1980s and 1990s earned at most modest excess returns
on average. But this hides the real circumstances, that highly profitable blockbuster products
served to cover for the 70 per cent of new drugs that failed to generate sufficient global
revenue to cover the average cost of R&D. The additional cost of covering for failed products
and research projects has therefore to be included in the costs for R&D (Danzon, 1998).
While the majority of costs are spent on R&D, marginal costs such as processing, packaging,
promotion and distribution also account for roughly 30% of total cost. Marginal cost pricing
would therefore increase distribution considerably, but incur large losses for innovative
pharmaceutical companies.
20
5.1.3 Profits of the Pharmaceutical Industry
Danzon (1998) states that the high share of R&D costs overstates the profits of the
pharmaceutical industry relative other industries. The reason for this is that R&D is treated as
an expense rather than as a capital investment in accounting statements. Accounting measures
of capital are therefore downward biased which leads to the return on capital being upward
biased. According to Danzon “This bias fuels the perception that the pharmaceutical industry
earns abnormally high profits, which in turn leads to pressure for lower prices”. In a model
constructed by Clarkson it is shown that if accounting rates of return are adjusted for
intangible capital the profits of the pharmaceutical industry are in line with those of other
industries (Clarkson, 1996). Danzon & Towse (2003) also state that there is evidence that the
entry of new actors in response to expected profits assure that profits are bid down to normal
levels and price mark-ups over marginal cost should correspond to Ramsey pricing levels. If
this is true it would mean that the difference between welfare maximising Ramsey pricing
structures and profit maximising pricing diminish.
5.2 The Pharmaceutical Market
5.2.1 Pricing Strategies for Pharmaceutical Products
For some illnesses and ailments there are a range of different pharmaceutical treatments with
varying levels of effectiveness. But if a product has unique qualities for treating an illness, the
demand elasticity is usually low as there are no real substitutes. This gives the company
concerned a high degree of freedom to set the price of the product. Lu & Comanor (1998)
investigated pricing strategies of pharmaceutical companies in the US and found that they
depended on the therapeutic value of the launched product. If the product possesses
significant therapeutic gains compared to available substitutes pharmaceutical companies tend
to opt for the ‘market skimming’ tactics described earlier in section 2.4 and set a high launch
price which is gradually reduced later. If the product has a similar therapeutic effect as other
available products companies tend to use a ‘market penetration’ tactic and set a low launch
price to gain market shares and then subsequently raise the price. Other studies confirm the
21
fact that the presence of competing products bring far lower prices than clear monopolies
(Maskus, 2001). In an international perspective, a company that possesses some amount of
market power will try to set a profit-maximising price in each individual market it has sales
operations in. But if there is arbitrage trading between markets the company will try to find a
set of prices that will maximise total profits.
5.2.2 Regulation and Purchasing Strategies in Pharmaceutical Markets
Effects of Price Controls and Government Purchasing Agencies
In many countries the price of pharmaceutical products are affected by government policies.
In the majority of high- and middle income countries it is a national health policy to assure
that access to health care is provided to citizens without regard to their ability to pay. This
usually includes measures to provide pharmaceuticals at “affordable” prices. In some
countries, such as Greece, India, Italy, Spain and others the pharmaceutical market is subject
to direct price controls (Lanjouw, 1998 and Maskus, 2001). In other countries governments
run social insurance programmes where pharmaceutical products are purchased en bloc by a
governmental agency to be re-sold to consumers via pharmacies. Sweden is such an example.
As the sole purchaser in the market the government insurer will have considerable monopsony
power which gives it the ability to put pressure on producers to lower prices. With health care
being a substantial post in many countries’ budgets health policy becomes a part of fiscal
policy, as Danzon (1998) remarks. With increasing pressure to decrease taxes and cut
government spending the incentive to demand lower prices from pharmaceutical companies
increases. This corresponds well with the cost shirking behaviour described in section 2.3.
Such a way of action might appear to government officials to be a “free lunch” but it might
actually be closer to a “tragedy of the commons” where all actors are keen on reaping the
benefits of new pharmaceutical products but nobody wants to foot the bill of R&D.
