Parallel Trade and the Pricing of Pharmaceutical Products Frank Müller-Langer Conference on „Health Economics and the Pharmaceutical Industry“

Frank Müller-Langer University of Hamburg Institute of Law and Economics 2 Agenda 1Introduction 2Prior literature 3Double marginalization model with complete information 4Conclusion and ideas for further research

Frank Müller-Langer University of Hamburg Institute of Law and Economics 3 Parallel imports (PIs) When do parallel imports actually occur? Why should we care about parallel imports? - Advocates of strong patent rights for new pharmaceutical products support a global regime of banning parallel imports - Restraints on parallel imports vary widely between developed and developing countries and even amongst developed countries

Frank Müller-Langer University of Hamburg Institute of Law and Economics 4 Questions to be analyzed 1.Why may parallel imports actually occur in equilibrium when information is complete? 2.Are parallel imports beneficial or detrimental to the producer of a patented product?

Frank Müller-Langer University of Hamburg Institute of Law and Economics 5 Agenda 1Introduction 2Prior literature: Determinants of parallel trade 3Double marginalization model with complete information 4Conclusion and ideas for further research

Frank Müller-Langer University of Hamburg Institute of Law and Economics 6 Determinants of Parallel Trade First strand of literature Exclusive distribution rights in foreign markets, vertical price control and parallel trade [Maskus and Chen (2002, 2004)]

Frank Müller-Langer University of Hamburg Institute of Law and Economics 7 Determinants of Parallel Trade Second strand of literature Price regulations by national governments and parallel trade [Ganslandt and Maskus (2004), Jelovac and Bordoy (2005)]

Frank Müller-Langer University of Hamburg Institute of Law and Economics 8 Agenda 1Introduction 2Prior literature 3Double marginalization model with complete information 4Conclusion and ideas for further research

Frank Müller-Langer University of Hamburg Institute of Law and Economics 9 Double Marginalization Game: 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 imports are allowed (perfect substitute) Distributor: marginal costs of parallel trade,

Frank Müller-Langer University of Hamburg Institute of Law and Economics 10 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, p B Third stage: manufacturer and distributor simultaneously choose the prices at which they sell the product in country A in a Bertrand price competition, and.

Frank Müller-Langer University of Hamburg Institute of Law and Economics 11 Bertrand price competition Rules of the game The low-price firm serves the entire market The high-price firm sells nothing Manufacturer has marginal costs of zero Distributor has positive marginal costs of Manufacturer sets a price that is smaller than the marginal costs of the distributor,

Frank Müller-Langer University of Hamburg Institute of Law and Economics 12 Bertrand price competition Result: PIs will never occur in any sub- game perfect Nash equilibrium in the double marginalization game with complete information

Frank Müller-Langer University of Hamburg Institute of Law and Economics 13 Distributor‘s decision In the second stage, the distributor anticipates that he will be driven out of the market in country A in the third stage In the second stage, the distributor sets a retail price in country B that is 50 per cent higher than the wholesale price set by the manufacturer

Frank Müller-Langer University of Hamburg Institute of Law and Economics 14 Maximization problem of the manufacturer

Frank Müller-Langer University of Hamburg Institute of Law and Economics 15 Solution 1 for low trade costs and high We use the Kuhn-Tucker Theorem and obtain two solutions Solution 1: Solution 1 only satisfies the non-negativity restrictions if

Frank Müller-Langer University of Hamburg Institute of Law and Economics 16 Solution 2 for equal to the monopoly price in the double marginalization game when parallel imports are prohibited equal to the profit-maximizing wholesale price in the double marginalization game when parallel imports are prohibited

Frank Müller-Langer University of Hamburg Institute of Law and Economics 17 Equilibrium Quantities and Prices PI‘s allowedPI‘s prohibited Price in A Quantity in A Wholesale Price in B Retail Pr. in B Quantity in B

Frank Müller-Langer University of Hamburg Institute of Law and Economics 18 Profit of the manufacturer 1.Parallel imports are allowed: 2.Parallel imports are prohibited:

Frank Müller-Langer University of Hamburg Institute of Law and Economics 19 Net effect on profit when PI‘s are allowed and and as b >0.

Frank Müller-Langer University of Hamburg Institute of Law and Economics 20 Net effect on profit when PI‘s are allowed For we obtain: Hence, Result: Manufacturer generates a lower profit when parallel imports are allowed

Frank Müller-Langer University of Hamburg Institute of Law and Economics 21 Results of the welfare analysis The net effect of parallel trade on global welfare is positive if the market in country A is large ( ) The net effect of parallel trade on global welfare can be negative if trade costs are at an intermediate level and countries are virtually homogenous in terms of market size ( )

Frank Müller-Langer University of Hamburg Institute of Law and Economics 22 Summary of the main results PIs will never occur in a double marginalization game with complete information If, potential competition from parallel trade does not arise. The manufacturer charges the monopoly price in country A and the optimal wholesale price in country B If, potential competition from parallel trade arises. The manufacturer strategically sets the wholesale price in country B and the price in country A, in order to prevent that parallel trade occurs

Frank Müller-Langer University of Hamburg Institute of Law and Economics 23 Summary of the main results The manufacturer generates a lower profit when parallel imports are allowed as he has to set prices strategically in order to deter parallel imports

Frank Müller-Langer University of Hamburg Institute of Law and Economics 24 Agenda 1Introduction 2Prior literature 3Double marginalization model with complete information 4Ideas for further research

Frank Müller-Langer University of Hamburg Institute of Law and Economics 25 Ideas for further research Does parallel trade occur when country A is less attractive in terms of market size, [ ], and trade costs are very low [ ] ? Impact of a price cap in country B?

Frank Müller-Langer University of Hamburg Institute of Law and Economics 26 Ideas for further research Parallel trade and medicines for neglected infectious and tropical 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:

Frank Müller-Langer University of Hamburg Institute of Law and Economics 27 Thank you

Frank Müller-Langer University of Hamburg Institute of Law and Economics 28 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

Frank Müller-Langer University of Hamburg Institute of Law and Economics 29 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

Frank Müller-Langer University of Hamburg Institute of Law and Economics 30 Hypothesis Depending on Nature’s choices with regard to local demand functions parallel imports may occur in equilibrium

Frank Müller-Langer University of Hamburg Institute of Law and Economics 31 Social welfare analysis of parallel imports 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

Frank Müller-Langer University of Hamburg Institute of Law and Economics 32 Hypothesis Hypothesis: There is an important rationale for restricting parallel importation of medicines for parasitic and infectious tropical diseases that are rampant in middle income and low income countries Parallel imports would further reduce the incentives to invest in R&D for medicines for parasitic and infectious tropical diseases

Frank Müller-Langer University of Hamburg Institute of Law and Economics 33 Parallel Imports and the WTO WTO members are free to choose whether to allow or prohibit parallel imports Article 6 of the TRIPS Agreement: “For the purposes of dispute settlement under this Agreement, subject to the provisions of Articles 3 and 4, nothing in this Agreement shall be used to address the issue of the exhaustion of intellectual property rights.”

Frank Müller-Langer University of Hamburg Institute of Law and Economics 34 Distributor‘s 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 Total profit is equal to the profit generated in country B through exclusive distribution

Frank Müller-Langer University of Hamburg Institute of Law and Economics 35 Distributor‘s decision The distributor has to pay the wholesale price Maximizes profit according to:

Frank Müller-Langer University of Hamburg Institute of Law and Economics 36 Distributor‘s decision The first-order condition is given by:

Frank Müller-Langer University of Hamburg Institute of Law and Economics 37 Parallel trade can have a negative effect on global welfare [, and ]