Vertical Pricing and Parallel Imports

Vertical Pricing and Parallel Imports

YONGMIN CHEN & KEITH E. MASKUS

Department of Economics, University of Colorado at Boulder, Boulder, CO 80309, USA

ABSTRACT We generalize an earlier model of international vertical pricing to explain key features of parallel imports, or unauthorized trade in legitimate goods. When a manufacturer (or trademark owner) sells its product through an independent agent in one country, the agent may find it profitable to engage in parallel trade, selling the product to another country without the authorization of the manufacturer. Although parallel imports can be deterred when the manufacturer’s wholesale price is sufficiently high, there is a trade-off between improving vertical pricing efficiency and reducing parallel imports. In equilibrium, parallel imports can come from a country with higher retail prices, which is consistent with some factual data. While countries have varying interests in such a policy, restricting parallel imports tends to increase global welfare when trade cost is high, but may reduce welfare when trade cost is low. This finding suggests that open parallel trading regimes may be most appropriate within regional trade agreements.

KEYWORDS: Parallel imports, vertical price formation, intellectual property rights

1. Introduction

Parallel imports are goods brought into a country without the authorization of the original trademark or copyright owner, after those goods have been placed into circulation legitimately in another market. For example, Coca-Cola syrup provided by a bottler in Belgium may be authorized for sale only in Belgium. If the Belgian dealer or an independent agent were to ship the syrup to Spain without the authorization of Coca-Cola Co., the shipment would be called parallel imports. Although there are no official statistics on the volume and nature of parallel imports, parallel trade is considered a significant phenomenon. According to some recent estimates, parallel imports account for 5 to 20 per cent of trade within the European Union for such goods as musical recordings, consumer electronics, cosmetics and perfumes, and soft drinks (NERA, 1999). Another study found that more than 50 per cent of certain high-volume brand-name pharmaceutical

Correspondence Address: Keith E. Maskus, Department of Economics, UCB 256, University of Colorado, Boulder CO 80309-0256, USA. E-mail: [email protected]

Vol. 14, No. 1, 1 – 18, March 2005

ISSN 0963-8199 Print/1469-9559 Online#2005 Taylor & Francis Group Ltd DOI: 10.1080/0963819042000333225

products sold in Sweden come from parallel imports (Ganslandt and Maskus, 2004).

A country’s policy regarding parallel imports stems from its specification of the territorial exhaustion of intellectual property rights (IPRs). Under the doctrine of national exhaustion, rights are exhausted upon first sale within a nation but the ability of IPRs owners to prevent parallel trade between countries remains intact. Under the doctrine of international exhaustion, rights are ended upon first sale anywhere and parallel imports are permitted. An intermediate policy is regional exhaustion, in which rights are exhausted within a group of countries, thereby permitting parallel trade among them, but are not exhausted outside the region.

Policies towards parallel imports are controversial on a number of grounds (Barfield and Groombridge, 1998; Maskus, 2000; Maskus and Chen, 2002). Many developing countries prefer to maintain openness to parallel imports in the belief that this policy permits them to source goods at lowest cost. This issue is central to the negotiations at the World Trade Organization over achieving access to essential medicines. However, the position taken by poor countries in this regard is curious because standard economic analysis of market segmentation would suggest that a policy of preventing parallel imports would generate low prices in those nations (Malueg and Schwarz, 1994; Richardson, 2002). In Australia, a decision was taken in 1998 to deregulate restrictions on imports of recorded music in view of the high retail prices in evidence at that time, while New Zealand partially deregulated its import restraints in copyrighted goods. The United States government is considering removing its ban on parallel imports of branded pharmaceuticals from Canada.

In the European Union, the issue of parallel imports has been raised in many legal cases, and the European Court of Justice (ECJ) has, through its rulings, essentially adopted the doctrine of regional exhaustion, permitting parallel imports within member countries but not from outside the region. Key rulings were Merck v Stephar, 187/80; Dior v Evora, C-337/95; and EMI v CBS, C-51/75. These decisions often stem from a competition policy interested in preventing market segmentation by patent and trademark holders (Ganslandt and Maskus, 2004). For example, in Rhone-Poulenc Rorer (case C-94/98), the ECJ held that manufacturers cannot partition the single market by introducing a new variety of a pharmaceutical product, which could have the effect of replacing market authorization for the prior variety, where the product is subject to competition from parallel imports.

Despite significant policy interests in parallel imports, there has been very limited economic analysis on this issue. Malueg and Schwartz (1994) were the first to conduct a formal analysis of parallel imports. They present a model in which parallel imports occur due to international third-degree price discrimination by a manufacturer (or copyright owner).

