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

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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

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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

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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

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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

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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).

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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

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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.

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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.

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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.

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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.

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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

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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.

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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

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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

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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

16

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

17

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

18

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

19

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.

20

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

21

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

22

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 2.4 earlier. 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

23

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

24

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

25

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

26

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

27

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

28

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

29

parallel imports on welfare in Sweden is negative, even without considering the dynamic

impact on R&D. But their is no detectable relationship between parallel imports and R&D

spending. In Italy, one of the main source markets of parallel imports in Europe R&D

performance languished during the 1990s, while Spain, another source country, experienced

an increase of roughly 80 percent in its R&D-to-sales ratio (Maskus, 2001) To further study

the effect of parallel trade on R&D Maskus (2001) propose an analysis linking the lagged

price impacts of parallel imports, product by product, with R&D expenditure of

pharmaceutical firms.

6.4 Reactions from the Pharmaceutical Industry Danzon (1998) states that the mounting parallel trade within the European Union has lead to

the pharmaceutical industry opting for the tactics of uniform pricing predicted in section 2.2

Several multinational companies now choose to launch new drugs across the EU at uniform

prices. In 1996 Merck launched its protease inhibitor Crixivan at a common EU price,

denominated in Ecu (the predecessor of the Euro). Another tactic used is that of ‘market

skimming’ described in section 4.4. Pharmaceutical companies have delayed the launch of

new drugs in traditional low-price markets in the EU, rather than accept prices that would

invite parallel trade that would erode revenues they can earn in other EU-markets. For

instance, Glaxo delayed the introduction in France of its antimigraine drug Imigran several

years, rather than accept a price that would have undercut higher prices elsewhere through

parallel trade (Danzon 1998).

6.5 Conclusions from Parallel Trade within the EU

The predictions from theory in chapter 4 have shown to be fairly consistent with what has

actually occurred within the European Union (Danzon, 1998). Parallel traders have put

pressure on prices in high-priced markets like Sweden. Although studies of the years 1994-98

show that the moderating effect of parallel imports on prices had been limited, the

acceleration in the impact of parallel imports toward the end of the time interval could imply

that the long-term effect of parallel imports are stronger. This reservation is also valid for the

absence of any significant price convergence between the Italian and Spanish market on one

hand, and the Swedish market on the other. This could be explained by several different

factors. Firstly the Italian and Spanish markets are larger than the Swedish which dilutes the

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effect of arbitrage on the former markets. Secondly price controls in the Italian and Spanish

markets could neutralise the effect of increased demand from parallel traders. Thirdly, the

effect on prices might have a time lag that runs beyond the period of time studied.

The strategies of market skimming and uniform pricing adopted by pharmaceutical companies

in response to parallel trade seem to be in line with what has been predicted in academic

literature. According to Reekie (2002) the regulated prices in some EU countries is the major

cause of parallel trade within the EU. So parallel trade should not offer the efficiency gains as

trade normally does. Reekie (2002) states that it is economically perverse to have differing

price regulations in an allegedly single market. This is something that I think most economists

would agree with. The root cause of this state of affairs is the division of competencies within

the European Union. Health policies, including the regulation of pharmaceuticals prices, are

seen to be of the exclusive competency of member states, while intra-EU trade is under the

reign of the EC-law and the institutions of the European Union. As the causes and solutions to

this state of affairs are political rather than economic, I will not further touch on this area in

this paper.

7. The Creation of a System of Differential pricing

As was mentioned previously in chapter 2 a system of differentiated prices could increase

total welfare and increase access to drugs for consumers in developing countries. I will

therefore in this section examine the possible effects and requirements of a system of

differential pricing. I will also make a short résumé of previous attempts to create a system of

differential pricing.

7.1 Effects on Prices and Welfare

As I have shown there are a lot of advantages of a system of differential pricing. It would be

beneficial for consumers in poor countries who would, in general, face lower prices.

