Parallel Imports, Product Innovation and Market Structures Hong Hwang, Cheng-Hau Peng and Pei-Cyuan Shih To presented at the Department of Economics, NCCU 2014/11/03

What Is Parallel Import? Parallel import (PI) occurs when a genuine product is sold back by licensed foreign distributers without the permission of the domestic intellectual property owner who, we call it the manufacturer, also serves the domestic market. Examples: DVD Textbook Automobile Medicine Aomori Summer Workshop 2014/8/182

Motivation Evidences have shown that there is a burgeoning trend in parallel imports around the world. Ganslandt and Maskus (2004) show that EU loses approximate $3 billion sales per year owing to the occurrence of PI. The value of PI in the US rose from 7–10 billion USD in the mid-1980s to 20 billion USD in the 1990s (Cespedes et al., 1988; Computer Reseller News, 2001) Aomori Summer Workshop 2014/8/183

Related Literature Trade cost : Maskus and Chen (2004), Chen and Maskus(2005), Mueller-Langer (2012) Labor union: Mukherjee and Zhao (2012) Process R&D: Li and Maskus (2006) Product R&D: Li and Robles (2007) Matteucci and Reverberi (2014) Aomori Summer Workshop 2014/8/184

Aims Consider the effect of PI on the manufacturer’s product innovation by assuming the manufacturer sells its product to the foreign distributor via two-part tariff pricing. Explore the effect of local rivals in the domestic market, which is commonly observed in the real world but has been overlooked in this line of research. Examine the case in which the manufacturer has multiple distributors in the foreign market. Aomori Summer Workshop 2014/8/185

Preview of the Findings PI necessarily decreases the manufacturer’s product R&D if the domestic market is monopolized by the manufacturer. PI definitely stimulates product innovation of the manufacturer if it faces local rivals. Aomori Summer Workshop 2014/8/186

Preview of the Findings If the manufacturer can authorize its product to multiple foreign distributors, its product innovation can be either positively or negatively affected by PI, depending on consumers’ preferences for innovation in the domestic and the foreign markets. Aomori Summer Workshop 2014/8/187

Outlines Section 2 introduces the basic model and examines the optimal product innovation with no parallel imports. Section 3 investigates the effect of parallel imports on the manufacturer’s product innovation. Section 4 explores the product innovation of the manufacturer when it faces domestic rivals or authorizes its product to multiple distributors. Section 5 concludes the paper. Aomori Summer Workshop 2014/8/188

The Model Assume there are two countries, H and F, hosting one firm each. Variables with a star are those associated with the foreign firm. In the home country, there is a manufacturer with marginal cost selling its product, in the home market and authorizing a foreign distributor to sell its product, in country F. The distributor can sell back to the home country through parallel import,, and the transport cost is nil. The manufacturer and the distributor compete in quantity in the home country if PI is permitted. Aomori Summer Workshop 2014/8/189

The Model The inverse demand functions for countries H and F are and with,,, and the second derivatives of the demands are assumed to be zero. The manufacturer engages in product innovation with the cost function,, and. The manufacturer adopts two-part tariff pricing (the per-unit wholesale price,, plus a fixed fee, ) when selling the product to the distributor. Aomori Summer Workshop 2014/8/1810

Game Structure The game in question consists of three stages. Stage1: The manufacturer determines its optimal product R&D. Stage 2: The manufacturer determines its optimal two-part tariff pricing contract. Stage 3: The two firms determine their optimal sales in the two markets with or with no PI. Aomori Summer Workshop 2014/8/1811

The No-PI Regime The profit functions of the manufacturer and the distributor can be expressed respectively as follows: (1) (2) Aomori Summer Workshop 2014/8/1812

No-PI regime—The Third-stage Game The FOCs (3) (4) The second-order conditions are satisfied given the linear demands and constant marginal cost. The comparative static effects are derivable as follows:. Aomori Summer Workshop 2014/8/1813

No-PI Regime—The Second-stage Game The profit function of the manufacturer for the second-stage game is as follows: (5) where The FOC: (6) Aomori Summer Workshop 2014/8/1814

Proposition 1 If the manufacturer adopts two-part tariff pricing and parallel trade is prohibited, product innovation has no effect on the wholesale price. Intuition: Under two-part tariff pricing, the manufacturer always sets its wholesale price w = c. Product innovation affects only the demand, yielding no effect on the equilibrium price. Aomori Summer Workshop 2014/8/1815

No-PI Regime—The First-stage Game The profit function of the manufacturer in the first-stage game can be expressed as follows: (7) The FOC: (8) From (8), we can derive the optimal product innovation level under the no PI regime. Aomori Summer Workshop 2014/8/1816

The PI Regime Now let us consider that country H adopts international exhaustion (i.e., the PI regime). Under the PI regime, the foreign distributor can engage in PI if it is profitable. All the assumptions and model settings are the same as those in the previous section, except that the foreign distributor competes with the manufacturer in Cournot fashion in country H. Aomori Summer Workshop 2014/8/1817

PI Regime— The Third-stage Game The profit functions of the two firms under the PI regime can be written respectively as follows: (9) (10) The FOC: (11) (12) (13) The SOCs and the stability condition are satisfied. Aomori Summer Workshop 2014/8/1818

PI Regime-- The Second-stage Game The profit function of the manufacturer for the second-stage game can be expressed as follows: (14) The FOC: (15) Aomori Summer Workshop 2014/8/1819

PI Regime– The Second-stage Game We can derive from the FOC: and also the comparative static effect as follows:, where. Aomori Summer Workshop 2014/8/1820

Proposition 2 If the manufacturer adopts two-part tariff pricing and parallel import is permitted, the wholesale price is necessarily higher than its marginal cost and is positively related to the product innovation level. Intuition: The manufacturer raises the wholesale price to lower the competition in its home market. Aomori Summer Workshop 2014/8/1821

