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Article Excerpt
Price controls create opportunities for international arbitrage. Man), have argued that such arbitrage, if tolerated, will undermine intellectual property rights and dull the incentives for investment in research-intensive industries such as pharmaceuticals. We challenge this orthodox view and show, to the contrary, that the pace of innovation often is faster in a world with international exhaustion of intellectual property rights than in one with national exhaustion. The key to our conclusion is to recognize that governments will make different choices of price controls when parallel imports are allowed by their trade partners than they will when they are not.
1. Introduction
* Parallel trade occurs when a good protected by a patent, copyright, or trademark, having been legally purchased in one country, is exported to another without the authorization of the local owner of the intellectual property rights in the importing market (see Maskus, 2000b). Parallel trade represents a form of arbitrage whereby a legitimate product is shipped from the market intended by the intellectual property rights holder to another where it commands a higher price. Like other forms of arbitrage, parallel imports (also known as "gray-market imports" or "reimports") respond to international price differences that result from retailer price discrimination, vertical pricing restraints, or national differences in government price controls.
The propriety of parallel trade is a matter of intense policy debate in a number of countries and in the World Trade Organization (WTO). At present, WTO provisions allow member countries to establish their own rules for the "exhaustion" of intellectual property rights (IPR). (1) If a country opts for national exhaustion of IPR, a rights holder there may exclude parallel imports, because intellectual property rights continue until such a time as a protected product is first sold in that market. If a country instead chooses international exhaustion of IPR, parallel imports cannot be blocked, because the rights of the patent, copyright, or trademark holder expire when a protected product is sold anywhere in the world. The United States practices national exhaustion for patents and copyrights, but permits parallel imports of trademarked goods unless the trademark owner can show that the imports are of different quality from goods sold locally or otherwise might cause confusion for consumers. The European Union provides for regional exhaustion of IPR whereby goods circulate freely within the trading bloc but parallel imports are banned from non-member countries. Japanese commercial law permits parallel imports except when such trade is explicitly excluded by contract provisions or when the original sale is made subject to foreign price controls. (2)
Public debate about parallel imports has been especially heated in the area of prescription drugs. In the United States, where consumers, public health officials, and politicians have become increasingly concerned about the high and rising cost of medicine, bills that would introduce international exhaustion of patent rights for prescription drugs have been introduced in one or both houses of Congress in each of the last three sessions. In fact, in 2000, Congress passed a bill to permit reimportation of medicines. Although President Bill Clinton signed the bill into law, his administration ultimately declined to implement it, citing concerns about consumer safety. New legislation was introduced to Congress in 2004 that would have forced deregulation of parallel imports of pharmaceuticals. In each case, the impetus for congressional action came from public pressures to step up imports from Canada, where regulations and price controls have generated prices for prescription drugs significantly lower than those across the border. (3) Despite the continuing legal impediments to parallel imports, reimportation has been a growing source of pharmaceutical supply in the United States due to increased personal trafficking and the proliferation of Internet purchases. By one estimate, parallel imports of prescription drugs from Canada amounted to $1.1 billion in 2004, or about 0.5% of the U.S. market (Cambridge Pharma Consultancy, 2004).
Parallel trade in pharmaceuticals features prominently in Europe as well, where it is the source of ongoing controversy. Differences in price regulations have resulted in significant variation in pharmaceutical prices across member countries of the European Union and the European Free Trade Association (Arfwedson, 2004; Kanavos and Costa-Font, 2005). Kanavos and Costa-Font, for example, report price differences for many products and country pairs of between 100% and 300%. Prices are highest in the countries with free or relatively free prices, which are Germany, the United Kingdom, Sweden, The Netherlands, and Denmark. These countries all have witnessed substantial growth in parallel importing, with reimports accounting for between 7% and 20% of their national expenditures on prescription drugs in 2002. The parallel exporters include Spain, France, Greece, Italy, and Portugal, all of which are countries with controlled prices or explicit price caps (Ganslandt and Maskus, 2004).
Opponents of parallel trade--of which there are many--are concerned that such trade undermines manufacturers' intellectual property rights. (4) The prevailing wisdom, expressed for example by Barfield and Groombridge (1998, 1999), Chard and Mellor (1989), Danzon (1997, 1998), and Danzon and Towse (2003), is that parallel trade impedes the ability of research-intensive firms such as those in the pharmaceutical industry to reap an adequate return on their investments in new technologies. Their arguments seem to find support in more formal analyses, which offer only a few minor caveats. For example, Li and Maskus (2006) develop a model in which parallel trade creates competition in the home market between a manufacturer and its own distributor in a foreign market. They find that the distortions associated with parallel imports reduce the manufacturer's incentive to invest in cost-reducing innovation at a prior stage. Szymanski and Valletti (2005) model an industry with vertical product differentiation and examine how parallel trade affects a firm's decision of whether to supply high-quality products. They conclude that such trade diminishes the firm's incentive to invest in quality and may reduce welfare in both countries. In a related model, Valletti (2006) shows that parallel trade reduces investment when differential pricing is based purely on differences in price elasticities, but increases investment when differential pricing results from idiosyncratic costs of serving the two markets (that the manufacturer must bear, but an arbitrager can avoid). Finally, Rey (2003) examines parallel importing that may result from differential price regulation, as is most germane in the case of pharmaceuticals. He argues that such trade impedes a country's ability to accept high local prices in order to promote R&D when its trade partner prefers to set lower prices. As a result, world investment in technology is lower in his model when parallel trade is allowed than when it is banned.
