Departement of Economics University of Uppsala Master’s Thesis (D-Uppsats) Author: Mark Bohlund
Supervisor: Sven-Åke Carlsson Spring Term (VT) 2005
The Price Effects of Differential Pricing and Parallel Trade in Pharmaceuticals
1. Introduction... 2
1.1 Introduction... 2
1.2 Purpose, Methodology and Disposition ... 3
2. Pricing Theory... 3
2.1. Monopoly Pricing ... 4
2.2 Price Discrimination... 5
2.3 Costs and Pricing in Research-intensive Industries... 7
2.4 Ramsey Pricing ... 10
2.5 Conclusions... 11
3. Industrial Location Theory: From Adam Smith to Cluster Theory... 11
4. Economic Theory on the Causes and Effects of Parallel Trade ... 12
4.1 Causes of Parallel Trade: Reasons Behind International Price Differentials ... 13
4.2 Effects of Parallel Trade... 13
4.3 Parallel Trade as a Mean to Fight Collusive Behaviour in a Market... 16
4.4 Costs of Parallel Trade ... 17
4.5 Theoretical Conclusions on Parallel Trade ... 17
5. Empirical Evidence. ... 17
5. 1 The Pharmaceutical Industry... 18
5.1.1 The Location of the Pharmaceutical Industry ... 18
5.1.2 Costs of the Pharmaceutical Industry... 19
5.1.3 Profits of the Pharmaceutical Industry ... 20
5.2 The Pharmaceutical Market ... 20
5.2.1 Pricing Strategies for Pharmaceutical Products ... 20
5.2.2 Regulation and Purchasing Strategies in Pharmaceutical Markets... 21
5.3 Evidence of Pharmaceutical Prices in International Markets... 22
5.4 Reasons for discrepancies between pharmaceutical prices and per capita income level... 23
5.5 Conclusions on International Price Differentials and the Opportunities for Parallel Trade ... 24
6. Evidence on the Effects of Parallel Trade: EU and Sweden ... 25
6.1 The European Union ... 25
6.2 The Case of the Swedish Entry into the EU... 26
6.3 Evidence of Price Convergence Between Markets ... 27
6.4 Reactions from the Pharmaceutical Industry... 29
6.5 Conclusions from Parallel Trade within the EU... 29
7. The Creation of a System of Differential pricing... 30
7.1 Effects on Prices and Welfare ... 30
7.2 Requirements ... 31
7.3 Efforts to Create Systems of Differential Pricing... 32
8. Conclusions on the Effects of Price Discrimination and Parallel Trade ... 33
8.1 Effect on prices in high-income markets... 34
8.2 Effect on prices in Low-income markets ... 35
8.3 Effects on Research and Development... 35
8.4 Areas of Regional Parallel Trade ... 36
9 References... 36
1. Introduction
1.1 Introduction
The debate on parallel trade has much relevance as it puts at conflict two of the most urgent and important issues of our modern-day society, namely the access to essential medicine in developing countries and the right of intellectual property holders to get remuneration for their innovations. The access to essential medicines can be a matter of life and death to many third-world citizens and the opposition to parallel trade and generic drugs by multinational pharmaceutical companies has often been seen as an expression of a cynic and inhuman reasoning which puts financial profit before human lives. To counter this claim
pharmaceutical companies have repeatedly stressed the importance of upholding incentives for pharmaceutical research and development (R&D) if we are to see new drugs and medical progress in fighting diseases like AIDS and malaria. A number of governments, non-
governmental organisations, academics etc have entered the debate with a varying degree of understanding of the aspects of the problem. When it comes to the academic debate, which will be my focus in this essay, the question of differential pricing and parallel trade has been a central topic. Differential pricing, and in particular Ramsey type pricing, has been presented as a near ideal solution for solving the dilemma of access to medicine and incentives for R&D spending. Differential pricing requires that markets are adequately segmented in order to prevent arbitrage trading. Parallel trade in pharmaceuticals is a form of arbitrage trading and has therefore taken a lot of flak from academics in favour of differential pricing between markets. My aim with this thesis has been to account for the case presented by academics in favour of differential pricing and opposed to parallel trade and then examine how well their suppositions corresponds with empirical evidence in pharmaceutical markets across the world.
I have found that although the theoretical case of a system of differential pricing clearly holds a lot of advantages, there is no guarantee that a segmentation of markets would lead to
Ramsey type prices, i.e. prices inversely related to demand elasticity. Real life facts present several obstacles for a system of differential pricing functioning well. Among other things, a system of segmented markets requires pharmaceutical companies not exploiting the absence of competition from parallel imports to set excessively high prices. It also requires
governments and consumers in developed countries to accept considerably higher prices than in developing countries. Developing countries would also have to agree on banning re-
exportation of drugs. An effort to create a system of differential pricing would therefore require a set of commitments from all parties, which could be hard to achieve and uphold practically. Maskus (2001) presents a compromise solution of allowing parallel trade among countries of the same per capita income level, which would retain the positive impact of parallel trade on competition but not impede different price levels in developed and
developing countries. Allowing parallel trade to but not from developing countries could also allay their fears of pharmaceutical companies acting collusively in the absence of parallel trade.
1.2 Purpose, Methodology and Disposition
This thesis is a literature study of the debate on parallel trade in pharmaceuticals. My aim has been to clear up the confusion that the debate might confer on an reader unfamiliar with the subject. Despite its importance parallel trade in pharmaceuticals hasn’t been extensively treated in academic literature. The obvious reason for this is the lack of an empirical base as empirical data on parallel trade is very limited. The reason for this, in turn, is that parallel imported pharmaceutical aren’t separated from licensed imports when trade statistics are kept (Maskus, 2001). Theoretical arguments can therefore seldom be challenged with empirical data. Instead I have chosen to examine the explicit or implicit assumptions in the case for differential pricing made by leading scholars in order to estimate what effects their proposed reforms would have in real life. But I will also give an account of a rare study of the observed effects of parallel trade, which is Ganslandt & Maskus study of parallel imports to Sweden following the Swedish entry into the European Union in 1995. Before making my conclusions I will also present some past efforts to create a system of differential pricing.
2. Pricing Theory
In this section I will present some pricing models that are relevant to the subject. While much of economic theory is built on the assumption of perfect competition, alternative market models have also been treated in economic literature. The pharmaceutical industry is often said to be monopolistic as new inventions are awarded patents which give them exclusive rights to sell the product during a limited period of time. It can also be described as
monopolistic competition as the industry consists of a range of manufacturers each marketing
a range of different products, all with their own specific brand name. For a customer or a doctor writing a prescription for a patient it is often difficult to grasp what the available options are, which mean that widely-known brands wield a degree of market power. I have therefore chosen to present the model of monopoly and monopolistic competition in order to give a background of the pricing strategies used in the pharmaceutical industry and their effect on welfare. As the thesis has a global perspective I will in section 2.2 describe how a company can act to increase profits by setting prices differently across markets, so called price discrimination. In section 2.3 I will describe how economists have seen the dilemma of recovering sunk costs, e.g. spending on R&D, in an economically efficient way.