External Referencing One way to bargain down prices on pharmaceuticals is to use external referencing. With
external referencing, or reference pricing, is meant the practice by government purchasers or
other monopsony buyers of demanding price cuts by referring to lower prices in other
22
countries. The line of argument commonly used is to accuse a pharmaceutical firm of
overcharging because they sell the drug in question at a lower price in another country. But
the reason for this might be that the company has set prices according to the elasticity of
demand or per capita income of each market. But this counter-argument might be disregarded
by a negotiator less interested in upholding incentives for R&D spending than limiting their
own health care expenditure. External referencing is used formally in regulating
pharmaceutical prices in several countries, e.g. the Netherlands, Canada, Greece and Italy. In
other countries, the US for instance, external referencing is used more informally as an
argument by purchasers when bargaining prices with pharmaceutical manufacturers (Danzon
& Towse, 2003). As Danzon (1998) states reducing pharmaceutical prices by external
referencing is equivalent to 100% parallel trade.
5.3 Evidence of Pharmaceutical Prices in International Markets
As Danzon & Kim (1998), Lanjouw (1998) and other remark, comparing pharmaceutical
prices is a difficult task, especially between countries. Differences in brand name, product
forms, concentrations and pack sizes make it difficult to find an adequate amount of precise
drug products that exist across several countries. The existence of therapeutic substitutes of
different degree also blur the lines when it comes to defining specific products. Finally, as
original prices are quoted in local currencies, the choice of exchange rate at which to convert
the prices into a common unit can have a significant impact on the result (Maskus, 2001) But
all the same, such comparisons have been made by a number of scholars like Danzon & Kim
(1998), Danzon & Furukawa (2003), Maskus (2001) and others.
It would be reasonable to expect that pharmaceutical prices would in some way be correlated
with per capita income as it can be seen as a proxy for price-sensitivity. But several studies
show that trans-national price differentials quite often deviate from per capita income
(Danzon & Towse, 2003, Maskus, 2001). Hence it follows that, at a first glance,
pharmaceutical companies appear to follow a different logic than the one of Ramsey pricing
described in section 2.4 earlier. I will later account for some possible reasons behind the weak
link between pharmaceutical prices and per capita income.
Danzon & Furukawa (2003) compare pharmaceutical prices in nine countries ( Canada, Chile,
France, Germany, Italy, Japan, Mexico, UK and US) and find that prices are highest in Japan
23
followed by the US which corresponds well with the suppositions made in section 2.3 on
effective payment of R&D as these are two of the richest countries of the world. However,
they also find that prices in Chile and Mexico are comparable to prices in Canada and
European countries, despite their markedly lower level of per capita income. As a
consequence per capita consumption of the sample compounds of pharmaceuticals is also
significantly lower in Chile and Mexico, reflecting that these drugs are unaffordable to most
people. As described in section 2.2, it is reasonable to assume that a large number of
consumers in these countries would be prepared to pay a price equivalent of the marginal cost
and a minor mark-up for these drugs. The outcome of high prices in Mexico and Chile is
therefore a considerable loss of welfare, both for Chileans and Mexicans who are withheld
consumption and for consumers elsewhere who have to carry an unnecessarily high burden of
the joint costs of R&D. Other studies, like Maskus (2001), Maskus & Ganslandt (2001) and
Scherer & Watal (2001) find a similarly weak link between per capita income and
pharmaceutical prices in many countries. Maskus (2001) even finds a negative correlation
between income level and the prices of some pharmaceuticals. But in general, as Danzon &
Kim (1998), Danzon & Furukawa (2003) and Maskus (2001) find, the correlation between
average pharmaceutical price level and per capita GNP is clearly positive, although well-
below unity.
5.4 Reasons for discrepancies between pharmaceutical prices and per capita income level
There are several factors that could explain the weak relationship between per capita income
and prices. Firstly, regulators in richer countries may use their monopsony power to force
down prices. One way this can be done is by using external referencing as described above,
and refer to a country where pharmaceutical prices are lower, which could be because the
country has a lower per capita income level. Apart from the direct effect on prices in high-
income countries, external referencing also has a secondary effect of manufacturers charging
higher prices in low-income countries to pre-empt external referencing.
Another reason that pharmaceutical prices deviate from per capita income levels is that
distribution systems in low-income countries are often concentrated or monopolistic. Corrupt
or badly-functioning public administrations might lead to that a single or only a few
wholesalers are given the legal rights to import certain pharmaceuticals. Consequently, these
24
wholesalers will be free to use their monopoly power to maximise profits by setting a price
with a large mark-up (Maskus 2001).