Subsequently, Anderson and Ginsburgh (1999) further considered con-sumer arbitrage costs in parallel imports, in a framework with both third-degree and second-third-degree international price discrimination by a mono-poly manufacturer. Less formal literature discussed the problems that emerge when parallel traders free ride on the marketing and service investments of authorized distributors (Chard and Mellor, 1989; Barfield and Groombridge, 1998). In essence, the existing explanations view parallel trade as arising from international price differences and the resulting price arbitrage by parallel traders.

While the existing studies have provided important insights, they miss two important features of such trade. First, frequently a parallel trader either is an authorized wholesaler himself or obtains the good directly from an authorized wholesaler.1Thus, it is the wholesale price, not the retail price, that determines the profitability of parallel trade. From a theoretical perspective, it is therefore important to depart from the existing theories’ focus on retail prices and to consider the vertical formation of prices. Second, there are important empirical regularities that are troublesome for the existing theories. In particular, it has been noticed that parallel imports sometimes flow from a country where the retail price is higher to a country where the price is lower (see, for instance, NERA, 1999; Palia and Keown, 1991). This is inconsistent with parallel trade based on price arbitrage and calls for the development of a theory based on vertical pricing between a rights holder and her authorized wholesalers.

Maskus and Chen (2004) addressed these two issues in the study of parallel imports by incorporating the formation of prices in a vertical relationship. However, the analysis there was based on the restrictive assumption of linear demand and relied on a number of special cases. It was not clear whether similar results exist under general demand conditions. This is an important question to ask because specific demand assumptions may not support general conclusions in this literature. Consider, for example, the central role that demand specification plays in determining whether third-degree price discrimination generates a welfare-increasing rise in output (Varian, 1985). The present paper fills this gap by analysing a model of parallel imports with general demand functions. We generalize the theoretical results obtained by Maskus and Chen (2004) and provide formal proofs.

We find that when a manufacturer sells its product through an independent agent (distributor) in a certain country, its incentive is to set its wholesale price below what it would be if the manufacturer could directly set the retail price, in order to reduce the double-markup distortion. This decision may enable the agent to sell the product profitably in another country, without the authorization of the manu-facturer, even when the retail price in the other country is lower. In a simple two-country model, we explore the manufacturer’s trade-off between improving vertical pricing efficiency and preventing parallel

importing,2 and show that parallel imports can flow from a high-price country to a low-price country. Both industry profits and combined social surplus in two countries can increase in the cost of conducting parallel trade. Government restrictions on parallel imports always benefit the manufacturer, but can either raise or reduce global welfare. Thus, whether policy should restrict or encourage parallel trade depends on market circumstances and the degree of trade costs.

Our paper may also be considered an extension into a different market setting of Brander and Krugman (1983), who developed the seminal theory of reciprocal dumping. They showed that trade can occur between two countries with identical demands, by two firms with identical costs. This is because the two markets are segmented and each firm chooses its outputs in the two countries separately. Our model has a similar intuition, but in our case the production cost for the distributor is endogenous, depending on the wholesale price of the manufacturer. This introduces additional interesting trade-offs that are the focus of our analysis.3

We set up the model in Section 2, analyse its equilibrium in Section 3, and consider the effects of restricting parallel imports in Section 4. We conclude in Section 5.

2. The Model

A manufacturer,M, sells its product in two countries,AandB. In country A, M sells directly to the consumers, or sells through a wholly-owned subsidiary whose output is set by M. In country B, M sells its product through an independent exclusive distributor,L. The inverse demand inA is p = pA(q), and that in B is p = pB(q), both of which are continuously differentiable functions. Manufacturer M has a constant marginal cost of production c 50. The retailing cost in both countries is normalized to zero.4

Suppose thatMcan offerLany contract in the form of (w,T), wherewis the wholesale price at which L purchases from M and T is a transfer payment (franchise fee) fromLtoM.5However,Mcannot preventLfrom selling the product back toA, either directly or through intermediaries. That is, eitherMcannot legally limit L’s territory of sales, or it is too costly forM to enforce any such constraint.6

Suppose that L incurs an additional constant marginal cost t 50 in selling the good back to A. For instance, t could be the additional transportation cost or transaction cost. Assume that ifLsells in CountryA, it will compete withMin a Cournot fashion in that market.

Let the quantities sold inAbyMandLbeqAMandqAL,respectively, and the quantity sold inBbyLbeqB. The timing of the game is as follows:Mfirst offers contract (w,T) toL, which is either accepted or rejected. If the contract is rejected, no product is sold inBandMchooses its output inA. Otherwise, Lchooses its outputs in both Aand B, and simultaneouslyMchooses its

output inA. A subgame-perfect Nash equilibrium is, for any (w,T) accepted byL, a pair (qAM, qAL) that constitutes a Nash equilibrium in A, together with an optimal choice of qB by L; and a contract (w,T) that is chosen optimally byM. As usual, we solve the model by backward induction.