In this article, we challenge the prevailing wisdom for the case (such as in pharmaceuticals) in which parallel trade is induced by different national price controls. We argue that the existing policy discussions and formal modelling overlook an important effect of national policy regarding the exhaustion of IPR. Whereas the papers in the literature that discuss parallel imports of pharmaceuticals in the presence of price regulation compare incentives for R&D in scenarios with and without parallel imports for given levels of controlled prices, we emphasize that a government will face different incentives in regulating prices in the presence or absence of arbitrage possibilities. This is so for two reasons. First, the admissibility of parallel trade introduces the possibility that a manufacturer will eschew low-price sales in the foreign market in order to mitigate or avoid reimportation. When arbitrage is impossible, the manufacturer is willing to export at any price above marginal production cost. But when the potential for arbitrage exists, the manufacturer may earn higher profits by selling only in the unregulated (or high-price) market than by serving both markets at the lower, foreign-controlled price. Accordingly, a switch from a regime of national exhaustion to one of international exhaustion can induce an increase in the controlled price as the foreign government seeks to ensure that its consumers are adequately served.
Second, the admissibility of parallel trade mitigates the opportunity for one government to free-ride on the protection of IPR granted by another. As we have shown in Grossman and Lai (2004), national policies to protect IPR often are strategic substitutes in a two-country (or many-country) policy-setting game; the greater is the protection afforded by one country, the less will be the optimal level of protection perceived by the other. In a world without parallel trade in which one government allows manufacturers to price freely in its market (or enforces a price ceiling at a relatively high level), the other government can hold the line on prices so as to benefit its local consumers and nonetheless enjoy the fruits of relatively high rates of innovation. But when arbitrage can occur, a low price cap in one country dulls incentives for investment worldwide. The government of a less-innovative country faces a different tradeoff in setting its regulated prices in the presence or absence of arbitrage. As we will show, the deregulation of parallel imports in a highly innovative economy always induces the government of its less-innovative trade partner to loosen its price controls. (5) In our analysis, the presumptive outcome is one in which deregulation of parallel imports generates both an increase in consumer surplus in the innovative country and an increase in the world pace of innovation. Thus, the more innovative country may face no tradeoff at all between static and dynamic gains in its choice of regime for exhaustion of IPR. We find that typically the more innovative country gains from parallel trade, whereas the less innovative country loses. (6)
The starting point for our analysis is the two-country model of ongoing innovation and trade that we developed in Grossman and Lai (2004) to study incentives that governments have to protect IPR in an open, world economy. In this model, firms devote resources to inventing horizontally differentiated goods with finite product lives. The greater is the global protection of IPR, as reflected in the duration of patents and the enforcement rate for live patents, the greater is the incentive for product development. The model yields a steady-state equilibrium in which the measure of differentiated products is constant. This measure responds to the policy regime. Here we take the global regime for protection of patent rights as given, but introduce the possibility of price controls. That is, we assume that new pharmaceutical products receive similar patent protection in all countries (as indeed is dictated by the terms of the TRIPS agreement), but that existing international agreements do not prevent a country from regulating domestic prices of prescription drugs. We compare prices, profits, and rates of innovation in a regime in which the high-price country allows parallel imports with those that arise when such trade is disallowed. We do so first under the assumption that the innovative "North" allows its firms to price freely and that no innovation takes place in "South." (7) Subsequently, we show that the main insights carry over to the case in which both countries regulate prices in a Nash equilibrium policy game, and also to the case in which innovation occurs in both countries provided that North conducts sufficiently more R&D than South.
We will argue that by allowing parallel imports, North dulls the incentives in South for free-riding on its protection of IPR. This argument does not require that South be a single, large economy, as we initially assume. In fact, our results extend readily to a setting with several or many countries in South. The size of a typical country in South enters our analysis in several ways. If such a country is small (for example, because there are many such countries), there will be fewer consumers there to benefit from faster world innovation. But there will also be fewer consumers to be harmed by high local prices. These two effects of country size offset one another in our model, and so they do not affect a government's incentives in setting its price ceilings. The size of a country in South can also affect the leverage that its government has over world innovation and the risk it faces that its local market will not be served. The policies of a small country have little effect on R&D investment in a world without parallel trade, because each firm captures only a tiny share of its profits in such a market. Therefore, in a regime of national exhaustion of IPR in North, the free-rider problem quickly grows more severe as the number of countries in South expands. In contrast, when arbitrage is possible, a country that strictly controls prices impinges upon profit opportunities not only in its own small market but also in other, larger markets to which the goods can be shipped. Accordingly, even a small country has considerable leverage over world innovation in such a setting. Note too that innovating firms may well be tempted to cut off supply from a very small market when goods can be shipped from there to North, but such firms have no reason to withhold supply from small markets in the absence of parallel trade. For these reasons, we find that North's preference for international exhaustion of IPR extends to a world with multiple symmetric Southern countries and even to a world in which the typical such country is vanishingly small.
The remainder of the article is organized as follows. In the next section, we adapt the Grossman-Lai model of ongoing innovation to allow for price controls. We develop the model under the assumption that all innovation takes place in North and that prices are regulated only in South. In Section 3, we derive and discuss our main results, which compare prices, profits, and rates of innovation under alternative regimes for exhaustion of IPR in which North does and does not allow parallel imports. Section 4 addresses circumstances in which North also may impose price controls and in which firms in South have the capacity to innovate, and Section 5 extends the analysis to a world with several or many countries in the South. The final section summarizes our findings.
2. A modal of ongoing innovation
* We consider an industry such as pharmaceuticals in which firms innovate by introducing new varieties of a differentiated product, all of which have finite economic lives. Our approach builds on Grossman and Lai (2004).
The world economy has two sectors, one that produces a homogeneous good and the other that produces a continuum of differentiated products. The designs for differentiated products are the outgrowth of investments in R&D. Each...
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