An Analysis of the Welfare Effects of Parallel Trade Freedom

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An Analysis of the Welfare Effects of Parallel
Trade Freedom

• Frank Müller-Langer
• International Max Planck Research School for
  Competition and Innovation, Munich

International Conference on Innovation,
Competitiveness and Growth, Institute of
Economics, Zagreb, November 27, 2008
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Agenda

• 1 Introduction
• 2 Double marginalization model with complete
  information
• 3 Welfare Analysis
• 4 Conclusion

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Parallel Trade (PT)?

• When does parallel trade actually occur?
• Why should we care about this issue?
• - WTO members are free to choose whether to
  allow or prohibit parallel trade (Art. 6 of
  TRIPS) - Restraints on parallel trade vary widely
  between developed and developing countries and
  even amongst developed countries
• - Advocates of strong patent rights for new
  pharmaceutical products support a global regime
  of banning parallel trade

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Questions to be Analyzed

• Why may parallel trade actually occur in
  equilibrium when information is complete?
• 2. Is parallel trade freedom beneficial or
  detrimental to the producer of a patented
  product?
• 3. Is parallel trade freedom beneficial or
  detrimental to global welfare?

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Agenda

• 1 Introduction
• 2 Double marginalization model with complete
  information
• 3 Welfare Analysis
• 4 Conclusion

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Assumptions

• Player 1 Monopolistic manufacturer of
  pharmaceuticals in country A
• Manufacturer has marginal costs of zero
• Player 2 Exclusive distributor in country B
• Players payoff functions their profits
• Demand in country A
• Demand in country B
• Parallel trade is allowed
• Distributor marginal costs of parallel trade,

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Structure of the Game

• First stage manufacturer chooses the wholesale
  price at which he sells the pharmaceutical
  product to the distributor in country B,
• Second stage distributor chooses the retail
  price in country B, pB
• Third stage manufacturer and distributor
  simultaneously choose the prices at which they
  sell the product in country A in a Bertrand price
  competition, and

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3rd Stage Bertrand Price Competition
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Net Effect of PT Freedom on ms Profit
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Agenda

• 1 Introduction
• 2 Double marginalization model with complete
  information
• 3 Welfare Analysis
• 4 Conclusion

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Effect of PT Freedom on Global Welfare

• First step Calculate the different levels of
  consumer surplus, profits and welfare in country
  A and B as well as global welfare if PT is
  allowed/prohibited
• Second step Calculate the net effect of PT
  freedom on global welfare by subtracting global
  welfare if PT is prohibited from global welfare
  under PT freedom

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Effect of PT Freedom on Country B
Proposition 3

• Market in country B remains unserved if parallel
  trade cost are very low and countries are
  sufficiently heterogeneous in terms of market size

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Effect of PT Freedom on Global Welfare
Proposition 4
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Effect of PT Freedom on Global Welfare
Proposition 5
Parallel trade freedom can have negative welfare
properties if trade costs are intermediate and
countries are virtually homogeneous in terms of
market size
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Agenda

• 1 Introduction
• 2 Double marginalization model with complete
  information
• 3 Welfare Analysis
• 4 Conclusion

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Summary of the Main Results

• PT will never occur in a double marginalization
  game with complete information
• The manufacturer strategically sets prices in
  order to prevent the occurrence of PT
• PT freedom is detrimental to the manufacturer
• The question as to whether PT freedom has
  positive or negative welfare properties depends
  on the heterogeneity of the countries and the
  level of trade cost

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• Thank you

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Idea for Further Research

• Game with asymmetric information with respect to
  local demand functions
• Exclusive distributor has better information than
  the manufacturer about local demand in country B
• Manufacturer overestimates demand in country B
• Will parallel trade occur in equilibrium in a
  game with asymmetric information?

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Game with Asymmetric Information

• First stage Manufacturer chooses the price at
  which he charges the distributor in country B
• Second stage Nature chooses the demand in
  country A and country B
• Third stage Distributor chooses the price he
  charges his customers in country B
• Fourth stage Manufacturer and distributor play a
  Bertrand game

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Determinants of Parallel Trade

• First strand of literature
• Exclusive distribution rights in foreign markets
  and parallel trade Maskus and Chen (2002, 2004)
• Second strand of literature
• Price regulations by national governments and
  parallel trade Ganslandt and Maskus (2004),
  Jelovac and Bordoy (2005)

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Distributors Decision

• In the second stage, the distributor anticipates
  that he will be driven out of the market in
  country A in the third stage
• Parallel trade does not occur

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Maximization Problem of the Manufacturer
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Solution 1 for Low Trade Cost and High

• We use the Kuhn-Tucker Theorem and obtain two
  solutions
• Solution 1
• Solution 1 only satisfies the non-negativity
  restrictions
• if

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Solution 2 for

• equal to the monopoly price in the double
  marginalization game when parallel trade is
  prohibited
• equal to the profit-maximizing wholesale price in
  the double marginalization game when parallel
  trade is prohibited

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Parallel Trade in the WTO

• Article 6 of the TRIPS Agreement
• () nothing in this Agreement shall be used to
  address the issue of the exhaustion of
  intellectual property rights.
• National exhaustion vs. international exhaustion
  of intellectual property rights

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Hypothesis

• Depending on Natures choices with regard to
  local demand functions parallel trade may occur
  in equilibrium

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Welfare Analysis of Parallel Trade

• Infectious diseases kill 14 million people around
  the world every year, with 90 per cent of those
  deaths occurring in the developing world
• Furthermore, almost 1,400 new medicines have been
  developed in the last 25 years, but only 1 per
  cent of these were medicines for parasitic and
  infectious tropical diseases that are rampant in
  the developing world

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Hypothesis

• Hypothesis There is an important rationale for
  restricting parallel trade of medicines for
  parasitic and infectious tropical diseases that
  are rampant in middle income and low income
  countries
• Parallel trade would further reduce the
  incentives to invest in RD for medicines for
  parasitic and infectious tropical diseases

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Ideas for Further Research

• Parallel trade and medicines for neglected
  infectious diseases
• - 99 per cent of global demand for medicines
  for such diseases is generated in the developing
  world
• - Country A high-income country
• - Country B low-income country

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Follow-up Paper New Timing of the Game

• Stage 0 Manufacturer chooses retail price in
  country A
• Stage 1 Manufactuer chooses wholesale price in
  country B
• Stage 2 Distributor chooses retail price in
  country B
• Stage 3 If , a third firm will
  enter the market, buys the product from the
  distributor in country B and then re-sells the
  product in country A

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Advantages of Bertrand over Cournot

• Parallel trade is an important issue in the
  context of third-degree price discrimination, as
  it erodes the monopolists ability to
  discriminate prices across markets
• -gt Prices and not quantities should be the
  decision variables in a model that elaborates on
  these issues

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Advantages of Bertrand over Cournot

• 2.Since prices are the decision variables in our
  model and not just an endogenous consequence of
  the firms output decisions, we do not need to
  resort to any additional mechanism such as an
  (artificial) auctioneer to determine the
  market-clearing price
• The Bertrand setup includes an explicit
  description of all components required for
  understanding how the market actually operates