2.1. Monopoly Pricing
A monopoly is when a single seller controls the entire market of a good. Unlike agents in a competitive market he or she can therefore raise prices and still retain sales. The number of customers lost by increasing prices is reflected by the elasticity of demand. There are varying degrees of monopoly or market power depending on the amount of substitutes to the
company’s good. It is therefore often common to talk about monopolistic competition, which is a hybrid form between a pure monopoly and perfect competition.
A strong monopolist will face an inelastic demand curve and will be able to raise prices without losing too much business. In contrast, a weak monopolist will see more customers turning to substitutes if he or she raises prices. The marginal revenue (MR) of a change in price (P) will depend on the elasticity of demand and is expressed algebraically as follows;
MR= P + Q(δP/δQ)
The first term is the revenue from the last unit sold and the second term is the effect of a price change on the revenue from the other units (Q) sold. The second term will, for a normal good, be negative as an increase in price entails a decrease in sales for normal goods. A decision to raise the price of a product is therefore normally a trade-off of the revenue lost by the
marginal buyer dropping out and the additional income from charging a higher price to the remaining clients. The summation of these two factors will make the marginal revenue for the monopolist. A monopolist will set a price which equates marginal cost and marginal revenue to maximise profits. This is less economically efficient for society as a whole than perfect competition as some consumers prepared to pay a price above marginal cost are withheld consumption (Pindyck & Rubinfeld, 1995). This is the reason why there in many countries are
regulatory authorities in place to assure that competition exists and is fair. But in some cases, e.g. industries with large economies of scale it can be motivated to accept monopolies (Bannock, Baxter & Davis, 1998). In other cases it can actually be motivated to create monopolies. The awarding of patents is a way of creating monopolies in certain goods. I will return to this issue later in section 2.3. The mirror image of a monopoly is a monopsony. The latter is when a market has only one purchaser. A monopsonist faces a similar trade-off as a monopolist as buying an additional unit will demand offering a higher price for all units bought. A monopsony will therefore also lead to a lower level of production than is economically efficient as a monopsonist will refrain from buying an additional unit even though the marginal benefit from it exceeds its price.
2.2 Price Discrimination
Price discrimination is the practice of offering the same commodity to different buyers at different prices. By doing this a seller can exploit the differences in the elasticity of demand of consumer groups. The seller will charge a higher price in markets where buyers are prepared to pay a high price and a lower price in a market were buyers are more price- sensitive. By being able to charge certain customers a higher price without forfeiting sales to other customers the seller will be able to gain a higher profit than by charging all customers a uniform price. As figure 1 shows this is done by usurping part of the consumer surplus, but also by reducing dead-weight losses. Price discrimination also benefits more price-sensitive consumers who are offered the product at a price lower than under uniform pricing. The only losers in the game are the less price-sensitive consumers who face a price higher than under uniform pricing.
However some prerequisites are needed for price discrimination to function well.
Firstly, the seller must posses some degree of monopoly power in at least one of the markets to be able to set prices independently. Secondly, there must be a difference in demand elasticity between the markets to make any price discrimination worthwhile. Thirdly, there must be a separation of markets so that trading between markets isn’t possible, as this would lead to price convergence (Bannock, Baxter & Davis, 1998).
Maskus (2001) illustrates the effect of price discrimination in segmented markets with the following figure.
Figure 1.
Price ($) 80
D(a) α β
45 A
35 MR(a) 29.4
22.5 B MR(b)
D(b)
10 MC
80 179 219 317 500 Q (Thousands)
The line D(a) is the demand curve for a pharmaceutical product in country A, which is assumed to be a high-income country where the inhabitants are able to pay for
pharmaceuticals. The line D(b) is the demand curve for a country B, which is assumed to be a low-income country where the demand for pharmaceuticals is more elastic. For simplicity it is assumed that demand in both markets would equal 500,000 units at a zero price. However the maximum willingness is $80 per treatment in country A but only $35 in country B. The demand curves may be written as Pa = $80 – 0.16 Qa and Pb = $35 – 0.07 Qb, where
quantities are in thousands. It is further assumed that the pharmaceutical company can supply both markets at a constant marginal cost of $10 per treatment. We initially suppose that the two markets are segmented by a restraint on parallel trading. In that case the manufacturer would maximise profits by setting marginal cost equal to marginal revenue, shown by lines MR(a) and MR(b) in the figure, in each market. This gives a market price of $45 in country A and $22.5 in country B. This corresponds to 219,000 units being sold in country A and
179,000 units sold in country B. The consumer surplus in country A is represented by the triangles α + β which make ((80 – 45) x 219,000)/2 which equals $ 3.8 million. The profit made by the manufacturer is the mark-up (market price minus average cost) multiplied by the
quantity sold. This makes (45-10) x 219,000 which equals $7.7 million. Correspondingly, the consumer surplus in country B amounts to $1.1 million and the manufacturers profit to $2.2 million. Total consumer surplus would amount to $ 4.9 million and the total profit of the manufacturer would be $9.9 million. The example clearly shows that a manufacturer is prepared to supply a market as long as the price it can charge exceeds the marginal cost.
But if arbitrage trading, e.g. parallel trade, would lead to the complete integration of the two markets, the manufacturer would be forced to set a uniform price that would maximise the total profits from both markets. The uniform price would depend on the intercepts and
demand curves of the markets in question. In this example there would be two possibilities for the manufacturer. By compounding the demand equations of the two markets we find that the manufacturer could set a profit-maximising price of $29.4 which would mean that 317,000 units would be sold in country A and 80,000 unit sold in country B. The consumer surplus in country A would increase by $4.2 million to $8 million but decrease in country B by $0.9 million to $0.2 million. The profit of the manufacturer would fall by $1.5 million in country A and by $0.9 million in country B. The total profits would be $7.5 million, compared to profits of $9.9 million when price discrimination could be used.
The other option for the manufacturer would be to stick to the profit-maximising price of $45 per treatment in country A. As nobody in country B would be prepared to pay this price, sales in that market would be foregone completely. But as the profit level of $7.7 million would be upheld in country A, this would be the preferred option of any profit-maximising
manufacturer. As the example shows parallel trade could result in some markets not being supplied at all, because their maximum willingness to pay is inferior to profit-maximising price levels in other more important markets (Maskus, 2001).
2.3 Costs and Pricing in Research-intensive Industries
The evolution from an economy based on manufacturing into a more knowledge-based economy has put new challenges to the field of economics. A faster pace of technological development has lead to costs for R& D of new products making up an increasing share of total costs. Economic theory states that the marginal benefit of the customer should be equal to the marginal cost of the producer for a fully efficient, or “first best”, outcome.
As Danzon & Towse (2003) state large R&D spending complicate pricing for several reasons.