Manufacturers would be able to increase their revenue by differentiating prices according to

demand elasticities in individual markets. The only group standing anything to lose is

consumers in high-income market as pharmaceutical prices might rise in these markets. As we

saw in chapter 6 parallel imports have a price-moderating effect on prices, although it wasn’t

substantial in the case of Sweden in the EU. In the absence of competition from parallel

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imports pharmaceutical companies will be freer to set higher prices if it would increase

profits. Similarly pharmaceutical companies can lower prices in low-income markets to

increase profits there without risking that the drugs will be re-exported to high-income

markets. It should be kept in mind that lower prices in low-income markets would not mean a

shifting of cost between markets. In other words, lower prices in low-income markets aren’t

something that has to be compensated by higher prices in high-income markets. On the

contrary, increased revenue from low-income markets would make pharmaceutical companies

less dependent on revenue from high-income markets. Theoretically they could then lower

prices in high-income markets and still make the same profits as before. But as profit-

maximising entities it is more likely that they opt for increased profits instead. But consumers

in high-income countries would benefit from this too as it would give pharmaceutical

companies increased incentives for R&D spending. This holds at least theoretically, as the

link between profits and increased R&D spending yet has to be established. In a joint report

from the World Health Organisation and the World Trade Organisation (2002) it is argued

that a system of differential pricing would reasonably not entail price increases in high-

income markets. At present a large part of the costs of R&D are already allocated to the high-

income markets of the industrialised countries as roughly two-thirds of the value of

pharmaceutical sales are spent in Japan, the US and Western Europe. Additional revenue from

third-world countries could, on the contrary, open up for lower prices in high-income markets.

7.2 Requirements The creation of a system of differential pricing would require the prevention of diversion of

low-priced products into high-income markets, which is a technical issue, and the readiness of

consumers in high-income markets to accept to pay higher prices than in poorer countries,

which is a political issue (Maskus, 2001). On the technical side, a system of differential

pricing would require measures to stop parallel trade. This could be import and export

controls implemented by customs authorities or stronger enforcement of intellectual property

rights by judicial authorities. But it is disputed among scholars whether or not market forces

would lead to a system of differential pricing if market segmentation was stopped. It can

therefore be necessary to request pharmaceutical companies to commit to providing medicines

at lower prices in low-income markets. Similarly, governments in high-income countries must

commit to not use external referencing to force down pharmaceutical prices in their home

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market(WHO-WTO, 2002). As was stated in section 5.3 external referencing is equivalent of

a 100% market share for parallel imports.

A system of differential pricing would , as mentioned, mean static losses for consumers in

high-income countries but as Danzon (1998) concludes they would still gain in the long run.

As Danzon & Towse (2003) points out it is required that high-income countries accept that

parallel trade and external referencing are incompatible with low-income countries getting

low prices of pharmaceuticals. This is something that will need to be thoroughly

communicated in high-income markets to avoid public opposition to differential pricing.

Government of countries where pharmaceutical prices are low would in turn have to ban

parallel exports, and thereby make it possible for manufacturers to continue to sell at low

prices without these prices spilling over to other markets through parallel trade (Danzon &

Towse, 2003).

7.3 Efforts to Create Systems of Differential Pricing

The European Commission Council Regulation, initiated in 2002, is an attempt to create a

regulatory framework which would allow a system of differential pricing of key

pharmaceuticals for the prevention, diagnosis and treatment of HIV/AIDS, tuberculosis and

malaria and related diseases frequent in poorer countries. Pharmaceutical companies were

asked to commit to supply low-income countries with medicines at a discount of 75% off the

calculated price. The exact prices offered by the companies are confidential, to prevent

external referencing, and only disclosed to the Commission in the application and in an annual

sales report. The current list of recipients consists of 76 countries, including China, India and

South Africa, from which re-importation into the EU is prohibited for both on-patent and

generic drugs. To facilitate for custom officials to discover attempted re-importation the

pharmaceutical products included in the program are marked with an EU-logo and have a

different colour, shape or size than the products sold in the EU Market (Danzon & Towse,

2003).

Investigations into putting into place a similar arrangement within the frames of the G8 group

was initiated by the UK government in co-operation with the pharmaceutical industry, WHO

and the EU. The initiative aimed to establish “an international framework that would facilitate

33

voluntary, widespread, sustainable and predictable differential pricing as the operational

norm”. The scope proposed included 63 developing or sub-Saharan (or both) countries.

One of the pitfalls of differential pricing is the reciprocal effect of linking prices in different

markets. A commitment by a pharmaceutical company to sell pharmaceuticals in low-income

countries at a 50% discount off prices in high-income countries could lead to higher prices in

the high-income market rather than the intended lower prices in the low-income market. If the

marginal effects on income are greater in the low-income market the company will raise

prices in high-income-countries to reach a profit-maximising price level in the low-income

market (Danzon & Towse, 2003).