For preliminaries, we first consider equilibrium in CountryA, taking as given any (w,T) that is accepted byL. The profits ofMandLthrough sales inAare:

pAM¼qAM½pAðqAMþqALÞ c þ ðwcÞqAL ð1Þ

pAL¼qAL½pAðqAMþqALÞ wt ð2Þ For any giventand any (w,T) accepted byL, a Nash equilibrium inA, denoted as (qAM(w + t), qAL(w + t)), where qAi 50, solves the following first-order conditions:7 pAðqAMþqALÞ cþqAMp 0 AðqAMþqALÞ 0 ð3Þ pAðqAMþqALÞ ðwþtÞ þqALp 0 AðqAMþqALÞ 0 ð4Þ where equation (3) holds as an equality ifqAM(w + t) 40 and equation (4) holds as an equality ifqAL(w + t)40.

The equilibrium price inAwill bepA(qAM(w + t) + qL (w + t)). For any given w and t, we shall denote the equilibrium PAM and PAL as

PAM(wjt) andPAL(wjt),where we emphasize thatwis a choice variable and tis a given parameter.

We next consider equilibrium in CountryB, again taking as given any (w,T) that is accepted byL. DistributorLchoosesqBto maximize (pB(qB) -w)qB. Denote the equilibrium (optimal) choice by qB(w),and let

PB(w)=(pB(qB(w)) –w)qB(w). The equilibrium price in B is pB (qB (w)). Since firmL’s profit inB, excludingT, isPB(w),the equilibrium choice ofT byMmust satisfy

T¼TðwjtÞ PALðwjtÞ þPBðwÞ

Any contract (w,T(w)) is accepted by L in equilibrium. The equilibrium choice ofwtherefore maximizes the joint industry profits in two countries,

P(wj(t),where PðwjtÞ ¼PAMðwjtÞ þPALðwjtÞ þPBðwÞ þ ðwcÞqBðwþtÞ That is, PðwjtÞ ¼PAðwjtÞ þPBðwÞ; ð5Þ where PAðwjtÞ ½qAMðÞ þqALðÞ½ðpAðqAMðÞ þqALðÞÞ c tqALðÞ ð6Þ

To allow for general results, we do not restrict the demand functions in either country to a particular form. We instead make the following assumptions.

Assumption A1

For i = A,B, q[pi(q)-c] is a concave function of q, qi0=argmaxq50

{q[pi(q)7c]} exists uniquely for any given c, and qB(pA0) 40, where pA0=pA(qA0).

Assumption A2

For anyqAM4 0 andqAL4 0, @ 2_p Ai @qAi@qAj<0 and @2_p Ai @qAi@qAj _<@2_p Ai @q2 Ai _. Assumption A3

For any givent5pA07c,P(wjt) is continuous and concave inwforw2[c, pA07t] and is continuously differentiable forw2[c, pA0 7t).

Notice thatqA0 (orpA0) is the profit-maximizing output (or price) for a monopolist in A. Assumption A1 ensures that profit in country i is maximized only with outputqi0fori = A,B, and quantity demanded inBis positive at pricepA0. Assumption A2 implies thatqAi andqAjare strategic substitutes and that there is a unique and stable equilibrium in marketA. Assumption A3 imposes additional technical restrictions on P(wjt) that facilitate our analysis. The concavity ofP, in particular, ensures that the optimal choice ofwis unique, but is not essential for the basic insights of the analysis. Assumptions A1 – A3 can be satisfied by a variety of demand functions and parameter values. Consider, for instance, the linear-demand structure used by Maskus and Chen (2004).

Example pA¼aq; pB¼1q; a2 ð3=4; 2; c¼0; t0:Then; p0A¼a=2 and forw2 ½0;ða=2Þ t; pAðwjtÞ ¼ ðaþwþtÞ2 9 þ wða2w2tÞ 3 þ ða2w2tÞ2 9 PðwjtÞ ¼ðaþwþtÞ 2 9 þ wða2w2tÞ 3 þ ða2w2tÞ2 9 þ ð1w2Þ 4 All assumptions A1 – A3 are satisfied for this example.8We shall use this example to illustrate our results throughout the paper but certain other classes of demand functions would satisfy them as well.

3. Analysis Lemma 1 DefinewðtÞ p0

At. For any given t2 [0,pA07c), there exists a unique

wðtÞ>c such that qALðwÞ>0 if w<wðtÞ and qALðwÞ ¼0 if wwðtÞ . Furthermore, when w<wðtÞ , qAM (.) increases in w and in t, qAL (.) decreases inwand int, and [qAM(.) + qAL(.)] decreases inwand int; and whenwwðtÞ, q AM(.)= qA0.

Proof

For the proof see the appendix.

