Planung und Entscheidung

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					  An Analysis of the Welfare Effects of
        Parallel Trade Freedom

                 Frank Müller-Langer
         International Max Planck Research
       School for Competition and Innovation,
                       Munich

       International Conference on Innovation,
            Competitiveness and Growth,
Institute of Economics, Zagreb, November 27, 2008
                         Welfare Analysis of Parallel Trade Freedom 1/16
Agenda

 1 Introduction

 2 Double marginalization model with complete
   information

 3 Welfare Analysis

 4 Conclusion



                  Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 2/16
Parallel Trade (PT)‫‏‬
 • When does parallel trade actually occur?
 • Why should we care about this issue?
   - WTO members are free to choose whether to
   allow or prohibit parallel trade (Art. 6 of TRIPS)
   - Restraints on parallel trade vary widely
   between developed and developing countries
   and even amongst developed countries
   - Advocates of strong patent rights for new
   pharmaceutical products support a global
   regime of banning parallel trade

                 Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 3/16
Questions to be Analyzed
 1. Why may parallel trade actually occur in
    equilibrium when information is complete?

 2. Is parallel trade freedom beneficial or
    detrimental to the producer of a patented
    product?

 3. Is parallel trade freedom beneficial or
    detrimental to global welfare?


                 Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 4/16
Agenda

 1 Introduction

 2 Double marginalization model with complete
   information

 3 Welfare Analysis

 4 Conclusion



                  Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 5/16
Assumptions
 •   Player 1: Monopolistic manufacturer of
     pharmaceuticals in country A
 •   Manufacturer has marginal costs of zero
 •   Player 2: Exclusive distributor in country B
 •   Players’ payoff functions: their profits
 •   Demand in country A: DA ( p A ) = g a - bp A with g > 1
 •   Demand in country B: DB ( pB ) = a - bpB
 •   Parallel trade is allowed
 •   Distributor: marginal costs of parallel trade,
     pB + t
      w


                    Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 6/16
Structure of the Game
 • First stage: manufacturer chooses the
   wholesale price at which he sells the
   pharmaceutical product to the distributor in
                w
   country B, pB
 • Second stage: distributor chooses the retail
   price in country B, pB
 • Third stage: manufacturer and distributor
   simultaneously choose the prices at which they
   sell the product in country A in a Bertrand price
                  m       d
   competition, p A and p A


                 Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 7/16
3rd Stage: Bertrand Price Competition



 Proposition 1
 Parallel trade will never occur in any sub-game
 perfect Nash equilibrium in the double
 marginalization game with complete
 information



                Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 8/16
Net Effect of PT Freedom on m‘s Profit




 Proposition 2
 Parallel trade freedom is detrimental to the
 manufacturer as it reduces his profit




                Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 9/16
Agenda

 1 Introduction

 2 Double marginalization model with complete
   information

 3 Welfare Analysis

 4 Conclusion



                  Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 10/16
Effect of PT Freedom on Global Welfare
 • First step: Calculate the different levels of
   consumer surplus, profits and welfare in
   country A and B as well as global welfare if PT
   is allowed/prohibited

 • Second step: Calculate the net effect of PT
   freedom on global welfare by subtracting
   global welfare if PT is prohibited from global
   welfare under PT freedom



                 Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 11/16
Effect of PT Freedom on Country B



 Proposition 3
  Market in country B remains unserved if
  parallel trade cost are very low and countries
  are sufficiently heterogeneous in terms of
  market size




               Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 12/16
Effect of PT Freedom on Global Welfare



 Proposition 4
             3
 Parallel trade freedom has positive welfare
 properties if countries are sufficiently
 heterogeneous in terms of market size




                Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 13/16
Effect of PT Freedom on Global Welfare



 Proposition 5
 Parallel trade freedom can have negative
 welfare properties if trade costs are
 intermediate and countries are virtually
 homogeneous in terms of market size




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

 1 Introduction

 2 Double marginalization model with complete
   information

 3 Welfare Analysis

 4 Conclusion



                  Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 15/16
Summary of the Main Results
 • PT will never occur in a double marginalization
   game with complete information

 • The manufacturer strategically sets prices in
   order to prevent the occurrence of PT

 • PT freedom is detrimental to the manufacturer

 • The question as to whether PT freedom has
   positive or negative welfare properties depends
   on the heterogeneity of the countries and the
   level of trade cost

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




Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 17/16
Idea for Further Research
 •   Game with asymmetric information with
     respect to local demand functions
 •   Exclusive distributor has better information
     than the manufacturer about local demand in
     country B
 •   Manufacturer overestimates demand in
     country B
 •   Will parallel trade occur in equilibrium in a
     game with asymmetric information?


