Parallel Trade and the Pricing of Pharmaceutical Products

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

2. Agenda 1 Introduction 2 Prior literature • Double marginalization model with complete information • Conclusion 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 • Why may parallel imports actually occur in equilibrium when information is complete? • 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 1 Introduction 2 Prior literature: Determinants of parallel trade • Double marginalization model with complete information • Conclusion 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 1 Introduction 2 Prior literature • Double marginalization model with complete information • Conclusion 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, 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 . 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 Frank Müller-Langer University of Hamburg Institute of Law and Economics

18. Profit of the manufacturer • 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 1 Introduction 2 Prior literature • Double marginalization model with complete information • Ideas 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 ] Frank Müller-Langer University of Hamburg Institute of Law and Economics