Note that whent5pA07c, qAL(c)=0. This is the case wheretis so high that parallel imports do not occur even ifw = c. We shall say in this case that parallel trade isblocked. Lemma 1 tells us that ift5pA

0₇

c, parallel imports will occur, or beaccommodated, whenw<wðtÞ p0At. We shall say that parallel trade isdeterredifw4candqAL(w)=0.

Proposition 1

For any givent, the model has a unique subgame perfect Nash equilibrium. Ift5pA0 7c, the equilibrium value ofwisw*(t)= c; and ift5pA07c, the equilibrium value ofwis

wðtÞ ¼w~2 ðc;wðtÞÞif@PðwjtÞ~

@w ¼0

wðtÞ ¼wðtÞ ¼p0_Atotherwise ð7Þ Proof

For the proof see the appendix.

We note that as long ast5pA07c, or parallel trade is not blocked, the wholesale price is not set at the true marginal cost sincew*(t) 4c. This suggests that either active or deterred parallel trading always causes vertical price inefficiency.

Proposition 2

There exists some t1>0 such that w*(t)5wðtÞ (parallel imports are accommodated) when t<t1; and there exists some t2 2 ½t; p0AcÞ such that w*(t) =wðtÞ (parallel imports are deterred) when t2<t<p0Ac. Furthermore,t1¼t2 ifdw_dðttÞ1.

Proof

For the proof see the appendix.

Intuitively, whentis small, parallel imports can be deterred only whenw is much higher thanc. Starting from thewthat is just high enough to cause qAL(w + t)=0, a small decrease inwhas small negative effects on the profit inAand on the value of trade costs incurred,9but has a large positive effect on the profit in B. Thus, w*(t)5wðtÞ and parallel imports occur (or are accommodated) whentis small. Whentis large but is still belowpA07c, on the other hand, parallel imports may be deterred with a w that is only slightly higher than c. Starting from w¼c<wðtÞ and qAL (w + t)40, a small increase inwhas a small negative effect on the profit inB, but has big positive effects on the profit inAand on lowering trade cost. Thusw*(t) =

wðtÞand parallel imports will be deterred.

The optimal change inwcaused by a change intis likely to be a smaller amount than the change intitself. Therefore, it is likely thatdw_dð_ttÞ41 and thust1¼t2. For our linear demand example,t1¼t2 ¼₁₄3a;wðtÞ ¼ a₂t, and

wðtÞ ¼2aþ8t 13 ift 3 14a wðtÞ ¼a 2 t if 3 14a<t a 2 wðtÞ ¼0 ifta 2

Since qAL(w*(t) + t) 40 when w*(t)5wðtÞ , qAL(w*(t)+t) = 0 when w*(t) =wðtÞ , t2<p0Ac, and w*(t) =wðtÞ ¼ c when t5pA

0

–c, we immediately have the following results concerning equilibrium parallel imports:

Corollary 1

In equilibrium, there is parallel importing from countryB to country Aif t<t1, parallel trade is deterred if t2<t<p0Ac, and parallel trade is blocked ift5pA0–c.

When parallel trade occurs, c5w*(t)5wðtÞ , qAM (w*(t)+ t)+ qAL (w*(t) + t) 4qA0, andqB(w*(t)) 5qB0. Thus, ifpA(qA0)4pB(qB0), which would be true if demand inAis not higher than inB, we must have

pA½qAMðwðtÞ þtÞ þqALðwðtÞ þtÞ<pB½qBðwðtÞÞ

This condition states that parallel imports originate from the country with the higher price. Notice that this condition can also hold even ifpA(qA

0

)

4pB(qB

0

Corollary 2

A sufficient (but not necessary) condition for parallel imports to occur and to be originated from a country with higher prices ist<t1 andpA (qA0) 4pB(qB0).

Thus, parallel imports can flow from a country with a higher retail price to a country with a lower retail price, showing that one of the central points of Maskus and Chen (2004) survives under general demand conditions. Indeed, this can happen for countries with similar demands or for countries with different demands. To see the intuition behind the result more strikingly, consider a special case of our model where the two countries are identical. In this case, the usual motive for parallel imports due to monopoly international price discrimination would not arise. Suppose for a moment that parallel imports are not legally allowed. Then, the manufacturer, M, would offer L a two-part tariff contract (w,T)=(c, PB(c)), which would enableM to receive the same profits from countries Aand B and lead to identical prices in both countries. Now make parallel imports legal. Consumers would have no incentive to arbitrage between the two countries since the retail prices are identical. But distributorLmay have an incentive to sell the good back toA, since its marginal cost of acquiring the product for parallel imports is the wholesale pricew, not the retail market price. Of course, M will anticipate this and raise the wholesale price above c to decreaseL’s incentive for parallel imports. But the increase inwdistortsL’s pricing incentive in marketB (causing double marginalization), and hence Mmay choose not to raisewto a level that would deter parallel imports. In equilibrium, the manufacturer balances the needs to improve vertical pricing efficiency and to limit parallel imports.