The use of monopoly power is especially damaging in low-income markets that are internally
segmented between a small elite with western living standards and an impoverished mass
population. While the former might be able to pay the same prices for pharmaceuticals as
consumers in high-income countries, the latter often have to make hard choices between the
different necessities of life. The market demand curve of pharmaceuticals will then be
“kinked” between a low-volume, inelastic segment and a high-volume elastic segment. In this
case it can often be the most profitable option for a pharmaceutical company with some
degree of market power to supply the inelastic segment at a large mark-up and thereby forego
the elastic segment altogether. The difficulty of segmenting consumers with different degrees
of price sensitivity within a geographically integrated market often leads to poorer consumers
not being supplied, which is economically inefficient as shown in section 2.2. A visible
indication, that so might be the case is that pharmaceutical price levels in some low-income
countries are similar to those in high-income markets (Danzon & Towse, 2003,Ganslandt &
Maskus, 2001 and Scherer & Watal, 2001). In a report by a joint committee of the WHO-
WTO (2002) it is stated that in many low-income markets pharmaceutical companies
concentrate on selling to the affluent middle class.
5.5 Conclusions on International Price Differentials and the Opportunities for Parallel Trade As we have seen from the sections above pharmaceutical markets do seldom fit the model of
perfectly competitive markets shown in economic textbooks. Firstly, some drugs possess a
certain market power due to unique qualities or brand-names. This indicates the market could
be describes as monopolistic competition. Secondly, price regulation and monopsony
tendencies among buyers push the markets further away from perfect competition. To
determine the likely price level of pharmaceuticals in a country is therefore far more
complicated than just looking at per capita income. Still there are several studies that have
established the existence of a correlation between pharmaceutical prices and per capita
income level. But the link is far from unity and there are numerous exceptions. Some possible
reasons for these discrepancies from Ramsey-type price levels have been listed above. I will
25
later in section 7 present some initiatives aimed at creating an international framework that
would facilitate the use of Ramsey pricing. But I would like to conclude this section by stating
that it is evident that price differentials in pharmaceutical products exist between countries,
but that these price differentials are not always caused by differences in per capita income. It
follows that there are opportunities for parallel trade between countries, but not exclusively
exports from low-income countries to high-income countries. Trade in the reverse direction
could also be profitable, as well as trade within the two groups of countries.
6. Evidence on the Effects of Parallel Trade: EU and Sweden
In this section I will present a study of the effects the opening to parallel trade had on the
Swedish pharmaceutical market when Sweden joined the European Union in 1995. This
occasion provides an unique opportunity to examine the effects parallel trade has on prices. In
section 6.1 I will give an account of the view on parallel trade that has been dominant within
the EU-institutions. In section 6.2 I will make a summary of the findings of Ganslandt &
Maskus (2001 & 2004) who studied the effects of parallel trade on pharmaceutical prices in
the Swedish market. In section 6.3 I will relate the evidence of price convergence between the
source and target markets, in this case the Swedish and the Italian/Spanish markets
respectively. In section 6.4 I will give a short account of how pharmaceutical companies have
reacted to the flows of parallel trade between EU-markets.
6.1 The European Union The EU provides an interesting case when studying the effects of parallel trade in
pharmaceuticals as it is one of few areas of the world were trade in pharmaceutical goods is
unhindered. The European Court of Justice has consistently upheld the view that, under article
30 of the Treaty of Rome, free circulation of goods takes precedence over patent rights in
individual countries of the European Union. This was definitely stated in the test case of
Merck v. Primecrown in 1996 (Danzon, 1998, Maskus, 2001 & Maskus & Ganslandt, 2004).
This gives considerable room for parallel trading between the more rigorously regulated
southern countries, such as Greece, Italy and Spain and richer and less regularised markets
like Sweden, Germany and the UK where pharmaceutical prices are higher (Ganslandt &
Maskus 2004). In a report by the consultancy REMIT consultants, under contract to the
European Commission, it was found that parallel imports amounted to approximately two
26
percent of the prescription drug market in the EC overall in 1990, but reached higher levels in
individual countries. For instance 5-10 percent of the Dutch market and 8 percent of the
British market in pharmaceuticals was made up of parallel imported products. It should be
noted that products with large markets had considerably higher volumes of parallel imports,
which is consistent with the previously expressed fact that parallel importers target
“blockbuster” medicines (Maskus, 2001). Still parallel trade had far from eradicated intra-EU
price differentials in 1998, when a survey by the Swedish Medical Products Agency (SMPA)
showed that e.g. average prices in Greece were 28 percent below the EU-wide average and
that prices in Germany were 11 percent above average. A regression analysis made by the
SMPA confirmed that these price differences were statistically significant across countries
(Maskus, 2001). A reason for the persistence of price differentials between countries in EU’s
common market could be that price controls were still in place in some countries.