The main reason for this is the introduction of a dynamic dimension into a normally static perspective. Equating marginal benefits and marginal cost for effectiveness still holds but it is also necessary that sunk cost of R&D are recovered to provide continued incentives for R&D spending. The latter requires that a mark-up is added upon marginal cost in pricing. The first- best solution in this case, would be to award new innovations with a fixed lump-sum transfer and then distribute the new drug at a price equal to marginal cost (Maskus, 2001). This is of course very difficult to arrange practically and efforts have therefore been concentrated to finding a second-best outcome.
As Chard & Mellor (1989) points out the role of property rights, and intellectual property rights in particular, can be said to be to maintain or extend the ability of market forces
towards their most valuable use. In the case of the pharmaceutical industry it could be argued that patent rights are economically efficient as they direct surplus value from drug sales to R&D activities at innovator firms rather than to monopolistic profits for “copy-cat”
producers. One could argue that the loss of consumer surplus could be weighed up by the development of new and/or better drugs.
Scholars in the field of intellectual property like Liebeler (1986) and Young (1986) point to the risk that “copy-cat” firms will free-ride on innovator and other firms investments in R&D, branding and marketing and they therefore argues that parallel imports should be severely restricted or completely banned. Such measures would encourage investments in innovation and quality management of trademarks, which would be beneficial also to customers as it decreases their search costs.
The way chosen out of this quandary has traditionally been the granting of patents to protect innovative companies from “copy-cat” companies free-riding on their R&D. Patents are barriers to entry that give companies a monopoly for a product during a limited period of time. This enables them to set prices above marginal cost and recover their R&D spending.
This is of course not fully efficient as consumers are withheld consumption even though their marginal benefit exceeds marginal cost. But patent protection is still viewed by most
economists as being the best practical approach to funding R&D.
Danzon & Towse (2003) puts the conditions of pharmaceutical pricing algebraically as follows. For R&D costs to be covered following conditions need to be fulfilled;
Pj≥ MCj and ∑(Pj – MCj) ≥ F
Where Pj is the price in a market j, MCj is the marginal cost of providing market j, this could be cost of transporting, packaging etc. The second term expresses that the combined revenue must both cover the marginal cost of the market and joint costs of R&D, including a normal, risk-adjusted rate of return on capital (F).
Normally competition from therapeutic substitutes constrains the market power of
pharmaceuticals products. But, as Lu & Comanor (1998) point out and which I will return to later in section 5.3 some products have so unique qualities that they leave companies virtually unrestrained in there pricing abilities. This has led to accusations of exorbitant pricing against pharmaceutical companies and motivated governments to impose price controls and other regulation to guarantee “affordable” prices of vital pharmaceuticals.
For a monopolist the choice is between charging price-insensitive customers up to their ability to pay or to expand sales to more price-sensitive customers. The sole solution to this dilemma is price discrimination, as described in section 2.2. This is often difficult to exercise in an individual country, as it is hard to separate different customer groups. But the possibility to price discriminate between geographical markets is larger. As the geographical distance and patent and license rules separate customer groups companies can set prices without having to create artificial barriers between groups to prevent trading. Consequently they will be able to reap all the potential revenue in high-income market by selling at a high price and at the same time cater to more price-sensitive consumers in other markets by offering lower prices. The effects of price discrimination are therefore harmful for price-insensitive consumers and beneficial for producers and price-sensitive consumers. But as section 2.2 showed, the overall effects of price discrimination on welfare should be positive.
2.4 Ramsey Pricing
The problem of recovering joint sunk costs across different markets in an efficient way was addressed by the British economist Frank Ramsey in the 1920s. The mainstay of Ramsey’s theory is linking prices to the price-sensitivity of consumers or in other words the price- elasticity of the market. Ramsey pricing is therefore based on both price discrimination and monopoly pricing. The difference is that while the latter choices of action aim to maximise the producer surplus Ramsey pricing aims at maximising the total amount of welfare. As previously mentioned it is economically efficient to provide a customer with a good as long as she or he is prepared to pay a price exceeding the marginal cost. But to recover sunk costs it is necessary to have a mark-up i.e. set prices above marginal cost. But if the mark-up is too high price-sensitive users will drop out of the market, even though they might be prepared to pay a price above marginal cost and hence contribute to paying the joint sunk costs. This would entail a loss of welfare or a so called dead-weight loss. This effect is also valid for more price- insensitive consumers also but to a lesser degree and consequently with smaller dead-weight losses.
Ramsey showed that the dead-weight losses can be minimised by charging price-insensitive consumers a high price and more price-sensitive consumers a lower price. In an economist prose this means that prices will be set higher in markets were the price elasticity is low and vice versa. The economic theory Ramsey developed is known as inverse elasticity pricing or simply Ramsey pricing (Danzon, 1998).
Making estimates of the demand elasticities of a market is a difficult task. As medicines or other pharmaceuticals are often necessary for the survival or the well-being of the consumer, their demand are normally less dependent of price than other goods, i.e. the demand is often inelastic. However, in poorer countries where disposable income is limited the demand for pharmaceuticals is often more elastic. People simply cannot afford medicines regardless of their need of them (Danzon, 1998). Hence, Ramsey pricing would mean that prices for pharmaceuticals will be set low in poor countries and higher in richer countries. This coincides with widely held concepts of fairness by providing consumers in low-income countries with access to medicines at lower prices than those charged in richer countries.
Ramsey pricing is therefore held out by scholars like Danzon and Maskus as a way to reconcile the conflicting interests of medicines at affordable prices and incentives for R&D.
This might appear to be an ideal solution to the issue of distributing the cost of R&D spending. Unfortunately it doesn’t coincide with the short-term interest of individual countries. Countries will have an incentive to shirk the costs of R&D and “free ride” on the R&D expenditure of other countries. This can be done by using the monopsony power of government purchasing agencies to force down pharmaceutical prices. As long as the price offered exceeds the marginal cost it is rational for a pharmaceutical company to supply a buyer. But if total revenue doesn’t cover the sunk costs of R&D pharmaceutical companies will lose their incentive to engage in R&D. If the cost shirking occurs in a small market the effect might be marginal, but with parallel trading the effects of this kind of “free-riding” can spread to other, and possibly more important, markets (Danzon, 1998).
2.5 Conclusions
I hope this section will have enlightened, or maybe refreshed, the reader’s knowledge of monopolistic pricing models and price discrimination. As was stated above sunk costs complicate economic theory in several ways. The clear-cut arguments of the virtues of trade and pricing at marginal costs are no longer valid when it comes to products which require large sunk costs. Historically the creation of monopolies by awarding exclusive rights to innovators has been the way chosen to guarantee returns on R&D spending. But as we saw in section 2.1 monopoly pricing entails dead-weight losses. As was shown in section 2.4 Ramsey pricing can according to theory be used to minimise the dead-weight losses of monopoly pricing, but it requires that markets are adequately separated. In section 5.3 I will present some empirical evidence on how pharmaceutical companies set prices across markets.