It is therefore clear that the reason for parallel imports to occur in this model is the presence of a vertical relationship and the need to avoid vertical pricing inefficiency.10We note that this analytical result does not necessarily depend on the availability of two-part tariff contracts. Even ifMcan only chargewand cannot chargeT, parallel imports can still occur and originate from a country with the higher (retail) price. The availability of two-part tariff contracts highlights the effects of parallel imports on vertical pricing efficiency.

Insertingw*(t) into equation (5), we obtain the equilibrium profits forM as

P_{ðtÞ ¼ ½q}

AMðwðtÞ þtÞ þqALðwðtÞ þtÞ½pAðqAMðwðtÞ þtÞþ

qALðwðtÞ þtÞÞ c

tqALðwðtÞ þtÞ þ ½pBðqBðwðtÞÞÞ cqBðwðtÞÞ

Parallel imports reduce the profits of the manufacturer (or the joint industry profits in two countries), not only because they create competition in the

country receiving such trade and because they incur additional transaction (transportation) costs, but also because they prevent the manufacturer from achieving efficient vertical pricing (setting the wholesale price equal to marginal cost). An interesting issue is howP* may change as trade cost t changes. An increase in t increases the trade cost for a given amount of parallel imports, but it can also cause reductions in both w*(t) and the amount of parallel imports, with generally ambiguous effects onP*.But if

t2<t<p0Ac, or if parallel trade is deterred in equilibrium, then a marginal increase int clearly increases P*.This is because in this case an increase in t will affect P* only through a reduction in w*(t) =

wðtÞ ¼p0

At, which in turn results in an increase in [pB (qB (w*(t))) –c] qB(w*(t)).

We next turn to the joint social surpluses in two countries, which we call global welfare. The global welfare in equilibrium is

S ðtÞ ¼ Z qAMðwðtÞþtÞþqALðwðtÞþtÞ 0 ½pAðqÞ cdqtqALðw ðtÞ þtÞþ Z qBðwðtÞÞ 0 ½pBðqÞ cdq ð8Þ

Similar to the effect on profit, the effect of a change inton global welfare tends to be ambiguous in general. However, ift2 <t<p0Ac, a marginal rise in t surely raises S* because, in this case, an increase in t will affect combined surplus only through a reduction inw*(t)= pA0–t, which in turn affectsS* only through an increase in the third term,

Z qBðwðtÞÞ

0

½pBðqÞ cdq

Whent<t2 it is less clear howP(t) and S*(t) will change as tchanges. For our linear demand example, P*(t) decreases in t when t<a

9 but increases int whena

9<t a

2; andS*(t) decreases in twhen t<143 a¼t1¼t2 but increases in t when 3

14a<t< a

2. Thus, at least in this example, both global profits and global welfare are U-shaped functions of t, but P*(t) assumes its minimum at a lower level oftthan doesS*(t).

4. The Effects of Restricting Parallel Imports

An interesting policy question to analyse is how a ban on parallel imports would affect pricing and welfare. It should be evident that such a restriction would support efficient vertical pricing, offering scope for welfare increases. However, the perfect market segmentation would also prevent competition

in the manufacturer’s market, raising the possibility of welfare reductions there.

Thus, supposeLis prevented from selling the product back toA, either because there exists an effective vertical restraint imposed byMor because parallel imports are not legally allowed by governments. Permitting again a contract (w,T), and denoting equilibrium (optimal) variables by adding superscriptv, it is optimal forMto set:

wv¼c; andTv¼P0B¼qBðcÞ½pBðqBðcÞÞ c Prices inAandBwill then be

pvA¼p0A; p v

B¼p0B ð9Þ

Whent 5pA

0₇

c, or parallel imports are not blocked, we havew* 4c p_B¼pBðqBðwÞÞ>p0B; andpA¼pAðqAMðwÞ þqALðwÞÞ p0A with strict inequality if parallel imports occur in equilibrium. We thus have Proposition 3.

Proposition 3

Assume thatt5pA0- c. Then restricting parallel imports reduces prices in the country where parallel imports originate and may or may not raise prices in the country receiving parallel imports. Thus, restricting parallel imports benefits consumers in the country where parallel imports originate but may or may not hurt consumers in the country receiving parallel imports. However, restricting parallel imports always benefits the manufacturer.