6.2 The Case of the Swedish Entry into the EU
Ganslandt & Maskus (2001) and Ganslandt & Maskus (2004) use the case of the Swedish
entry into the European Union to examine the effects of parallel trade. Before Sweden joined
the EU in 1995 parallel trade in pharmaceuticals was prohibited, but as an EU-member
Sweden was required to permit such trade. This opened up for imports from countries such as
Greece, Italy, Portugal and Spain where pharmaceutical prices were lower due to price
regulations using price caps and external referencing (Ganslandt & Maskus, 2001). The
sudden change of policy from total prohibition of parallel import to being part of a “single
market” makes Sweden an interesting case to study. No applications to import were filed in
1995, but by 1998 parallel imports of pharmaceuticals had grown to 1.0 billion SEK, which
corresponded to 6 percent of the Swedish pharmaceutical market. In the 50 highest-selling
molecules parallel imports amounted to 16 percent of sales, which gives further support to the
argument that parallel importers mainly target “blockbuster” drugs. Parallel imported drugs
were in average sold at a price equal to 89 percent of manufacturers’ prices in Sweden in
1998.
The source of the imports was to a large majority countries in southern Europe with Greece,
Italy or Spain being the source in 74 per cent of the cases. By making an econometric analysis
of pharmaceutical prices Ganslandt & Maskus (2004) found no statistically significant effect
27
during the initial years after the Swedish EU-accession in 1995. However data from 1997-
1998 showed that prices of pharmaceuticals facing competition from parallel imports fell 4
percent in relation to prices of other pharmaceuticals (Ganslandt & Maskus, 2004). By
comparing the price changes of the two categories of products with changes in manufacturers’
prices Ganslandt & Maskus (2001) could attribute 75 percent of the price fall to parallel
imports and the remaining effect to changes in manufacturers’ prices. The authors then
perform a regression analysis with the relative price change of a product as the dependent
variable and as explaining variables parallel imports’ percentage share of total sales of the
product (PI Share) and a dummy variable denoting the existence of an approval for parallel
imports of the given product (Approval). For the period 1997-98 the coefficient on PI Share
was –0.039 and was significantly negative at the one-percent level. This means that an
increase of one percent in the share of a product’s sales that came from parallel imports in
average reduced the average price increase by 3.9 percent. The coefficient of the dummy
variable of approval was –0.0125 and significant at the five percent level.(Ganslandt &
Maskus, 2001). The limited effect of parallel imports on prices could, according to Ganslandt
& Maskus (2001 & 2004), suggest that manufacturers have chosen to accommodate parallel
imports rather than to deter them by cutting prices to a level where parallel imports would be
unprofitable.
Ganslandt & Maskus (2004) estimate the effect of the entry of a parallel importer to be a
reduction of between 12 and 19 percent in the manufacturers’ prices of affected product. The
authors observed that the result suggested that drug manufacturers reacted to parallel imports
with a lag and that the fact that the growth of parallel imports seemed to be accelerating at the
end of the sample indicated that the available data presumably didn’t reflect a long-term
equilibrium. Ganslandt & Maskus (2004) conclusion is that parallel imports represent a
significant form of competition in markets such as Sweden, and as such have a moderating
effect on prices.
6.3 Evidence of Price Convergence Between Markets
Ganslandt & Maskus (2001) then continues by studying the effect of parallel trading on
prices in source countries. According to theory the demand from parallel traders should lead
to price increases in source markets. In addition, a logical reaction from manufacturers would
28
be to raise prices in the source countries in order to protect total revenue. Ganslandt &
Maskus compare the prices of pharmaceuticals in Italy and Spain in relation to prices in the
Swedish market at two occasions, in 1994 and in 1998. They then made a regression of the
relative price changes with a dummy variable indicating if there were parallel imports of the
product or not. The fact that the estimated coefficient of 0.018 was small and not statistically
significant could be seen as an indication that parallel imports have not lead to any price
convergence of importance. As a consequence, pharmaceutical prices in Italy and Spain still
only amounted to, on average, 68 percent of prices in Sweden in 1998 (Ganslandt & Maskus,
2001).
