1. Welfare Analysis of Parallel Trade Freedom 1/16 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

2. Welfare Analysis of Parallel Trade Freedom 2/16 Frank Müller-Langer Agenda 1Introduction 2Double marginalization model with complete information 3Welfare Analysis 4Conclusion

3. Welfare Analysis of Parallel Trade Freedom 3/16 Frank Müller-Langer 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

4. Welfare Analysis of Parallel Trade Freedom 4/16 Frank Müller-Langer Questions to be Analyzed 1.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?

5. Welfare Analysis of Parallel Trade Freedom 5/16 Frank Müller-Langer Agenda 1Introduction 2Double marginalization model with complete information 3Welfare Analysis 4Conclusion

6. Welfare Analysis of Parallel Trade Freedom 6/16 Frank Müller-Langer 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,

7. Welfare Analysis of Parallel Trade Freedom 7/16 Frank Müller-Langer 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

8. Welfare Analysis of Parallel Trade Freedom 8/16 Frank Müller-Langer 3rd Stage: Bertrand Price Competition Parallel trade will never occur in any sub-game perfect Nash equilibrium in the double marginalization game with complete information Proposition 1

9. Welfare Analysis of Parallel Trade Freedom 9/16 Frank Müller-Langer Net Effect of PT Freedom on m‘s Profit Parallel trade freedom is detrimental to the manufacturer as it reduces his profit Proposition 2

10. Welfare Analysis of Parallel Trade Freedom 10/16 Frank Müller-Langer Agenda 1Introduction 2Double marginalization model with complete information 3Welfare Analysis 4Conclusion

11. Welfare Analysis of Parallel Trade Freedom 11/16 Frank Müller-Langer 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

12. Welfare Analysis of Parallel Trade Freedom 12/16 Frank Müller-Langer Effect of PT Freedom on Country B Market in country B remains unserved if parallel trade cost are very low and countries are sufficiently heterogeneous in terms of market size Proposition 3

13. Welfare Analysis of Parallel Trade Freedom 13/16 Frank Müller-Langer Proposition 3 Parallel trade freedom has positive welfare properties if countries are sufficiently heterogeneous in terms of market size Effect of PT Freedom on Global Welfare Proposition 4

14. Welfare Analysis of Parallel Trade Freedom 14/16 Frank Müller-Langer 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

15. Welfare Analysis of Parallel Trade Freedom 15/16 Frank Müller-Langer Agenda 1Introduction 2Double marginalization model with complete information 3Welfare Analysis 4Conclusion

16. Welfare Analysis of Parallel Trade Freedom 16/16 Frank Müller-Langer 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

17. Welfare Analysis of Parallel Trade Freedom 17/16 Frank Müller-Langer Thank you

18. Welfare Analysis of Parallel Trade Freedom 18/16 Frank Müller-Langer 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?

19. Welfare Analysis of Parallel Trade Freedom 19/16 Frank Müller-Langer 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

20. Welfare Analysis of Parallel Trade Freedom 20/16 Frank Müller-Langer 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)]

21. Welfare Analysis of Parallel Trade Freedom 21/16 Frank Müller-Langer 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

22. Welfare Analysis of Parallel Trade Freedom 22/16 Frank Müller-Langer Maximization Problem of the Manufacturer

23. Welfare Analysis of Parallel Trade Freedom 23/16 Frank Müller-Langer 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

24. Welfare Analysis of Parallel Trade Freedom 24/16 Frank Müller-Langer 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

25. Welfare Analysis of Parallel Trade Freedom 25/16 Frank Müller-Langer 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

26. Welfare Analysis of Parallel Trade Freedom 26/16 Frank Müller-Langer Hypothesis Depending on Nature’s choices with regard to local demand functions parallel trade may occur in equilibrium

27. Welfare Analysis of Parallel Trade Freedom 27/16 Frank Müller-Langer 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

28. Welfare Analysis of Parallel Trade Freedom 28/16 Frank Müller-Langer 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 R&D for medicines for parasitic and infectious tropical diseases

29. Welfare Analysis of Parallel Trade Freedom 29/16 Frank Müller-Langer 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:

30. Welfare Analysis of Parallel Trade Freedom 30/16 Frank Müller-Langer 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

31. Welfare Analysis of Parallel Trade Freedom 31/16 Frank Müller-Langer Advantages of Bertrand over Cournot 1.Parallel trade is an important issue in the context of third-degree price discrimination, as it erodes the monopolist’s ability to discriminate prices across markets -> Prices and not quantities should be the decision variables in a model that elaborates on these issues

32. Welfare Analysis of Parallel Trade Freedom 32/16 Frank Müller-Langer 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