Turning to global welfare, restricting parallel imports increases welfare of the country where parallel imports originate, but has ambiguous effects on the country receiving parallel imports. When t2 ðt2; p0AcÞ, parallel imports will be deterred through somew*(t) 4cin equilibrium. In this case, government restrictions on parallel imports replace the inefficient vertical-price deterrence and thus eliminate the vertical-price distortion inBwithout causing other losses. When t<t2, on the other hand, restricting parallel imports eliminates the inefficiency in vertical pricing forB and avoids the wasteful additional transaction costs due to parallel imports, but results in higher prices inA. The policy thus has ambiguous effects on global welfare. For our linear demand example, we find that the change in global welfare due to restricting parallel imports is

DS¼að5a4Þ 104 þ tð12a23tþ4Þ 26 ift 3 14a

DS¼ða2tþ4Þða2tÞ 32 if 3 14a<t a 2

It is clear here thatDS40 when 3

14a<t a

2andDS50 iftis sufficiently small. We thus have Proposition 4.

Proposition 4

Restricting parallel trade may either increase or reduce global welfare. When t2 ðt2;p0AcÞ,restricting parallel imports increases global welfare but when

tis sufficiently small, restricting parallel imports can reduce global welfare. We also note that if t 5pA

0₇

c, restricting parallel imports has no welfare effects.

The result that restricting parallel trade has ambiguous welfare effects bears resemblance to the finding in the literature that such restriction facilitates international price discrimination (Malueg and Schwartz, 1994; Anderson and Ginsburgh, 1999). However, the ambiguity in our model comes from a different source, which is the elimination of the vertical pricing inefficiency in one market, combined with reduced competition in the other market. In general, the welfare effects of restricting parallel import are ambiguous in this framework, depending on the values oft. Moreover, it is easy to show in the linear-demand case that this ambiguity does not disappear when the two countries face identical demands (and hence restricting parallel imports would have no effect on global welfare if the motive for parallel imports were international price discrimination).

In Brander and Krugman (1983), restricting reciprocal dumping avoids resource waste in cross-hauling but results in higher prices in both countries. Restricting parallel trade in our model also avoids resource waste in cross-hauling but results in higher prices in the country receiving parallel imports. However, here restricting parallel trade actually reduces prices in the country where parallel imports originate. The reason is that there is the additional vertical pricing inefficiency caused by parallel trade in our case. Although, in both cases, restricting trade is (weakly) welfare improving when trade cost is sufficiently high, the mechanisms for these outcomes are different. In Brander and Krugman, whentis just at the prohibitive level, a small decrease intreduces welfare due to the loss from the replacement of domestic production with high-cost imports. But here whentis high enough to deter parallel trade, a marginal decrease intreduces welfare since it leads to an even higherw*(t) and thus to more inefficiency in vertical pricing. In Brander and Krugman, when t is sufficiently small, free trade is welfare-improving since resource waste in cross-hauling is small. In our case, however, allowing parallel trade may have ambiguous welfare effects even whentis small, since the inefficiency in vertical pricing does not go away ast

goes to zero. There are situations, though, where allowing parallel trade is welfare-improving iftis sufficiently small, as is the case in our linear demand example.

The question of whether parallel importing should be established as a global policy has been debated at the WTO. Our analysis can shed light on this issue in a more general setting than that in Maskus and Chen (2004). The results suggest that neither a policy that always bans parallel trade nor a policy that always facilitates it is justified from the perspective of global economic efficiency.11 Our analysis further suggests that policy choices concerning parallel imports are closely related to choices on other trade policies. For instance, if it is desirable that parallel imports be legally allowed, then it could also be desirable to reduce any trade barrier that increases the cost of parallel trading. On the other hand, if the cost of conducting parallel trade is sufficiently high, part of which could be due to the presence of significant trade barriers, then it might be desirable to ban parallel imports.12

In considering the welfare effects of our analysis, it is important to keep in mind the restrictions we have imposed on our model. In particular, we have assumed that the manufacturer can affect the retailer’s incentive for parallel imports only through changing wholesale prices. More generally, a manufacturer may have other instruments to limit parallel imports and to avoid vertical pricing inefficiency. First, the manufacturer may restrict the quantity the foreign distributor may purchase, which could alleviate the problem of parallel imports.13 Second, the manufacturer may impose (maximum) resale price maintenance on the distributor in country B, resolving directly the tension between controlling parallel imports and avoiding double marginalization. How-ever, there may be legal limitations on resale price maintenance, and even if it is legally allowed, price maintenance may be costly to enforce. Third, the manufacturer may choose to vertically integrate with the distributor, eliminating the distributor’s incentive for parallel imports and the problem of double marginalization. However, if the distributor sells products of many other manufacturers, vertical integration may not be practical. Moreover, vertical integration can also introduce well-known incentive problems of its own. Fourth, the manufacturer may enter the foreign market directly or contract with several independent distributors to create retail competition. But these choices may not be economical if there are fixed costs in running a distribution system; a fact that we have not considered but can be easily incorporated into our model. Furthermore, retail competition may alleviate, but need not eliminate, the double mark-up problem.