A possible reason for this could be that the differences in size of the Italian, Spanish and
Swedish market, which entails that traded volumes should have a larger impact in the Swedish
market than in the Italian and Spanish markets. But as I mentioned in section 4.2 there is no
clear link between the volume of parallel exports/imports and the impact on prices. Another
possible reason, could be the fact that just four firms accounted for 96 percent of parallel
imports in 1998. The lack of price convergence could therefore be attributed to the lack of
competition among parallel importers.
As readers may conclude by themselves, if parallel trade has not led to any price convergence
remaining price differentials should equal the rents of parallel traders minus the costs
incurred. In 1998, parallel imports were, on average, sold at a price of 89 percent of
manufacturers’ prices in Sweden. As it was stated above that pharmaceuticals in Italy and
Spain were sold at a price averaging 68 percent of corresponding prices in Sweden in 1998.
This leaves an average margin of approximately 21 percent for parallel traders. But the
reported margins in different products ranged from 9 to 39 percent. It should be fair to assume
that these margins exceed the transport and administrative costs of parallel trade. It may also
be fair to assume that the high margins of parallel traders should attract new entrants to the
industry, which would compress margins and, consequently, pharmaceutical prices between
countries.
Finally Ganslandt & Maskus (2001) try to establish what transfers of welfare parallel imports
have brought to Sweden. It is clear that pharmaceutical manufacturers have lost out through
falling prices. But the welfare gains, approximately 190 million SEK, to Swedish consumers
of cheaper pharmaceuticals seem to be off-set by a similar amount of rents paid to parallel
importers. Ganslandt & Maskus therefore draw the conclusion that the net static impact of
29
parallel imports on welfare in Sweden is negative, even without considering the dynamic
impact on R&D. But their is no detectable relationship between parallel imports and R&D
spending. In Italy, one of the main source markets of parallel imports in Europe R&D
performance languished during the 1990s, while Spain, another source country, experienced
an increase of roughly 80 percent in its R&D-to-sales ratio (Maskus, 2001) To further study
the effect of parallel trade on R&D Maskus (2001) propose an analysis linking the lagged
price impacts of parallel imports, product by product, with R&D expenditure of
pharmaceutical firms.
6.4 Reactions from the Pharmaceutical Industry Danzon (1998) states that the mounting parallel trade within the European Union has lead to
the pharmaceutical industry opting for the tactics of uniform pricing predicted in section 2.2
Several multinational companies now choose to launch new drugs across the EU at uniform
prices. In 1996 Merck launched its protease inhibitor Crixivan at a common EU price,
denominated in Ecu (the predecessor of the Euro). Another tactic used is that of ‘market
skimming’ described in section 4.4. Pharmaceutical companies have delayed the launch of
new drugs in traditional low-price markets in the EU, rather than accept prices that would
invite parallel trade that would erode revenues they can earn in other EU-markets. For
instance, Glaxo delayed the introduction in France of its antimigraine drug Imigran several
years, rather than accept a price that would have undercut higher prices elsewhere through
parallel trade (Danzon 1998).
6.5 Conclusions from Parallel Trade within the EU
The predictions from theory in chapter 4 have shown to be fairly consistent with what has
actually occurred within the European Union (Danzon, 1998). Parallel traders have put
pressure on prices in high-priced markets like Sweden. Although studies of the years 1994-98
show that the moderating effect of parallel imports on prices had been limited, the
acceleration in the impact of parallel imports toward the end of the time interval could imply
that the long-term effect of parallel imports are stronger. This reservation is also valid for the
absence of any significant price convergence between the Italian and Spanish market on one
hand, and the Swedish market on the other. This could be explained by several different
factors. Firstly the Italian and Spanish markets are larger than the Swedish which dilutes the
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effect of arbitrage on the former markets. Secondly price controls in the Italian and Spanish
markets could neutralise the effect of increased demand from parallel traders. Thirdly, the
effect on prices might have a time lag that runs beyond the period of time studied.
The strategies of market skimming and uniform pricing adopted by pharmaceutical companies
in response to parallel trade seem to be in line with what has been predicted in academic
literature. According to Reekie (2002) the regulated prices in some EU countries is the major
cause of parallel trade within the EU. So parallel trade should not offer the efficiency gains as
trade normally does. Reekie (2002) states that it is economically perverse to have differing
price regulations in an allegedly single market. This is something that I think most economists
would agree with. The root cause of this state of affairs is the division of competencies within
the European Union. Health policies, including the regulation of pharmaceuticals prices, are
seen to be of the exclusive competency of member states, while intra-EU trade is under the
reign of the EC-law and the institutions of the European Union. As the causes and solutions to
this state of affairs are political rather than economic, I will not further touch on this area in
this paper.