3. Industrial Location Theory: From Adam Smith to Cluster Theory
The subject of the most economically efficient location of an industry has been a central part of classic economic theory since the days of Adam Smith. Smith’s theory of absolute
advantages stated that an industry should ideally be located where the costs of resources such as manpower are the lowest. Ricardo developed Smith’s thoughts by adding that it is the local production costs relative to the production of other goods that matter. The most efficient location of production for a given good would be determined by the relative prices demanded by the different parties when trading. Eli Heckscher and Bertil Ohlin gave further substance to
this theoretical line in their model of international trade. But industrial location theory was established as a discipline of economics by the works of Alfred Weber in the early 20th century. Weber highlighted the transport costs of resources and finished products as a vital factor in the choice of location. The shift in the industrialised countries from labour- and capital-intensive industry to more knowledge-intensive industries during the second half of the 20th century has also shifted the focus of academics in industrial location theory. Modern academic work has in particular concentrated on the phenomena of agglomeration, also known as “clustering”, which is common in knowledge-intensive industries. This phenomena is caused by economies of scale external to the individual firm. These can exist in the form of labour pooling, i.e. a concentration of skilled labour demanded and attracted by an
agglomeration of companies in a certain industry. This can also occur for subcontractors and other auxiliary services crucial to the industry. Other scholars emphasise socio-cultural reasons for agglomeration, such as the creation of an dynamic environment of knowledge and innovation. Regardless of its causes the phenomena of agglomeration leads to what Gunnar Myrdal pointed out in 1958 “Within broad limits the power of attraction today of a centre has its origin mainly in the historical accident that something once started there, and not in a number of places were it equally well or better have started, and that the start met with success”(Dicken, 1996). The phenomena of strong economics of scale working in a self- reinforcing loop is known in economics as a “First-mover Advantage” (Bannock, Baxter &
Davis, 1998, , Krugman & Obstfeld, 2000). It has a strong conserving effect that makes it difficult for new players to get a foothold and establish themselves in a mature industry.
4. Economic Theory on the Causes and Effects of Parallel Trade
In this section I will attempt to summarise what economic theory states as the reasons for and effects of parallel trade. I will commence by citing some reasons for international price
differentials between pharmaceuticals markets as they give opportunities for arbitrage trading.
Then I will give an account of the case that a group of scholars led by Danzon has made that parallel trade has negative effects both on the access to affordable drugs in developing countries and on the incentives for R&D spending. They therefore call for a ban on parallel trade in pharmaceuticals. To counter this claim I will subsequently present some views that hold parallel trade as an important function in combating collusive behaviour in monopolistic markets. Finally I will give an account for the transport and other costs of parallel trade.
4.1 Causes of Parallel Trade: Reasons Behind International Price Differentials
Parallel trade is like all kinds of trade basically an arbitrage between two markets. For trade to come about and be profitable it is necessary that prices differ between the two markets.
Parallel trade in itself is a proof of international price differentials in pharmaceuticals. But what causes these price differentials? Bale (1998) lists the following reasons for real price differentials between countries;
• Differences in patent duration. The expiry of a patent normally entails increased price pressure due to the entry of generic substitutes. If a product goes off-patent earlier in one country than in others, competition may force the price of the product to fall in relation to corresponding prices in other countries. This opens up an opportunity for parallel trading.
• Differences in inflation and/or exchange rates may lead to diverging real prices of products, as prices are generally relatively inflexible or “sticky”. Wholesalers or retailers may choose to keep prices unchanged despite currency fluctuations to, for example increase profit margins or, conversely, maintain their customer base.
• Differences in prices attributable to national price regulation. I will return to this in section 5.2.2.
• Differences in per capita income and consumption preferences mean differences in demand and prices between countries.
• Pharmaceutical companies may chose to set prices differently as part of a marketing strategy.
• Pharmaceutical companies may chose to offer discounts or donations to less developed countries through agreements with governments, UN institutions or private volunteer organisations.
4.2 Effects of Parallel Trade
As I mentioned in the introduction parallel trade is hard to measure as it isn’t separated from licensed imports when trade statistics are kept. This is probably also a reason behind the fact that the academic literature on parallel trade is relatively meagre and dominated by a few scholars. A possible reason for this could be that it might be hard to question a set of views
established by leading scholars without having some kind of empirical backing. Danzon (1998) has made the following analysis of the causes and effects of parallel trade.
Trade is enabled by the possibility of buying an article abroad and having it transported to you at a total cost lower than the price charged in the domestic market. In this way trade normally leads to inefficient producers pricing themselves out of the market and therefore improves overall efficiency. This has been the foundation of trade theory since the days of Ricardo.
However, a requisite for this to hold is that prices reflect true costs. In Danzon (1998),
Danzon & Towse (2003), Ganslandt & Maskus (2001) and Maskus (2001) it is argued that the lower prices of pharmaceuticals in general reflect more aggressive regulation rather than efficiency in production, lack of patent protection or price discriminating by drug
manufacturers because of lower per capita income. Danzon (1998) therefore argues that parallel trade in pharmaceuticals doesn’t yield the normal efficiency gains attributed to trade.
Instead it dissolves the segmentation of markets that price discrimination and Ramsey pricing are build upon and lead to prices converging between high and low income markets. In response to losing market shares to parallel traders, manufacturers will raise prices in low- income markets and lower prices in high-income markets to make parallel trade unprofitable.
Even a small amount of parallel trade can lead to a large shift in price if a manufacturer decides to set a significantly lower price in order to deter additional parallel trade (Danzon 1998).
When it comes to consumers in the low-income market, they will lose welfare as they will face higher prices. A number of them will drop out of the market which will create the losses of total welfare described in section 2.1 of monopoly pricing. Consumers in the high-income market will benefit from cheaper prices of pharmaceuticals. But they will also have to bear an increased burden of paying R&D as pharmaceutical companies will have lost revenue from low-income markets and will be increasingly dependent on them for recovering the costs of developing new drugs. As for producers, they will lose revenue as sales will drop in high- income markets as customers turn to cheaper parallel imports instead. Increased sales in low- income countries will only compensate these losses partially as prices are lower there.
One tactic the pharmaceutical industry might try to adopt to keep its revenue up is that of
‘market skimming’. This is one frequently used by firms in the high-tech industry. It consist of launching a new product at a high-price to cater to the most price-insensitive clients and
then successively lower prices in order to expand sales to more price-sensitive customers. A pharmaceutical company might adopt this kind of tactic by delaying the introduction of drugs in markets where they cannot sell at the price level that is profit maximising in other larger markets. The threat of parallel trade could thus effectively leads to certain markets being denied new drugs for an unknown period of time. But a more long-term solution to counter parallel trade is to adopt uniform pricing. As was shown in the example in section 2.2 above the distributive effect of uniform pricing would be to transfer welfare from consumers in poorer countries to consumers in richer countries. Ultimately, as the example in section 2.2 showed it could lead to some markets not being supplied at all. According to Maskus (2001) small, least-developed countries would almost certainly not be served by pharmaceutical companies in the case of a global uniform price of certain products. Danzon (1998) reaches the same conclusion. But uniform pricing will also reduce revenue for producers. The
reduction in expected revenue for new pharmaceutical products will mean less incentives for them to spend money on R&D. Hence some medicines may not be developed that consumers would have been willing to pay for had differential pricing been possible. Thus Danzon
(1998) concludes that in the long run also consumers in high-price countries will be worse off.