8. Conclusions on the Effects of Price Discrimination and Parallel Trade

As we saw in chapter 4 economic theory presents a clear case of parallel trade being

beneficial to consumers in high-income markets but reducing the welfare of producers and

consumers in low-income countries as it impedes producers’ ability to price discriminate

between markets with different demand elasticities. A system of uniform pricing across the

world would severely limit pharmaceutical companies possibilities of recuperating R&D cost

while still serving low-income markets at an affordable price. In my research work for this

thesis I haven’t found a single scholar that rejects this theoretical case. However, as so often is

the case, real circumstances differ somewhat from the assumptions and predictions of

theoretical models. As was shown in chapter 5, pharmaceutical prices aren’t always correlated

with per capita income levels. As a consequence the flow of parallel trade would also differ

from the predictions of the theoretical model of Danzon and other advocates of a ban on

parallel trade. As mentioned in the introduction, parallel traded pharmaceuticals are not

separated from other pharmaceutical imports/exports when trade statistics are kept. This

makes it near impossible to clearly establish how actual parallel trade flows run. It follows

that the real-life effects on global welfare of parallel trade remain equally unclear.

However, the Ganslandt & Maskus study provides an interesting exception, which was why I

chose to include it as a case study in this thesis. It should be said that it is unclear to what

degree the findings of Ganslandt & Maskus study can be extra-polated to other areas of the

world. Ganslandt & Maskus (2001 & 2004) show that parallel trade does mean a shift of

welfare from producers to consumers, as Danzon et al predicted. However Ganslandt &

34

Maskus didn’t find any significant price convergence between the source and target market

due to parallel trade. This could, as mentioned, be down to differences in size of the markets

or the presence of price controls in the source markets. As a consequence, a large part of the

welfare lost by producers didn’t fall to consumers, but to parallel trading firms. To counter the

risk that the welfare gains that should fall to consumers are swallowed by the rents of parallel

traders Maskus (2001) advises that measures are taken to make competition as active as

possible if parallel trading is to be allowed. But excess profits should lead to new entrants and

the compression of margins and, consequently price differentials between markets.

8.1 Effect on prices in high-income markets

Despite the price-moderating effect parallel imports had on pharmaceutical prices in Sweden,

the main inference from Ganslandt & Maskus study was that substantial differences in

pharmaceuticals price levels remain in between EU-countries, despite the European Court of

Justice ruling on free movement of pharmaceutical goods (Maskus, 2001). It is probably

premature to say that this is a definite outcome as Ganslandt & Maskus make the reservation

that the study probably hadn’t established the long-term effects of parallel trade. A possible

reason for remaining price differences could be that consumers don’t fell entirely assured that

parallel imported pharmaceuticals are of the same quality as licensed products. The problems

of marketing parallel imported goods with different brand names and packaging could also be

impediments for full price integration. It is therefore reasonable to expect that original

license-holders will retain some measure of price premium even under a regime that permits

parallel trade. Notwithstanding parallel traders will surely seek opportunities to make profits

from arbitrage trading between different markets. In a free market the long-term effect should

be that producers will be limited in their price discrimination to the range of parallel traders’

costs of transport plus the price premium they can take out. But one should remember that the

effect on prices depends on if manufacturers and original licensees choose to accommodate

the inflow of parallel imports or to deter them by setting a price that would make parallel

imports unprofitable. The possibility of them opting for the latter has the consequence that

even relative amount of parallel trade can lead to significant price changes. The size of the

price moderating effect of parallel trade on can therefore be hard to predict as it doesn’t

necessarily have to be correlated with trade volumes (Maskus, 2001).

35

8.2 Effect on prices in Low-income markets

Danzon & Towse (2003) are of the view that ‘the breakdown of market separation and hence

manufacturers’ ability to price discriminate is probably the single most important obstacle to

lower prices in low-income countries’. Consumers in low-income markets would suffer from

higher prices and fewer new drugs due to less R&D as a consequence of parallel trade. There

is also a risk of them being withheld new drugs as a consequence of market skimming tactics

used by pharmaceutical companies. On the other hand, as Maskus (2001) points out, as price

evidence show that pharmaceuticals aren’t necessarily cheaper in low-income markets than in

high-income markets, parallel imports from foreign markets could also provide a source of

lower-cost drugs for developing countries. A ban on parallel trade could therefore possibly

lead to higher prices. As Abbott (1998) mentions, many developing countries are worried that

bans on parallel trade will lead to pharmaceutical companies colluding and thereby result in

excessively high prices. Maskus (2001) therefore suggests that parallel imports to low-income

markets should be allowed in order to allay these fears. The countries in question would have

to ban parallel exporting in order to assure that their access to low-price pharmaceuticals isn’t

abused by re-exporting them to high-income markets.