7. The Creation of a System of Differential pricing
As was mentioned previously in chapter 2 a system of differentiated prices could increase
total welfare and increase access to drugs for consumers in developing countries. I will
therefore in this section examine the possible effects and requirements of a system of
differential pricing. I will also make a short résumé of previous attempts to create a system of
differential pricing.
7.1 Effects on Prices and Welfare
As I have shown there are a lot of advantages of a system of differential pricing. It would be
beneficial for consumers in poor countries who would, in general, face lower prices.
Manufacturers would be able to increase their revenue by differentiating prices according to
demand elasticities in individual markets. The only group standing anything to lose is
consumers in high-income market as pharmaceutical prices might rise in these markets. As we
saw in chapter 6 parallel imports have a price-moderating effect on prices, although it wasn’t
substantial in the case of Sweden in the EU. In the absence of competition from parallel
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imports pharmaceutical companies will be freer to set higher prices if it would increase
profits. Similarly pharmaceutical companies can lower prices in low-income markets to
increase profits there without risking that the drugs will be re-exported to high-income
markets. It should be kept in mind that lower prices in low-income markets would not mean a
shifting of cost between markets. In other words, lower prices in low-income markets aren’t
something that has to be compensated by higher prices in high-income markets. On the
contrary, increased revenue from low-income markets would make pharmaceutical companies
less dependent on revenue from high-income markets. Theoretically they could then lower
prices in high-income markets and still make the same profits as before. But as profit-
maximising entities it is more likely that they opt for increased profits instead. But consumers
in high-income countries would benefit from this too as it would give pharmaceutical
companies increased incentives for R&D spending. This holds at least theoretically, as the
link between profits and increased R&D spending yet has to be established. In a joint report
from the World Health Organisation and the World Trade Organisation (2002) it is argued
that a system of differential pricing would reasonably not entail price increases in high-
income markets. At present a large part of the costs of R&D are already allocated to the high-
income markets of the industrialised countries as roughly two-thirds of the value of
pharmaceutical sales are spent in Japan, the US and Western Europe. Additional revenue from
third-world countries could, on the contrary, open up for lower prices in high-income markets.
7.2 Requirements The creation of a system of differential pricing would require the prevention of diversion of
low-priced products into high-income markets, which is a technical issue, and the readiness of
consumers in high-income markets to accept to pay higher prices than in poorer countries,
which is a political issue (Maskus, 2001). On the technical side, a system of differential
pricing would require measures to stop parallel trade. This could be import and export
controls implemented by customs authorities or stronger enforcement of intellectual property
rights by judicial authorities. But it is disputed among scholars whether or not market forces
would lead to a system of differential pricing if market segmentation was stopped. It can
therefore be necessary to request pharmaceutical companies to commit to providing medicines
at lower prices in low-income markets. Similarly, governments in high-income countries must
commit to not use external referencing to force down pharmaceutical prices in their home
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market(WHO-WTO, 2002). As was stated in section 5.3 external referencing is equivalent of
a 100% market share for parallel imports.
A system of differential pricing would , as mentioned, mean static losses for consumers in
high-income countries but as Danzon (1998) concludes they would still gain in the long run.
As Danzon & Towse (2003) points out it is required that high-income countries accept that
parallel trade and external referencing are incompatible with low-income countries getting
low prices of pharmaceuticals. This is something that will need to be thoroughly
communicated in high-income markets to avoid public opposition to differential pricing.
Government of countries where pharmaceutical prices are low would in turn have to ban
parallel exports, and thereby make it possible for manufacturers to continue to sell at low
prices without these prices spilling over to other markets through parallel trade (Danzon &
Towse, 2003).