Although Danzon’s theoretical analysis may appear to be infallible a crucial requisite for it to hold is that pharmaceutical companies would actually use Ramsey pricing if markets were adequately segmented from each other. Other scholars like Malueg & Schwartz (1994), Maskus (2001) and Scherer & Watal (2001) also give support for the case that pharmaceutical companies would use price discrimination if it was possible. This would, in general, lead to higher prices than under uniform pricing for consumers in large markets with inelastic demand and the opposite in smaller markets with elastic demand, that is consumers would face lower-than-uniform prices. But one should keep in mind that pharmaceutical firms have no incentive to adopt Ramsey pricing if they can earn higher profits by raising prices further, as Maskus (2001) points out. According to Danzon & Towse (2003) profit-maximising pricing structures are so similar to the welfare maximising Ramsey pricing structures that the outcomes should be similar. But this is not undisputed as we will see in the next section.
Moreover, in some countries government agencies account for a large part of purchased volumes. As I describe in section 5.2 they are likely to use their monopsony power to bargain for prices, and ignore the negative externalities this would have on R&D spending. As long as the price offered exceeds marginal cost a pharmaceutical firm would be rational to accept the
offered price (Maskus 2001). These are two reasons that prices might differ from Ramsey prices. I will present some others later in section 5.4.
4.3 Parallel Trade as a Mean to Fight Collusive Behaviour in a Market Import barriers are often used to reduce competition in a market: Often, it is the “Infant Industry”-argument that is claimed, that a newly-started industry needs temporary protection from established foreign competitors in order to give it time to become efficient. But it has proved difficult to remove these import barriers once they have been put in place. Either the industry in question never becomes efficient enough to compete on equal terms or they fiercely protect the fat margins they make under protection by applying pressure on or even bribing the public officials in charge of trade policy. The country would then be stuck in a situation where consumers lose welfare by paying unnecessarily high prices for certain goods (Krugman & Obstfeld, 2000). A ban on parallel imports could in a similar way be used to increase the market power of certain actors. Abbott (1998) takes the example of the Australian book market where foreign book publishers took advantage of restrictions on parallel trade to charge significantly higher prices for books exported to the Australian market compared with books exported to other markets. According to Abbot (1998) parallel imports are often an effective policing function on abusive price setting of patent products. Maskus (2001) also highlights the risk for colluding behaviour as a result of trade barrier, e.g. a ban on parallel imports of pharmaceuticals. This could weaken price competition in pharmaceutical products and might lead to that efficiency gains might be lost. Many developing countries are therefore concerned that restricting parallel trade would invite collusive behaviour and abusive price setting in their markets by foreign companies (Abbot, 1998 & Maskus, 2001). They thereby completely dismiss the case of Danzon and other scholars, who claim that developing countries have everything to lose from parallel trade.
In contrast, academics specialised in intellectual property like Chard & Mellor (1989) claim that restrictions on parallel trade might be pro-competitive if they encourage investment in inter-brand competition and through providing incentives to build markets. They base their analysis on the view that parallel trade is a way to free ride on the official licensees’
investment in building up a local market through quality branding, advertising, discounting and by providing post-sale services (Chard & Mellor, 1989, Liebeler, 1986, Maskus, 2001 and Young, 1986). If parallel trade weakens the incentives for these kind of efforts it could be claimed that parallel trade leads to efficiency losses. Unfortunately there are no available data
or empirical studies that may be used to determine the effects of parallel imports free-riding on the marketing efforts of authorised distributors (Maskus, 2001).
4.4 Costs of Parallel Trade
As Maskus (2001) points out transport, repackaging and administrative costs of parallel trading are essentially non-productive activities and mean a loss of welfare. If as we assume pharmaceuticals are produced in the high income markets and then exported to low-income markets only to be re-imported back in to the high-income markets, as the case was in Danzon‘s scenario, there will be no efficiency gains from the trade. On the contrary the transport costs and administrative handling of parallel traded drugs will be an economic waste that will reduce total welfare. From a welfare perspective it is therefore worth noting that a price reduction caused by potential competition from parallel importers would be more efficient than actual competition as no real resources would be spent on transport, repackaging and other administrative costs connected with parallel trading (Ganslandt &
Maskus, 2004).
4.5 Theoretical Conclusions on Parallel Trade
I hope this section will have informed the reader on the main current of academic literature on parallel trade, which is that of Danzon et al. According to them parallel trade undermines the market segmentation that makes price discrimination such as Ramsey pricing possible. But as we saw it is not undisputed that segmented markets will lead to a Ramsey-pricing structure. In the coming sections I will examine how the different theoretical lines of argument correspond with real circumstances.
5. Empirical Evidence.
In this chapter I will at first, in section 5.1, present some essential facts of the pharmaceutical industry such as location, costs and spending on R&D. In section 5.2 I will describe how the pharmaceutical market functions; what strategies manufacturers use when launching new drugs, the incidence of regulation in pharmaceutical markets and the purchasing behaviour of large players. In section 5.3 I will turn to the international markets and examine
pharmaceuticals price differentials across countries. As we’ll see the correlation between pharmaceutical price levels and per capita income is far from perfect. In section 5.4 I will
account for some reasons for the deviations between pharmaceutical price levels and per capita income.
5. 1 The Pharmaceutical Industry
5.1.1 The Location of the Pharmaceutical Industry
This section builds in much on the industrial location theory presented in section 3. It might be of use to separate the location of production and the location of research and development (R&D) as they are dependent of different factors for their cost-effectiveness. However it is common in the pharmaceutical industry to keep production and R&D together as mutual learning can give opportunities for improvements in both production and R&D. Therefore I will treat the two as one collected unit. The pharmaceutical industry can be seen as
independent of transport cost as both its inputs and finished goods have an extremely high value to weight ratio. It has therefore no need to be located close to the source of any
materials used in the production as transportation costs are negligible. This is equally true for transporting the finished goods to the market but there are other reasons for choosing to locate close to potential or existing markets. The development of new medicines and chemical entities is often pursued in close interaction with their intended consumers. This gives
opportunities to draw expertise from the treatment and observation of patients suffering from illnesses that new drugs are intended to treat. Pharmaceutical products at an advanced stage of development are tested on patients, so called phase-II clinical testing, before launched on the market (Schweitzer, 1997). It is therefore often crucial for a pharmaceutical company to be located close to a critical mass of people suffering from the illness the company is hoping to provide a treatment for with its products. For reasons of profitability it is also crucial that the intended consumers have the means to pay for new drugs. This is the reason why much of R&D spending is allocated to treat life-style diseases as obesity and high cholesterol levels rather than far more mortal illnesses like malaria and AIDS. Hence, it follows that the pharmaceutical industry will be prone to locate in countries were consumers have the ability to pay for pharmaceutical treatment.