                 Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 18/16
Game with Asymmetric Information
 •   First stage: Manufacturer chooses the price
     at which he charges the distributor in country
     B
 •   Second stage: Nature chooses the demand
     in country A and country B
 •   Third stage: Distributor chooses the price he
     charges his customers in country B
 •   Fourth stage: Manufacturer and distributor
     play a Bertrand game


                  Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 19/16
Determinants of Parallel Trade
 First strand of literature
    Exclusive distribution rights in foreign
    markets and parallel trade [Maskus and Chen
    (2002, 2004)]

 Second strand of literature
   Price regulations by national governments
   and parallel trade [Ganslandt and Maskus
   (2004), Jelovac and Bordoy (2005)]


                Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 20/16
Distributor‘s Decision

 • In the second stage, the distributor anticipates
   that he will be driven out of the market in
   country A in the third stage

 • Parallel trade does not occur




                 Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 21/16
Maximization Problem of the Manufacturer


                  ab B 
                      w

             
     a  A a bA p
   mx p   p +B
         m    m  w  -p
                                  
                   2 
    m w
   p ,p
    A B



    uj c o p 
   s bett     m
              0
              A

   n
   ad       p
             w
             B0
   ad
   n        p p 
             m
             A    t      w
                         B




             Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 22/16
Solution 1 for Low Trade Cost and High                                                             g
 • We use the Kuhn-Tucker Theorem and obtain
   two solutions
 • Solution 1:
         a             1
    pA =
     m*
            ( 2g + 1) + t
         6b            3
               a             2
    p   w*
        B    =    ( 2g + 1) - t
               6b            3
 • Solution 1 only satisfies the non-negativity
   restrictions
         a
   if t Ł ( g - )
                1
         2b

                          Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 23/16
Solution 2 for t > a ( g - 1) / 2b
                ga
  p   m**
      A     =
                2b
 • equal to the monopoly price in the double
   marginalization game when parallel trade is
   prohibited
              a
  p   w**
      B     =
              2b
 • equal to the profit-maximizing wholesale price
   in the double marginalization game when
   parallel trade is prohibited

                     Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 24/16
Parallel Trade in the WTO


 • Article 6 of the TRIPS Agreement:

   “(…) nothing in this Agreement shall be used to
   address the issue of the exhaustion of
   intellectual property rights.”

 • National exhaustion vs. international
   exhaustion of intellectual property rights


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

  Depending on Nature’s choices with regard to
  local demand functions parallel trade may
  occur in equilibrium




               Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 26/16
Welfare Analysis of Parallel Trade
 •   Infectious diseases kill 14 million people
     around the world every year, with 90 per cent
     of those deaths occurring in the developing
     world
 •   Furthermore, almost 1,400 new medicines
     have been developed in the last 25 years, but
     only 1 per cent of these were medicines for
     parasitic and infectious tropical diseases that
     are rampant in the developing world



                  Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 27/16
Hypothesis
 • Hypothesis: There is an important rationale for
   restricting parallel trade of medicines for
   parasitic and infectious tropical diseases that
   are rampant in middle income and low income
   countries
 • Parallel trade would further reduce the
   incentives to invest in R&D for medicines for
   parasitic and infectious tropical diseases




                 Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 28/16
Ideas for Further Research

 •   Parallel trade and medicines for neglected
     infectious diseases
     - 99 per cent of global demand for
         medicines for such diseases is generated
     in the developing world
     - Country A high-income country:
            DA ( p A ) = g a - bp A with g < 1
     - Country B low-income country:
            DB ( pB ) = a - x bpB with x > 1


                  Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 29/16
Follow-up Paper: New Timing of the Game
 • Stage 0: Manufacturer chooses retail price in
   country A
 • Stage 1: Manufactuer chooses wholesale price
   in country B
 • Stage 2: Distributor chooses retail price in
   country B
 • Stage 3: If p A > t + pB , a third firm will enter
                 m        w

   the market, buys the product from the
   distributor in country B and then re-sells the
   product in country A

                  Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 30/16
Advantages of Bertrand over Cournot

 1.Parallel trade is an important issue in the
   context of third-degree price discrimination, as
   it erodes the monopolist’s ability to
   discriminate prices across markets

   -> Prices and not quantities should be the
   decision variables in a model that elaborates
   on these issues




                 Frank Müller-Langer   Welfare Analysis of Parallel Trade Freedom 31/16
Advantages of Bertrand over Cournot

 2.Since prices are the decision variables in our
   model and not just an endogenous
   consequence of the firms’ output decisions, we
   do not need to resort to any additional
   mechanism such as an (artificial) auctioneer to
   determine the market-clearing price

  The Bertrand setup includes an explicit
  description of all components required for
  understanding how the market actually
  operates


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

				
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