7.3 Efforts to Create Systems of Differential Pricing
The European Commission Council Regulation, initiated in 2002, is an attempt to create a
regulatory framework which would allow a system of differential pricing of key
pharmaceuticals for the prevention, diagnosis and treatment of HIV/AIDS, tuberculosis and
malaria and related diseases frequent in poorer countries. Pharmaceutical companies were
asked to commit to supply low-income countries with medicines at a discount of 75% off the
calculated price. The exact prices offered by the companies are confidential, to prevent
external referencing, and only disclosed to the Commission in the application and in an annual
sales report. The current list of recipients consists of 76 countries, including China, India and
South Africa, from which re-importation into the EU is prohibited for both on-patent and
generic drugs. To facilitate for custom officials to discover attempted re-importation the
pharmaceutical products included in the program are marked with an EU-logo and have a
different colour, shape or size than the products sold in the EU Market (Danzon & Towse,
2003).
Investigations into putting into place a similar arrangement within the frames of the G8 group
was initiated by the UK government in co-operation with the pharmaceutical industry, WHO
and the EU. The initiative aimed to establish “an international framework that would facilitate
33
voluntary, widespread, sustainable and predictable differential pricing as the operational
norm”. The scope proposed included 63 developing or sub-Saharan (or both) countries.
One of the pitfalls of differential pricing is the reciprocal effect of linking prices in different
markets. A commitment by a pharmaceutical company to sell pharmaceuticals in low-income
countries at a 50% discount off prices in high-income countries could lead to higher prices in
the high-income market rather than the intended lower prices in the low-income market. If the
marginal effects on income are greater in the low-income market the company will raise
prices in high-income-countries to reach a profit-maximising price level in the low-income
market (Danzon & Towse, 2003).
8. Conclusions on the Effects of Price Discrimination and Parallel Trade
As we saw in chapter 4 economic theory presents a clear case of parallel trade being
beneficial to consumers in high-income markets but reducing the welfare of producers and
consumers in low-income countries as it impedes producers’ ability to price discriminate
between markets with different demand elasticities. A system of uniform pricing across the
world would severely limit pharmaceutical companies possibilities of recuperating R&D cost
while still serving low-income markets at an affordable price. In my research work for this
thesis I haven’t found a single scholar that rejects this theoretical case. However, as so often is
the case, real circumstances differ somewhat from the assumptions and predictions of
theoretical models. As was shown in chapter 5, pharmaceutical prices aren’t always correlated
with per capita income levels. As a consequence the flow of parallel trade would also differ
from the predictions of the theoretical model of Danzon and other advocates of a ban on
parallel trade. As mentioned in the introduction, parallel traded pharmaceuticals are not
separated from other pharmaceutical imports/exports when trade statistics are kept. This
makes it near impossible to clearly establish how actual parallel trade flows run. It follows
that the real-life effects on global welfare of parallel trade remain equally unclear.
However, the Ganslandt & Maskus study provides an interesting exception, which was why I
chose to include it as a case study in this thesis. It should be said that it is unclear to what
degree the findings of Ganslandt & Maskus study can be extra-polated to other areas of the
world. Ganslandt & Maskus (2001 & 2004) show that parallel trade does mean a shift of
welfare from producers to consumers, as Danzon et al predicted. However Ganslandt &
34
Maskus didn’t find any significant price convergence between the source and target market
due to parallel trade. This could, as mentioned, be down to differences in size of the markets
or the presence of price controls in the source markets. As a consequence, a large part of the
welfare lost by producers didn’t fall to consumers, but to parallel trading firms. To counter the
risk that the welfare gains that should fall to consumers are swallowed by the rents of parallel
traders Maskus (2001) advises that measures are taken to make competition as active as
possible if parallel trading is to be allowed. But excess profits should lead to new entrants and
the compression of margins and, consequently price differentials between markets.
8.1 Effect on prices in high-income markets
Despite the price-moderating effect parallel imports had on pharmaceutical prices in Sweden,
the main inference from Ganslandt & Maskus study was that substantial differences in
pharmaceuticals price levels remain in between EU-countries, despite the European Court of
Justice ruling on free movement of pharmaceutical goods (Maskus, 2001). It is probably
premature to say that this is a definite outcome as Ganslandt & Maskus make the reservation
that the study probably hadn’t established the long-term effects of parallel trade. A possible
reason for remaining price differences could be that consumers don’t fell entirely assured that
parallel imported pharmaceuticals are of the same quality as licensed products. The problems
of marketing parallel imported goods with different brand names and packaging could also be
impediments for full price integration. It is therefore reasonable to expect that original
license-holders will retain some measure of price premium even under a regime that permits
parallel trade. Notwithstanding parallel traders will surely seek opportunities to make profits
from arbitrage trading between different markets. In a free market the long-term effect should
be that producers will be limited in their price discrimination to the range of parallel traders’
costs of transport plus the price premium they can take out. But one should remember that the
effect on prices depends on if manufacturers and original licensees choose to accommodate
the inflow of parallel imports or to deter them by setting a price that would make parallel
imports unprofitable. The possibility of them opting for the latter has the consequence that
even relative amount of parallel trade can lead to significant price changes. The size of the
price moderating effect of parallel trade on can therefore be hard to predict as it doesn’t
necessarily have to be correlated with trade volumes (Maskus, 2001).