As the pharmaceutical industry is intensive in high-skilled labour it is prone to locate close to universities and other research facilities specialised in medicine, biology and other fields relevant to the industry. As a knowledge-based and innovative industry there should also be considerable external economies of scale to take advantage of by choosing to locate at an
agglomeration of other pharmaceutical companies and, publicly or privately-funded, research facilities (Schweitzer 1997). This ought to lead to the risk that Myrdal pointed out, that the location of the industry might be decided by historical rather than present condition. It is therefore not surprising that the pharmaceutical industry is concentrated to a few regions in the richer countries. It is at these places that the joint global sunk costs of R&D are spent and to where the revenue of pharmaceutical are collected. It is of course possible to recuperate the sunk costs of R&D in the home market, provided it is large enough. But to renounce revenue from buyers abroad prepared to pay a price above marginal cost would be contrary to profit- maximising, which is the raison d’être of private companies. The absolute majority of all pharmaceuticals are therefore sold in several markets. The marketing of products in different countries can give the company the opportunity to price discriminate as shown in section 2.2.
5.1.2 Costs of the Pharmaceutical Industry
As I stated earlier the greater part of the costs of the pharmaceutical industry are those of R&D spending. The Pharmaceutical Industry spends a higher percentage of sales on R&D than most industries – roughly 21% of sales compared to less than 4% for US industry overall.
It is estimated that the average cost of developing a new drug in the US or the EU is estimated to be between approximately $300 million and $500 million but that it in some cases can be substantially higher (Danzon, 1998). These large costs mean that a pharmaceutical company needs to be of a certain size to shoulder the costs of developing new products. In addition, a pharmaceutical company needs to spread risks across a number of research projects, as most projects don’t generate any profits. Danzon & Towse (2003) refer to evidence that new chemical entities launched during the 1980s and 1990s earned at most modest excess returns on average. But this hides the real circumstances, that highly profitable blockbuster products served to cover for the 70 per cent of new drugs that failed to generate sufficient global revenue to cover the average cost of R&D. The additional cost of covering for failed products and research projects has therefore to be included in the costs for R&D (Danzon, 1998).
While the majority of costs are spent on R&D, marginal costs such as processing, packaging, promotion and distribution also account for roughly 30% of total cost. Marginal cost pricing would therefore increase distribution considerably, but incur large losses for innovative pharmaceutical companies.
5.1.3 Profits of the Pharmaceutical Industry
Danzon (1998) states that the high share of R&D costs overstates the profits of the
pharmaceutical industry relative other industries. The reason for this is that R&D is treated as an expense rather than as a capital investment in accounting statements. Accounting measures of capital are therefore downward biased which leads to the return on capital being upward biased. According to Danzon “This bias fuels the perception that the pharmaceutical industry earns abnormally high profits, which in turn leads to pressure for lower prices”. In a model constructed by Clarkson it is shown that if accounting rates of return are adjusted for intangible capital the profits of the pharmaceutical industry are in line with those of other industries (Clarkson, 1996). Danzon & Towse (2003) also state that there is evidence that the entry of new actors in response to expected profits assure that profits are bid down to normal levels and price mark-ups over marginal cost should correspond to Ramsey pricing levels. If this is true it would mean that the difference between welfare maximising Ramsey pricing structures and profit maximising pricing diminish.
5.2 The Pharmaceutical Market
5.2.1 Pricing Strategies for Pharmaceutical Products
For some illnesses and ailments there are a range of different pharmaceutical treatments with varying levels of effectiveness. But if a product has unique qualities for treating an illness, the demand elasticity is usually low as there are no real substitutes. This gives the company concerned a high degree of freedom to set the price of the product. Lu & Comanor (1998) investigated pricing strategies of pharmaceutical companies in the US and found that they depended on the therapeutic value of the launched product. If the product possesses
significant therapeutic gains compared to available substitutes pharmaceutical companies tend to opt for the ‘market skimming’ tactics described earlier in section 2.4 and set a high launch price which is gradually reduced later. If the product has a similar therapeutic effect as other available products companies tend to use a ‘market penetration’ tactic and set a low launch price to gain market shares and then subsequently raise the price. Other studies confirm the
fact that the presence of competing products bring far lower prices than clear monopolies (Maskus, 2001). In an international perspective, a company that possesses some amount of market power will try to set a profit-maximising price in each individual market it has sales operations in. But if there is arbitrage trading between markets the company will try to find a set of prices that will maximise total profits.
5.2.2 Regulation and Purchasing Strategies in Pharmaceutical Markets
Effects of Price Controls and Government Purchasing Agencies
In many countries the price of pharmaceutical products are affected by government policies.
In the majority of high- and middle income countries it is a national health policy to assure that access to health care is provided to citizens without regard to their ability to pay. This usually includes measures to provide pharmaceuticals at “affordable” prices. In some
countries, such as Greece, India, Italy, Spain and others the pharmaceutical market is subject to direct price controls (Lanjouw, 1998 and Maskus, 2001). In other countries governments run social insurance programmes where pharmaceutical products are purchased en bloc by a governmental agency to be re-sold to consumers via pharmacies. Sweden is such an example.
As the sole purchaser in the market the government insurer will have considerable monopsony power which gives it the ability to put pressure on producers to lower prices. With health care being a substantial post in many countries’ budgets health policy becomes a part of fiscal policy, as Danzon (1998) remarks. With increasing pressure to decrease taxes and cut government spending the incentive to demand lower prices from pharmaceutical companies increases. This corresponds well with the cost shirking behaviour described in section 2.3.
Such a way of action might appear to government officials to be a “free lunch” but it might actually be closer to a “tragedy of the commons” where all actors are keen on reaping the benefits of new pharmaceutical products but nobody wants to foot the bill of R&D.
External Referencing
One way to bargain down prices on pharmaceuticals is to use external referencing. With external referencing, or reference pricing, is meant the practice by government purchasers or other monopsony buyers of demanding price cuts by referring to lower prices in other
countries. The line of argument commonly used is to accuse a pharmaceutical firm of overcharging because they sell the drug in question at a lower price in another country. But the reason for this might be that the company has set prices according to the elasticity of demand or per capita income of each market. But this counter-argument might be disregarded by a negotiator less interested in upholding incentives for R&D spending than limiting their own health care expenditure. External referencing is used formally in regulating
pharmaceutical prices in several countries, e.g. the Netherlands, Canada, Greece and Italy. In other countries, the US for instance, external referencing is used more informally as an argument by purchasers when bargaining prices with pharmaceutical manufacturers (Danzon
& Towse, 2003). As Danzon (1998) states reducing pharmaceutical prices by external referencing is equivalent to 100% parallel trade.