8.3 Effects on Research and Development

It is extremely difficult to estimate the effect of parallel imports on R&D incentives and the

development of new drugs, as Maskus (2001) points out. This is because of the unknown

impact of parallel imports on prices and the equally unknown link between profit levels and

R&D spending (Maskus, 2001). As was mentioned earlier, the theoretical line of argument

made by Danzon (1998), Bale (1998) et al may appear infallible but it should be kept in mind

that there are no available empirical studies that establishes the link between parallel imports

and prices or the link between profits of the pharmaceutical companies and their R&D

spending (Maskus, 2001). Another important aspect is that parallel trading is likely to

concentrate on economically successful, so called “Blockbuster”, drugs. These are usually

priced so that their revenue will cover also the incurred cost of other products and research

projects than fail to yield sufficient - or any - revenue. This entails that the impact on overall

36

profitability could be severe even when only a few products are subject to parallel imports

(Maskus, 2001).

8.4 Areas of Regional Parallel Trade A case can therefore be stated for allowing parallel trade among countries with similar

demand structures, but that parallel trading would be harmful between countries with different

demand patterns (Maskus 2001). Maskus (2001) also concludes that parallel imports are likely

to be beneficial in terms of total surplus generated among nations when trade costs are low

but harmful when they are high. A regime of regional exhaustion could therefore be the

optimal policy. A larger market would help discipline collusive behaviour within the region,

while the proximity would limit transportation costs. The possibility of creating a system of

differential pricing between regions with different levels of income would then still be

possible.

9 References Abbott, Frederick M, 1998 ’First Report (Final) to the committee on International Trade Law

of the International Law Association on the subject of Parallel Importation’, Journal of

International Economic Law, 1(4), December, 607-636

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Innovation: The Case of Pharmaceuticals’, Journal of International Economic Law, 1(4),

December, 637-53

Bannock Graham, Baxter R.E. and Davis, Evan (1998), ’Penguin Dictionary of Economics’

6th edition, Kent England, Penguin Books

Chard, J.S. & Mellor C.J. (1989) ’Intellectual Property Rights and parallel imports’, World

Economy (12)1, March, 69-83

Clarkson KW (1996), ’The effects of Research and promotion rates of return’ in ed. Helms, R

Competitive Strategies in the Pharmaceutical Industry, Washington D.C, The American

Enterprise Institute Press

37

Danzon, Patricia M. (1998), ‘Economics of Parallel Trade’, Pharmacoeconomics 13(3), 293-

303

Danzon, Patrica M. & Kim Jeong (1998) ‘ International Price Comparisons for

Pharmaceuticals’ Pharmacoeconomics 14 (supplement) 129-136

Danzon, Patricia M & Towse, Adrian (2003)‘Differential Pricing for Pharmaceuticals:

Reconciling Access, R&D and Patents’, International Journal of Health Care and Economics

3(3), 183-205

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Pharmaceuticals: Evidence from Nine Countries” Health Affairs Web Exclusive October 29

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Working Paper 6366, USA

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Liebeler, Lars 1986 ‘Trademark Law, Economics and Grey-market Policy’, Indiana Law

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Abstract: This thesis attempts to examine the academic debate on differential pricing and parallel trade in pharmaceuticals. The subject has great relevance as it concerns both the

access to medicine of citizens in developing countries with the incentives for research and development which now constitutes a vital part of our society. Many scholars, among them

Danzon and Maskus, champion the merits of a ban on parallel trade, as it would create opportunities for price discrimination between markets. A system of differentiated prices

inversely correlated to demand elasticities, so called Ramsey pricing, would be both economically efficient and correspond to widely held ideas of global equity. But as I

conclude, a ban on parallel trade alone would not guarantee the creation of a system of Ramsey-type prices as several discrepancies exist between the economic model and real

circumstances.

Keywords; differential pricing, parallel trade, pharmaceutical prices, price discrimination, R&D incentives. Ramsey pricing.