Is medicines parallel trade ‘regulatory arbitrage’?

In the European Union, medicines are regulated products subject to both single market and country specific health care regulations (e.g., medicines pricing and distribution regulation). This gives rise to parallel trade (PT), a phenomenon that takes place when a patented product is diverted from the official distribution chain (the distribution channel chosen by the originator) to another one in another European member state where it competes with the official distribution chain as a parallel distributor. PT is a legal activity even though medicines are products under the protection of intellectual property rights (IPR). This is the case because such IPR are subject to European-wide (as opposed to country wide) legal exhaustion after first sale in an existing European member state. A patent does not confer legitimate control of the product to the originator company upon sale in one-member state country. Hence, if price differences arise across countries, a parallel distribution chain may well be developed in higher price countries in response.

The consolidation of a single European market uncovers several opportunities for different forms of arbitrage. Typically, ‘common arbitrage’ takes place when an agent profits from product price differences across markets, which is expected to give rise to some form of price equalisation between markets, namely a common price. However, when price differences result from heterogeneous competitive conditions created from regulated prices (Costa-Font et al. 2014, 2015), as well as country specific statutory margins, we refer to such a phenomenon as ‘regulatory arbitrage’. In such a case, price equalisation is not guaranteed¹, as regulations result from country specific lobbying and pressure group capacities (Grossman and Lai 2006).

A number of decisions adopted by the European Court of Justice have further encouraged distributors to engage in parallel trade (Barfield and Groombridge 1998). However, this paper does not attempt to examine the effects of parallel trade legislation, nor offer a state of the art of European parallel trade policy. Instead, we attempt to contribute to the literature by providing a different interpretation of how European PT should be regarded from an economics standpoint. More specifically, we examine here the extent to which parallel trade (PT) flows are driven by distribution chain regulations (and especially country specific statutory margins) rather than other factors including (unregulated) price differences which would drive more ‘common forms of arbitrage’ (Mauleg and Schwartz 1994; Richardson 2002; Jelovac and Borodoy 2005; Pecorino 2002). ‘Clean evidence’ that establishes the impact of distribution regulation is rare insofar as it requires access to source country data, and merge it with data on country specific statutory distribution margins (determining the profitability of the parallel trade business)².

We empirically document whether European medicines parallel trade (PT) falls, at least partially, in the ‘regulatory arbitrage’ category. We add to the literature by taking advantage of a unique proprietary dataset (Intercontinental Medical Statistics, IMS) containing information on the source country of PT flows. Thus, we can compute for each product in the therapeutic group the exact price difference at the point of distribution. In addition, by identifying the destination and source countries, it is possible to match for each product/country the statutory distribution margins (that are added to the price³, which in turn provides a conservative estimate of the potential gain from PT given the potential presence of rebates and discounts which are not observed). We use data on parallel imports for cholesterol drugs from as many as eight European source countries (Belgium, France, Germany, Greece, Italy, Portugal, Spain, and the UK), which in our dataset are found to distribute up to 95 % of all observable parallel imported statins to the Netherlands across 24 quarters (1997–2002).

Previous studies have either failed to precisely identify the product origin, or have not taken into account the presence of generic drug penetration (Kanavos et al. 2008; Costa-Font et al. 2014, 2015). Furthermore, the theoretical literature remains inconclusive about the capacity of parallel trade to increase the country’s welfare (Mauleg and Schwartz 1994; Richardson 2002). That is, the normative implications for welfare of parallel trade expansion are ambiguous and tightly dependent on the welfare effects of a common price as compared to price discrimination equilibrium. Furthermore, previous empirical studies are limited by the wide therapeutic heterogeneity. This paper overcomes some of the limitations of previous studies.

Unlike previous empirical studies, our estimates are from a flexible augmented gravity specification of trade (import) flows that contains rich information on the heterogeneity of the supply chain regulation (more specifically retail and wholesale regulation). We can distinguish distribution chain regulation effects and we are able to estimate the volume of PT medicines in one country (the Netherlands) for a given therapeutic group from a given quarter. PT flows are modelled as a function of relative product prices (consistently with any form of arbitrage) and country specific wholesale regulations (specific of regulatory arbitrage), exchange rates (which is a variable that we separate from relative price to capture the adoption of a common currency in the period), and other covariates that are commonly employed in gravity specifications of trade such as geographical distance, and three different transformations of GDP (difference in GDP per capita, sum of GDP, relative GDP).

Our findings are consistent with the hypothesis of medicines’ parallel trade (imports) being an economic activity driven by cross-country differences in statutory distribution margins . An extension of the statutory margins can act as an incentive for PT even after controlling by medicines prices. The latter is (suggestive of and) consistent with the hypothesis of regulatory arbitrage as statutory distribution margins are determined by country regulation, which is specific of each country.

The remainder of the paper is as follows. In “Background” section provides the paper background. In “Data and Empirical Strategy” section presents the methodology, data sources and empirical strategy, while “Results” section reports the results and discusses them. Finally, “Conclusion” section outlines the main conclusions.

We use data from the Intercontinental Medical Statistics (IMS) database, which contain quarterly records on import sales and units over the 1997–2002 periods for a set of products that fall in the therapeutic product category of statins and exhibit parallel trade during the study period. The gives rise to a total sample size of 768 observations. However, due to the presence of some missing observations we were left with a final full sample of 625 for all variables. The data exhibits a three-way panel structure, 4 products 8 exporters to the Netherlands, in 24 quarters. Data for each product were made available at dispensation level. IMS collect data on prices and sales for a number of countries, including the Netherlands, and for the selected product group, statins, on a product-by-product (e.g. simvastatin, pravastatin, etc) and product presentation basis (e.g. simvastatin, 20 mg, 28 tablets). The accuracy of the data sources has been validated externally (IMS 2004). Data on both wholesale margin and regulation was obtained from publicly available sources for each country Ministry of Health. Rather than relying in different therapeutic groups, which are subject to different degrees of competition and the presence of generic competitors, we instead rely on a single therapeutic group (statins) which accounts for a significant proportion of total retail sales of prescription only medicines in European countries (5.7 % in 2002) (see Fig. 1).