5.3 Evidence of Pharmaceutical Prices in International Markets
As Danzon & Kim (1998), Lanjouw (1998) and other remark, comparing pharmaceutical prices is a difficult task, especially between countries. Differences in brand name, product forms, concentrations and pack sizes make it difficult to find an adequate amount of precise drug products that exist across several countries. The existence of therapeutic substitutes of different degree also blur the lines when it comes to defining specific products. Finally, as original prices are quoted in local currencies, the choice of exchange rate at which to convert the prices into a common unit can have a significant impact on the result (Maskus, 2001) But all the same, such comparisons have been made by a number of scholars like Danzon & Kim (1998), Danzon & Furukawa (2003), Maskus (2001) and others.
It would be reasonable to expect that pharmaceutical prices would in some way be correlated with per capita income as it can be seen as a proxy for price-sensitivity. But several studies show that trans-national price differentials quite often deviate from per capita income (Danzon & Towse, 2003, Maskus, 2001). Hence it follows that, at a first glance,
pharmaceutical companies appear to follow a different logic than the one of Ramsey pricing described in section 2.4earlier. I will later account for some possible reasons behind the weak link between pharmaceutical prices and per capita income.
Danzon & Furukawa (2003) compare pharmaceutical prices in nine countries ( Canada, Chile, France, Germany, Italy, Japan, Mexico, UK and US) and find that prices are highest in Japan
followed by the US which corresponds well with the suppositions made in section 2.3 on effective payment of R&D as these are two of the richest countries of the world. However, they also find that prices in Chile and Mexico are comparable to prices in Canada and European countries, despite their markedly lower level of per capita income. As a
consequence per capita consumption of the sample compounds of pharmaceuticals is also significantly lower in Chile and Mexico, reflecting that these drugs are unaffordable to most people. As described in section 2.2, it is reasonable to assume that a large number of
consumers in these countries would be prepared to pay a price equivalent of the marginal cost and a minor mark-up for these drugs. The outcome of high prices in Mexico and Chile is therefore a considerable loss of welfare, both for Chileans and Mexicans who are withheld consumption and for consumers elsewhere who have to carry an unnecessarily high burden of the joint costs of R&D. Other studies, like Maskus (2001), Maskus & Ganslandt (2001) and Scherer & Watal (2001) find a similarly weak link between per capita income and
pharmaceutical prices in many countries. Maskus (2001) even finds a negative correlation between income level and the prices of some pharmaceuticals. But in general, as Danzon &
Kim (1998), Danzon & Furukawa (2003) and Maskus (2001) find, the correlation between average pharmaceutical price level and per capita GNP is clearly positive, although well- below unity.
5.4 Reasons for discrepancies between pharmaceutical prices and per capita income level
There are several factors that could explain the weak relationship between per capita income and prices. Firstly, regulators in richer countries may use their monopsony power to force down prices. One way this can be done is by using external referencing as described above, and refer to a country where pharmaceutical prices are lower, which could be because the country has a lower per capita income level. Apart from the direct effect on prices in high- income countries, external referencing also has a secondary effect of manufacturers charging higher prices in low-income countries to pre-empt external referencing.
Another reason that pharmaceutical prices deviate from per capita income levels is that distribution systems in low-income countries are often concentrated or monopolistic. Corrupt or badly-functioning public administrations might lead to that a single or only a few
wholesalers are given the legal rights to import certain pharmaceuticals. Consequently, these
wholesalers will be free to use their monopoly power to maximise profits by setting a price with a large mark-up (Maskus 2001).
The use of monopoly power is especially damaging in low-income markets that are internally segmented between a small elite with western living standards and an impoverished mass population. While the former might be able to pay the same prices for pharmaceuticals as consumers in high-income countries, the latter often have to make hard choices between the different necessities of life. The market demand curve of pharmaceuticals will then be
“kinked” between a low-volume, inelastic segment and a high-volume elastic segment. In this case it can often be the most profitable option for a pharmaceutical company with some degree of market power to supply the inelastic segment at a large mark-up and thereby forego the elastic segment altogether. The difficulty of segmenting consumers with different degrees of price sensitivity within a geographically integrated market often leads to poorer consumers not being supplied, which is economically inefficient as shown in section 2.2. A visible indication, that so might be the case is that pharmaceutical price levels in some low-income countries are similar to those in high-income markets (Danzon & Towse, 2003,Ganslandt &
Maskus, 2001 and Scherer & Watal, 2001). In a report by a joint committee of the WHO- WTO (2002) it is stated that in many low-income markets pharmaceutical companies concentrate on selling to the affluent middle class.
5.5 Conclusions on International Price Differentials and the Opportunities for Parallel Trade
As we have seen from the sections above pharmaceutical markets do seldom fit the model of perfectly competitive markets shown in economic textbooks. Firstly, some drugs possess a certain market power due to unique qualities or brand-names. This indicates the market could be describes as monopolistic competition. Secondly, price regulation and monopsony
tendencies among buyers push the markets further away from perfect competition. To determine the likely price level of pharmaceuticals in a country is therefore far more complicated than just looking at per capita income. Still there are several studies that have established the existence of a correlation between pharmaceutical prices and per capita
income level. But the link is far from unity and there are numerous exceptions. Some possible reasons for these discrepancies from Ramsey-type price levels have been listed above. I will
later in section 7 present some initiatives aimed at creating an international framework that would facilitate the use of Ramsey pricing. But I would like to conclude this section by stating that it is evident that price differentials in pharmaceutical products exist between countries, but that these price differentials are not always caused by differences in per capita income. It follows that there are opportunities for parallel trade between countries, but not exclusively exports from low-income countries to high-income countries. Trade in the reverse direction could also be profitable, as well as trade within the two groups of countries.
6. Evidence on the Effects of Parallel Trade: EU and Sweden
In this section I will present a study of the effects the opening to parallel trade had on the Swedish pharmaceutical market when Sweden joined the European Union in 1995. This occasion provides an unique opportunity to examine the effects parallel trade has on prices. In section 6.1 I will give an account of the view on parallel trade that has been dominant within the EU-institutions. In section 6.2 I will make a summary of the findings of Ganslandt &
Maskus (2001 & 2004) who studied the effects of parallel trade on pharmaceutical prices in the Swedish market. In section 6.3 I will relate the evidence of price convergence between the source and target markets, in this case the Swedish and the Italian/Spanish markets
respectively. In section 6.4 I will give a short account of how pharmaceutical companies have reacted to the flows of parallel trade between EU-markets.
6.1 The European Union
The EU provides an interesting case when studying the effects of parallel trade in
pharmaceuticals as it is one of few areas of the world were trade in pharmaceutical goods is unhindered. The European Court of Justice has consistently upheld the view that, under article 30 of the Treaty of Rome, free circulation of goods takes precedence over patent rights in individual countries of the European Union. This was definitely stated in the test case of Merck v. Primecrown in 1996 (Danzon, 1998, Maskus, 2001 & Maskus & Ganslandt, 2004).