The presence of these other instruments implies that the possibility of parallel imports need not necessarily cause vertical pricing inefficiencies. We thus need to be cautious in interpreting the welfare results of our analysis and the policy implications. However, to the extent that these other

instruments have their own costs and limitations, there will be situations where a manufacturer may still want to sell its product through independent agents in another country who have certain market power, and our analysis offers insights in these situations.

5. Conclusion

In this paper we have studied a model of parallel imports incorporating vertical pricing considerations, generalizing and extending the results of Maskus and Chen (2004). We find that while the possibility of parallel imports can increase retail market competition, it can also affect a manufacturer’s incentive, as the rights owner, in setting the wholesale price (or royalty payment) and so reduce vertical pricing efficiency. Although parallel imports can be deterred by the manufacturer through a sufficiently high wholesale price, they can nevertheless occur in equilibrium and can even originate from the country with higher retail prices. Both industry profits and global welfare can increase in trade costs. The possibility of parallel imports decreases global welfare when trade cost is large, but can increase welfare when trade cost is low. To the extent that trade cost is likely to be higher for countries in different regions than for countries within a region, parallel trade is more likely to increase welfare within a region than in the entire world trading system.14

To the extent that parallel imports may allow one distributor to free ride on another distributor’s promotional activities and reduce efficiency of these activities, a case may be made for the prevention of parallel imports. Our analysis suggests that there need not be externalities of this type in order to have welfare-improving restrictions on parallel imports. The need to improve vertical price efficiency can make it desirable to prevent parallel imports. Recently, concern about parallel trade has surfaced in pharma-ceuticals and biotechnology, as well as in copyright industries including software, recorded music, videos, and book publishing. These sectors are characterized by high R&D costs but low marginal costs of production and distribution. Thus, the differences between retail prices and marginal costs for these products are often significant. The theory may prove to be particularly useful in these situations.

Appendix

This appendix contains the proofs for Lemma 1, Proposition 1, and Proposition 2.

Proof of Lemma 1

Whenw<wðtÞ ¼ p0At, we must haveqAL(w + t)40, since ifqAL(w + t) = 0, we would haveqAM(w + t)= qA

0

pAðqAMðwþtÞ þqALðwþtÞÞ wtþqALðwþtÞp0AðqAMðwþtÞþ

qALðwþtÞÞ ¼p0Awt>0

contradicting equilibrium condition (4). When wwðtÞ ¼ p0 A, qAM (.)= qA0and qAL(.)=0 solve equations (3) and (4) and thus constitute the equilibrium in marketA.

When w<wðtÞ , both equations (3) and (4) hold with equality. Differentiating these two equations with respect to w and rearranging terms, we obtain @qALðwþtÞ @w ¼ @2_p AM @qAM@qAL @2_p AM @q2 AM 1 @2_p AL @qAM@qAL þ@2pAL @q2 AL " #1 <0 @qAMðwþtÞ @w ¼ @2_p AM @qAM@qAL @2_p AM @q2 AM 1_@ qALðwþtÞ @w >0 Similarly,@qALðwþtÞ @t <0 and @ qAMðwþtÞ

@t >0. Further, adding up equations (3) and (4), we have

2pAðqAMðwþtÞ þqALðwþtÞÞ cwtþ ðqAMðwþtÞ þqALðwþtÞÞp0A

ðqAMðwþtÞ þqALðwþtÞÞ ¼0

which implies that (qAM(w + t) + qAL(w + t)) decreases in wandt. Proof of Proposition 1

First, whent5pA0–c, w*(t)= csince this induces the optimal retail price inBwithout causing positive parallel imports. Next, suppose thatt5pA0– c. Notice that ifwwðtÞ , thenqAL(w + t) = 0, and thus further increases in w have no effect on PAM (w(t) but reduce PB(wjt). Next, if w 5c, then

P(wjt) 5 P(cjt). Therefore the search for the optimalwcan be limited on the compact interval c;wðtÞ , on which P(wjt) is continuous. Thus w*(t) exists andw*(t)2 c;wðtÞ . Moreover, since on this intervalP(wjt) is strictly concave inwby Assumption A3,w*(t) is unique, wherew*(t) =w~if there is somew~2c;wðtÞ such that@P_@ð~_wwjtÞ¼0, andw*(t) =wðtÞ otherwise.

By construction, the contract ((w*(t), T(w*(t)) jt), together with (qAM (w + t), qAL(w + t)) in country A and qB(w) in country B, constitute the unique subgame perfect Nash equilibrium.

Finally, notice that ift 5pA0 – c, then @

pAðwjtÞ

@w is positive at w = c, but

@pBðwÞ

@w is zero at w = c. Therefore

@pðcjtÞ

@w >0 and hence w*(t) 4c for any

t5pA

0

Proof of Proposition 2 First, @PðwjtÞ @w wðtÞ ¼@pAðwjtÞ @w wðtÞ þ@pBðwÞ @w wðtÞ where@pAðwjtÞ

@w jwðtÞ ?0 whent?0, but@p@BwðwÞjwðtÞ is a negative constant as t?0. Therefore, when t is sufficiently small, @P_@ð_wwjtÞjwðtÞ<0 and hence w*(t)5wðtÞ . That is, there exists somet1>0 such that w*(t)5wðtÞ when t<t1.

