Impact of parallel trade on pharmaceutical firm’s profits: rise or fall?

Abstract

Most existing studies on parallel trade conclude that it reduces pharmaceutical firms’ profits. One special feature of the pharmaceutical industry is the presence of price regulation in most countries. Taking into account the impact of parallel trade on the regulated pharmaceutical prices [Pecorino, P.: J. Health Econ. 21, 699–708 (2002)] shows that a pharmaceutical firm’s profit is greater in the presence of parallel trade. The present paper relaxes the assumption on identical demands among countries, and takes into account transaction costs. The results of our model show that a firm’s profits may increase or decrease in the presence of parallel trade, depending on its bargaining power in the price negotiation and market size of the drug. Changes in social welfare due to the transition to parallel trade regime are also considered.

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Notes

  1. 1.

    Valletti [24] shows that although a firm’s profits always fall under parallel trade, investment in innovation increases when differential pricing results from idiosyncratic costs of serving the two markets.

  2. 2.

    The bargaining power remains unchanged, but the change in the payoff drives harder bargaining. Although it is rare, we still could find examples that the pharmaceutical firms refuse to serve a market. Danzon [5] mentions that Glaxo delayed launching its antimigraine product sumatriptan (Imigran®) in France for several years, rather than accepting a low price that would have undercut its higher price elsewhere.

  3. 3.

    Our analysis framework is more similar to that in Pecorino [21], which is static and examines mainly the short term effect of parallel trade. Grossman and Lai [13], and some other studies in the literature, endogenise R&D and examine the long term effect of parallel trade. Therefore, our model is less comparable to those studies.

  4. 4.

    In an early version of this paper, we tried a more generalized demand function q L = α − βp L. In this version, β is normalized to 1. This normalization does not affect the conclusion, and it is easier to illustrate the results.

  5. 5.

    Alternatively, we can assume that firms engage in a Stackelberg competition, which does not change our main results.

  6. 6.

    Although it is more realistic to model price bargaining between the firm and the government in country H, and price bargaining between the firm and the government in country L simultaneously, it makes the model far less tractable. We therefore follow Pecorino [21] in focusing on the case where the government in country H does not control the drug price. This is not a very unrealistic assumption. North America accounted for 45.9% of world pharmaceutical sales in 2007, and 66% of sales of new medicines launched during the period 2004–2008 were in the US market [9]. Meanwhile, there is no price control in the US.

  7. 7.

    The timing of regulation, i.e., whether the negotiated price in country L has some anticipatory effect on the price in country H, has important implications, which may be worth further exploration. A recent study [3] has formally investigated this issue.

  8. 8.

    For a proof of this condition, please see “Appendix”.

  9. 9.

    This simulation is based on Eq. 21.

  10. 10.

    One concern here might be that the analysis conflates a size effect with possible price effects, which may deserve some further exploration.

  11. 11.

    We assume that the pharmaceutical firm is owned by households in country H, and all the profits earned in country L are transferred back to country H. This is not a very unrealistic assumption since most host countries of large pharmaceutical firms have rather weak price regulation and relatively high drug prices. For example, the US accounted for about two-thirds of sales of new medicines launched during the period 2004–2008 [9]. Meanwhile, there is no price control in the US.

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Acknowledgments

We would like to thank Jerry Hurley, Ross McKitrick, John Leach and two anonymous referees for their valuable comments and suggestions. Any mistakes are our own.

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Correspondence to Hai Zhong.

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Appendix

Appendix

Proof

\( \Upgamma \equiv \gamma {\text{CS}}^{\prime \prime } (p_{\text{L}} )\left[ {\pi (p_{\text{L}} ) - \pi^{\text{m}} } \right] + {\text{CS}}^{\prime } (p_{\text{L}} )\pi^{\prime } (p_{\text{L}} ) + (1 - \gamma )\pi^{\prime \prime } (p_{\text{L}} ){\text{CS}}(p_{\text{L}} ) < 0. \) Since CS′(p L) < 0 and π′(p L), the second term is negative at equilibrium in the case of 0 < γ < 1, for the other two terms

$$ \gamma {\text{CS}}^{\prime \prime } (p_{\text{L}} )\left[ {\pi (p_{\text{L}} - \pi^{\text{m}} )} \right] + \pi^{\prime \prime } (p_{\text{L}} ){\text{CS}}(p_{\text{L}} ) - \gamma \pi^{\prime \prime } (p_{\text{L}} ){\text{CS}}(p_{\text{L}} ) $$
(26)

Since \( {\text{CS}}^{\prime \prime } (p_{\text{L}} ) = 1 \), Eq. 26 can be rewritten as:

$$ \gamma \left\{ {\left[ {\pi (p_{\text{L}} ) - \pi^{m} } \right] - \pi^{\prime \prime } (p_{\text{L}} ){\text{CS}}(p_{\text{L}} )} \right\} + \pi^{\prime \prime } (p_{\text{L}} ){\text{CS}}(p_{\text{L}} ) $$
(27)

The Eq. 27 is maximized at γ = 1 and equals to 0, therefore, we have

$$ \Upgamma \equiv \gamma {\text{CS}}^{\prime \prime } (p_{\text{L}} )\left[ {\pi (p_{\text{L}} ) - \pi^{m} } \right] + {\text{CS}}^{\prime } (p_{\text{L}} )\pi^{\prime } (p_{\text{L}} ) + (1 - \gamma )\pi^{\prime \prime } (p_{\text{L}} ){\text{CS}}(p_{\text{L}} ) < 0. \quad \square$$

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Guo, S., Hu, B. & Zhong, H. Impact of parallel trade on pharmaceutical firm’s profits: rise or fall?. Eur J Health Econ 14, 345–355 (2013). https://doi.org/10.1007/s10198-012-0380-0

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Keywords

  • Parallel trade
  • Price control
  • Prescription drugs

JEL Classification

  • F13
  • L51
  • I18