This gives considerable room for parallel trading between the more rigorously regulated southern countries, such as Greece, Italy and Spain and richer and less regularised markets like Sweden, Germany and the UK where pharmaceutical prices are higher (Ganslandt &
Maskus 2004). In a report by the consultancy REMIT consultants, under contract to the European Commission, it was found that parallel imports amounted to approximately two
percent of the prescription drug market in the EC overall in 1990, but reached higher levels in individual countries. For instance 5-10 percent of the Dutch market and 8 percent of the British market in pharmaceuticals was made up of parallel imported products. It should be noted that products with large markets had considerably higher volumes of parallel imports, which is consistent with the previously expressed fact that parallel importers target
“blockbuster” medicines (Maskus, 2001). Still parallel trade had far from eradicated intra-EU price differentials in 1998, when a survey by the Swedish Medical Products Agency (SMPA) showed that e.g. average prices in Greece were 28 percent below the EU-wide average and that prices in Germany were 11 percent above average. A regression analysis made by the SMPA confirmed that these price differences were statistically significant across countries (Maskus, 2001). A reason for the persistence of price differentials between countries in EU’s common market could be that price controls were still in place in some countries.
6.2 The Case of the Swedish Entry into the EU
Ganslandt & Maskus (2001) and Ganslandt & Maskus (2004) use the case of the Swedish entry into the European Union to examine the effects of parallel trade. Before Sweden joined the EU in 1995 parallel trade in pharmaceuticals was prohibited, but as an EU-member Sweden was required to permit such trade. This opened up for imports from countries such as Greece, Italy, Portugal and Spain where pharmaceutical prices were lower due to price regulations using price caps and external referencing (Ganslandt & Maskus, 2001). The sudden change of policy from total prohibition of parallel import to being part of a “single market” makes Sweden an interesting case to study. No applications to import were filed in 1995, but by 1998 parallel imports of pharmaceuticals had grown to 1.0 billion SEK, which corresponded to 6 percent of the Swedish pharmaceutical market. In the 50 highest-selling molecules parallel imports amounted to 16 percent of sales, which gives further support to the argument that parallel importers mainly target “blockbuster” drugs. Parallel imported drugs were in average sold at a price equal to 89 percent of manufacturers’ prices in Sweden in 1998.
The source of the imports was to a large majority countries in southern Europe with Greece, Italy or Spain being the source in 74 per cent of the cases. By making an econometric analysis of pharmaceutical prices Ganslandt & Maskus (2004) found no statistically significant effect
during the initial years after the Swedish EU-accession in 1995. However data from 1997- 1998 showed that prices of pharmaceuticals facing competition from parallel imports fell 4 percent in relation to prices of other pharmaceuticals (Ganslandt & Maskus, 2004). By
comparing the price changes of the two categories of products with changes in manufacturers’
prices Ganslandt & Maskus (2001) could attribute 75 percent of the price fall to parallel imports and the remaining effect to changes in manufacturers’ prices. The authors then perform a regression analysis with the relative price change of a product as the dependent variable and as explaining variables parallel imports’ percentage share of total sales of the product (PI Share) and a dummy variable denoting the existence of an approval for parallel imports of the given product (Approval). For the period 1997-98 the coefficient on PI Share was –0.039 and was significantly negative at the one-percent level. This means that an increase of one percent in the share of a product’s sales that came from parallel imports in average reduced the average price increase by 3.9 percent. The coefficient of the dummy variable of approval was –0.0125 and significant at the five percent level.(Ganslandt &
Maskus, 2001). The limited effect of parallel imports on prices could, according to Ganslandt
& Maskus (2001 & 2004), suggest that manufacturers have chosen to accommodate parallel imports rather than to deter them by cutting prices to a level where parallel imports would be unprofitable.
Ganslandt & Maskus (2004) estimate the effect of the entry of a parallel importer to be a reduction of between 12 and 19 percent in the manufacturers’ prices of affected product. The authors observed that the result suggested that drug manufacturers reacted to parallel imports with a lag and that the fact that the growth of parallel imports seemed to be accelerating at the end of the sample indicated that the available data presumably didn’t reflect a long-term equilibrium. Ganslandt & Maskus (2004) conclusion is that parallel imports represent a significant form of competition in markets such as Sweden, and as such have a moderating effect on prices.
6.3 Evidence of Price Convergence Between Markets
Ganslandt & Maskus (2001) then continues by studying the effect of parallel trading on prices in source countries. According to theory the demand from parallel traders should lead to price increases in source markets. In addition, a logical reaction from manufacturers would
be to raise prices in the source countries in order to protect total revenue. Ganslandt &
Maskus compare the prices of pharmaceuticals in Italy and Spain in relation to prices in the Swedish market at two occasions, in 1994 and in 1998. They then made a regression of the relative price changes with a dummy variable indicating if there were parallel imports of the product or not. The fact that the estimated coefficient of 0.018 was small and not statistically significant could be seen as an indication that parallel imports have not lead to any price convergence of importance. As a consequence, pharmaceutical prices in Italy and Spain still only amounted to, on average, 68 percent of prices in Sweden in 1998 (Ganslandt & Maskus, 2001).
A possible reason for this could be that the differences in size of the Italian, Spanish and Swedish market, which entails that traded volumes should have a larger impact in the Swedish market than in the Italian and Spanish markets. But as I mentioned in section 4.2 there is no clear link between the volume of parallel exports/imports and the impact on prices. Another possible reason, could be the fact that just four firms accounted for 96 percent of parallel imports in 1998. The lack of price convergence could therefore be attributed to the lack of competition among parallel importers.
As readers may conclude by themselves, if parallel trade has not led to any price convergence remaining price differentials should equal the rents of parallel traders minus the costs
incurred. In 1998, parallel imports were, on average, sold at a price of 89 percent of manufacturers’ prices in Sweden. As it was stated above that pharmaceuticals in Italy and Spain were sold at a price averaging 68 percent of corresponding prices in Sweden in 1998.
This leaves an average margin of approximately 21 percent for parallel traders. But the
reported margins in different products ranged from 9 to 39 percent. It should be fair to assume that these margins exceed the transport and administrative costs of parallel trade. It may also be fair to assume that the high margins of parallel traders should attract new entrants to the industry, which would compress margins and, consequently, pharmaceutical prices between countries.
Finally Ganslandt & Maskus (2001) try to establish what transfers of welfare parallel imports have brought to Sweden. It is clear that pharmaceutical manufacturers have lost out through falling prices. But the welfare gains, approximately 190 million SEK, to Swedish consumers of cheaper pharmaceuticals seem to be off-set by a similar amount of rents paid to parallel importers. Ganslandt & Maskus therefore draw the conclusion that the net static impact of