Statins are products that lower levels of LDL (“bad”) cholesterol by 30–50 %, and have been popularly prescribed to prevent coronary heart disease (CHD), including myocardial infarction (MI), and their use has been increasing over time, making them, in turn, desirable targets for parallel trade. All products within the group were protected by a patent during the study period, therefore, the effect of parallel trade could be isolated from other effects, such as competition from generic equivalents, and studied without having to account for the competition effect due to generic penetration (Frank and Salkever 1991; Grabowski and Vernon 1992; Ganslandt and Maskus 2004).

An important feature to note is that we were able to identify the price and volume of each product at any point in time. The dependent variable is the logarithm of imports of statins into the Netherlands. First, we use the basic specification and consider the impact of core explanatory variables such as GDP, population and distance. Subsequently, in line with recent theoretical developments (Egger 2002), we include variables measuring the size of trading countries and other barriers that might explain the development of parallel trade such as distance and exchange rates.

Although the influence of price differences on parallel imports to the Netherlands is consistent with the presence of both the common and regulatory arbitrage; the significance of differences in statutory distribution margins provides cleaner evidence of ‘regulatory arbitrage’. The only downside is that, as reported elsewhere (Kanavos and Costa-Font 2005), some of the gains from parallel trade are invisible because of the incentive structures of different stakeholders are influenced by rebates and informal discounts.

We first report the results of a pooled cross-section specification purely for comparative purposes it as relies on implausible assumptions (e.g., the presence of unobserved heterogeneity resulting from unobserved characteristics related to bilateral trade relationships). Then, we show the estimates of a panel data specification including country-pair “individual” effects, which partially account for the clustered nature of the data and hence, captures some of the existing unobserved heterogeneity. The panel specification refers to a generalised least squares (GLS) model with random effects consistent with the gravity specification outlined above whereby some variables are country-specific (e.g. distance) and does not allow country fixed effects. The interpretation of such a specification is that a country would export different volume of the same product to two other countries, even if their GDPs are identical and they are equidistant from the exporting country. This is due to potential differences in drug regulation, which affect prices and margins, and hence gains from PT.

We then estimate both two stage least squares (2SLS) and two stage generalised least squares (2SGLS) models to account for the endogenenity of price differences and the panel structure of the data. To instrument price differences, we are able to observe the variability in the competitive conditions in the drug distribution in the source country which we do not expect it would affect the volume of parallel traded product though other mechanisms but prices. Specifically, we use the relative number of wholesalers as an instrument for product price at the wholesale level. Given that prices are regulated, one would not expect they would conflate with direct price regulation in some countries (e.g., some countries might have free drug pricing and regulate heavily the margins of pharmaceutical distributors). We test and confirm the existence of endogeneity in the price formation, and the statistical validity of the instrument with the common F-test.

The variables employed in the analysis are presented in Table 2 and are reported as follows: (a) the observed volume of each statin imported into the Netherlands from another EU country; (b) the distance between two countries defined as the Euclidean distance of latitude and longitude between country capitals; the reason for measuring distance in this way rests on the fact that kilometers are not necessarily a good approximation for transport costs given alternative and more direct ways of transportation (e.g. air travel); (c) exchange rate is an obvious determinant of parallel imports insofar as it impacts price transparency (given that not all countries examined are in the euro area and the period examined corresponds to before the euro was introduced), especially in the context of European integration.; (d) following the predictions of a gravity model, our model includes the bilateral sum of country GDPs (in logs) \(\ln \left( {GDP_{it} +GDP_{jt} } \right) \) , as it is conventional in the literature we measure relative country size (in logs), the difference of GDP per capita (in logs), and the sum of statins sales in € (in logs) that is the specific therapeutic group in question which has been growing in size during the study period which were included after testing for colinearity in the regression; (e) furthermore, we consider the point of entry of a parallel imported drug or product presentation. As expected from a model of arbitrage, relative prices between countries (in logs) should be a key determinant, with a negative expected sign. Finally, (g) a set of variables has been added to measure the aggregate number of distributors, which accounts for the degree of competition in the distribution chain in both countries proxied by the relative number of wholesalers in the Netherlands and the exporting country and the (h) relative wholesaler and account for possible economic incentives for parallel trade which are exogenous proxies for regulations.

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We have empirically examined the hypothesis of PT being a type of regulatory arbitrage that takes place at the medicines distribution level. We have studied the combined influence of both distribution chain and price regulation in driving PT flows drawing from unique data (that includes source country information, and hence allows estimating the effect of both specific price differences and cross-country statutory margins). Our dataset is from the Netherlands (a country that ranks among the highest parallel importers) and for one therapeutic group: statins (a therapeutic group subject to patent protection during the period of analysis and not affected by generic entry). We specifically examine the influence of differences in both price and statutory margins between the Netherlands and country of origin countries in driving parallel trade flows.

Our results are consistent with the hypothesis of parallel trade in Europe being indeed a regulation-induced phenomenon, which we refer to as ‘regulatory arbitrage’. That is, we find that changes in the statuary margins across countries afford incentives for the development of parallel distribution channels. Hence, even if all European countries were not to regulate medicines prices, there could still be some potential for PT driven by differences in statutory distribution margins. Nonetheless, our results need to inevitably be taken with caution as they rely on only one therapeutic group, and refer to a period where the European Union was restricted to 15 members. One would expect differences in the nature of the activity in an enlarged Europe.