PI regime– The First-stage Game The profit function of the manufacture firm is as follows: (16) By differentiating the above equation with respect to, we can derive the first-order condition for profit maximization as follows: (17) Aomori Summer Workshop 2014/8/1822

Product Innovation with and without PI Assume that the inverse demand functions of the home and the foreign markets take respectively the following linear forms as and. By evaluating the above equation at the product innovation level derived under the no-PI regime, we obtain: Aomori Summer Workshop 2014/8/1823

Proposition 3 If the manufacturer adopts two-part tariff pricing, parallel import definitely reduces the product innovation of the manufacturer. Intuition: (1) duopoly in the home market (2) w is too high Matteucci and Reverberi (2014) Li and Maskus (2006) Aomori Summer Workshop 2014/8/1824

Product Innovation and Market Structures In the existing literature on PI, it is commonly assumed that there are only two firms- one manufacturer and one distributor- in the models. In this section, we shall relax this assumption to investigate if the domestic or the foreign market becomes oligopolistic, how it affects the manufacturer’s product innovation with and with no PI. Aomori Summer Workshop 2014/8/1825

The Existence of Domestic Rivals All the model settings are the same as those in the previous sections except that now there are homogeneous rivals in the domestic market whose product innovation is predetermined and whose outputs are sold to the home market only. The inverse demand functions under the PI regime are and, and if there is no PI. Aomori Summer Workshop 2014/8/1826

The First-stage Game with No PI The second- and the third- stage games are akin to the previous section, we need to work out the first-stage game. With no PI, the profit function of the manufacturer for the first-stage game is as follows: FOC: (18) Aomori Summer Workshop 2014/8/1827

The Second-stage Game with PI The third-stage game is the same as before, we need to work out the first and the second-stage games. Proceeding as before, we can derive the optimal wholesale price as follows:. It can be shown that the optimal wholesale price is equal to (lower than) if. Aomori Summer Workshop 2014/8/1828

Proposition 4 If the manufacturer faces domestic rivals, parallel import reduces the wholesale price to a level lower that the marginal cost. If there is only one rival in the domestic market, PI has no effect on the wholesale price (i.e., w = c). Intuition: If n = 1, the effective output of the manufacturer is the same as that of the Stackelberg leader. It is optimal to set w =c. If n >1, the Stackelberg leader’s output is higher. It means that the manufacturer needs to set w to a lower level (i.e., lower than c). Aomori Summer Workshop 2014/8/1829

The First-stage Game with PI In the first stage, the manufacturer faces the following maximization problem: The FOC: Aomori Summer Workshop 2014/8/1830

Product Innovation with and with No PI By evaluating the above equation at the product quality level derived under the no PI regime, we can derive: Aomori Summer Workshop 2014/8/1831

Proposition 5 If there are rivals in the domestic market, parallel import stimulates the product innovation of the manufacturer. Intuition: If there are rivals in the domestic market, PI increases the market share of the manufacturer, raising its marginal benefit from innovation and thus the investment. Aomori Summer Workshop 2014/8/1832

Multiple Distributors For simplicity, we assume that all the distributors are symmetric and can engage in PI if it is permitted by the home country. The inverse demand functions for country H and country F under the PI regime are and, and if there is no PI. Aomori Summer Workshop 2014/8/1833

The Second-stage Game with No PI The third stage game is similar to that in Section 3. Proceeding as before, we can derive the optimal wholesale price as follows: with. Aomori Summer Workshop 2014/8/1834

The First-stage Game with No PI The profit function of the manufacture firm is as follows: The FOC: Aomori Summer Workshop 2014/8/1835

Proposition 6 With no PI, the optimal wholesale price increases with the number of authorized distributors in the foreign market. However, the equilibrium outputs of the two markets, the optimal product R&D and the profits of the manufacturer are not affected by the number of the authorized distributors. Intuition: With no PI, the home market is unaffected by n. Since the distributors are symmetric, the manufacturer can always set the output at the first-best level, via two-part tariff pricing. Aomori Summer Workshop 2014/8/1836

The Second-stage Game with PI The third stage game is similar to that in Section 3. Proceeding as before, we can derive the optimal wholesale price under the PI regime as follows: Aomori Summer Workshop 2014/8/1837

The First-stage Game with PI The objective function of the manufacturer for the first-stage game is as follows: The FOC: Aomori Summer Workshop 2014/8/1838

Product innovation with and with No PI By evaluating the above first-order condition at the product quality level derived under the no-PI regime, we can obtain: Aomori Summer Workshop 2014/8/1839

Proposition 7 If the manufacturer authorizes its product to multiple distributors in the foreign country, parallel imports may increase or decrease its product innovation, depending on the consumers’ quality valuations in the two countries. Aomori Summer Workshop 2014/8/1840

Intuition: PI has two effects on innovation: A negative effect: With PI, the domestic market becomes oligopolistic which discourages product innovation. A positive effect: The manufacturer has an incentive to do more product R&D as it can raise the wholesale price, mitigating the amount of PI. Aomori Summer Workshop 2014/8/1841

Conclusions Product innovation of the manufacturer is definitely stifled by parallel import if the domestic market is monopolized by the manufacturer. Contrarily, if there are rivals in the domestic market, permitting parallel import necessarily enhances the production innovation. If the manufacturer authorizes its product to multiple distributors in the foreign country, parallel import may increase or decrease the product innovation depending on the consumers’ preferences for product innovation in the two countries. Aomori Summer Workshop 2014/8/1842

Thank you Comments and suggestions are welcome Aomori Summer Workshop 2014/8/1843