35
8.2 Effect on prices in Low-income markets
Danzon & Towse (2003) are of the view that ‘the breakdown of market separation and hence
manufacturers’ ability to price discriminate is probably the single most important obstacle to
lower prices in low-income countries’. Consumers in low-income markets would suffer from
higher prices and fewer new drugs due to less R&D as a consequence of parallel trade. There
is also a risk of them being withheld new drugs as a consequence of market skimming tactics
used by pharmaceutical companies. On the other hand, as Maskus (2001) points out, as price
evidence show that pharmaceuticals aren’t necessarily cheaper in low-income markets than in
high-income markets, parallel imports from foreign markets could also provide a source of
lower-cost drugs for developing countries. A ban on parallel trade could therefore possibly
lead to higher prices. As Abbott (1998) mentions, many developing countries are worried that
bans on parallel trade will lead to pharmaceutical companies colluding and thereby result in
excessively high prices. Maskus (2001) therefore suggests that parallel imports to low-income
markets should be allowed in order to allay these fears. The countries in question would have
to ban parallel exporting in order to assure that their access to low-price pharmaceuticals isn’t
abused by re-exporting them to high-income markets.
8.3 Effects on Research and Development
It is extremely difficult to estimate the effect of parallel imports on R&D incentives and the
development of new drugs, as Maskus (2001) points out. This is because of the unknown
impact of parallel imports on prices and the equally unknown link between profit levels and
R&D spending (Maskus, 2001). As was mentioned earlier, the theoretical line of argument
made by Danzon (1998), Bale (1998) et al may appear infallible but it should be kept in mind
that there are no available empirical studies that establishes the link between parallel imports
and prices or the link between profits of the pharmaceutical companies and their R&D
spending (Maskus, 2001). Another important aspect is that parallel trading is likely to
concentrate on economically successful, so called “Blockbuster”, drugs. These are usually
priced so that their revenue will cover also the incurred cost of other products and research
projects than fail to yield sufficient - or any - revenue. This entails that the impact on overall
36
profitability could be severe even when only a few products are subject to parallel imports
(Maskus, 2001).
8.4 Areas of Regional Parallel Trade A case can therefore be stated for allowing parallel trade among countries with similar
demand structures, but that parallel trading would be harmful between countries with different
demand patterns (Maskus 2001). Maskus (2001) also concludes that parallel imports are likely
to be beneficial in terms of total surplus generated among nations when trade costs are low
but harmful when they are high. A regime of regional exhaustion could therefore be the
optimal policy. A larger market would help discipline collusive behaviour within the region,
while the proximity would limit transportation costs. The possibility of creating a system of
differential pricing between regions with different levels of income would then still be
possible.
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International Economic Law, 1(4), December, 607-636
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Clarkson KW (1996), ’The effects of Research and promotion rates of return’ in ed. Helms, R
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Danzon, Patricia M. (1998), ‘Economics of Parallel Trade’, Pharmacoeconomics 13(3), 293-
303
Danzon, Patrica M. & Kim Jeong (1998) ‘ International Price Comparisons for
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Abstract: This thesis attempts to examine the academic debate on differential pricing and parallel trade in pharmaceuticals. The subject has great relevance as it concerns both the
access to medicine of citizens in developing countries with the incentives for research and development which now constitutes a vital part of our society. Many scholars, among them
Danzon and Maskus, champion the merits of a ban on parallel trade, as it would create opportunities for price discrimination between markets. A system of differentiated prices
inversely correlated to demand elasticities, so called Ramsey pricing, would be both economically efficient and correspond to widely held ideas of global equity. But as I
conclude, a ban on parallel trade alone would not guarantee the creation of a system of Ramsey-type prices as several discrepancies exist between the economic model and real
circumstances.
Keywords; differential pricing, parallel trade, pharmaceutical prices, price discrimination, R&D incentives. Ramsey pricing.