Next, we show that there exists somet2, wheret1t2<p0Ac, such that

w*(t) =wðtÞ whenevert>t2. Suppose this were not true. Then there exists some t that is arbitrarily close to pA

0₇

c, for which w*(t)5wðtÞ and

@PðwjtÞ @w jwðtÞ¼0. But sincew*(t) ? c + when t ? (pA07c)-, and @pBð wÞ @w ?0 whenw?c+, we have @PðwjtÞ @w wðtÞ !@pAðwjtÞ @w wðtÞ >0

whenw*(t)? c+. This implies that @P_@ð_wwjtÞjw_ðtÞ>0 for anyt that is lower than, but sufficiently close to, (pA0– c), a contradiction.

Finally, we show that t1¼t2 if jdw

_ðtÞ

dt j 1. It suffices to show that if

1dw_dtðtÞ1, then for anyt’ 40 such thatw*(t’)5wðt 0Þ,w*(t)5wðtÞ for all t5t’. Since w*(t’)5wðt 0Þ, dP_dð_wwÞjwðtÞ0¼0. Consider any t5t’. Then wðtÞ ¼ p0At¼p0At0þt0t¼wðt 0Þ þt0t. If 0

dwðtÞ dt , then

wðtÞ wðt0Þ<wðt 0Þ<wðtÞ . If 1dw_dtðtÞ<0, then – dt 4dw*(t) 50, or dt57dw*(t). Integrating on both sides, we have

t0t ðw ðt0Þ w ðtÞÞ; orw ðtÞ<w ðt0Þ þt0t<wðt0Þ þt0t¼ wðtÞ:

Notes

We thank Jonathan Eaton, Damien Neven, Marius Schwartz, two anonymous referees, and participants at numerous seminars for helpful comments. Chen acknowledges research support from the National Science Foundation under grant # SES 9911229 and Maskus is grateful to the World Intellectual Property Organization for support.

1

The NERA report (1999) makes this point clearly, noting many sectors in which parallel trade is a distributor-level phenomenon. In a concrete example, it is estimated that up to 20 per cent of the market for Coca-Cola syrup in UK is served by parallel imports coming from

wholesalers in other European nations. See ‘Coke’s Public-Relations Trouble Was Worsened by Gray Trade’,The Wall Street Journal, 6 July 1999.

2 _{We shall allow the manufacturer to use two-part tariff contracts, so that the double-markup}

problem could be avoided if not for the concerns of parallel imports.

3 _{The prevention of parallel imports is essentially the enforcement of an exclusive territory in}

the international context. As such, our study is also closely related to the literature on vertical restraints (see, for instance, Katz, 1989). While our analysis is rather different from this literature, it shares some similar intuition with Chen (1999).

4 _{The model can be easily extended to include positive retailing costs in both countries.} 5 _{Equivalently, we can think ofLbeing a licensee ofMin countryB. In this case,Twill then}

be the license fee andwthe royalty payment per unit of output. Contracts with a fixed fee and per-unit royalty are common in international licensing (Contractor, 1981).

6

However, we assume thatMor any agents ofMother thanLwill not sell inB.

7

For ease of exposition, we shall sometimes suppress the arguments in the functional expressions forqAMandqAL.

8

We note that while Assumptions A1 and A2 are fairly standard, Assumption A3 is a stronger assumption. SincePconsists of the profits in market Aof a Cournot duopoly and the monopoly in marketB, from the usual monopoly and Cournot analysis, the demand curves in these two markets may not be too convex to ensure the concavity ofPonw. Clearly, linear demand satisfies this condition but so do other demand specifications.

9 _{This comment refers to trade costs}

tqALrather than to exogenous ad valorem costt. 10 _{IfMcould set the retail price inBdirectly so that vertical pricing efficiency were not a}

concern, parallel trade may still occur. But such parallel trade would then only be due to international price differences. The theory discussed here does not preclude such parallel imports, but suggests an additional important reason for them.

11 _{We note that nations may have conflicting interests in policies towards parallel imports.}

When manufacturers are foreign-owned firms, parallel imports are more likely to raise national welfare in the importing country, which would not count manufacturers’ profits in its welfare, but this could be at the expense of other countries.

12

For countries that lack effective control of their borders, a ban on parallel imports is unlikely to be fully enforced because of smuggling. In that context,tcan be interpreted as the cost of evading controls, or, equivalently, as the level of enforcement of a prohibition. Thus, the best policy may be to have no prohibition (so thatt= 0), which would be preferred to a situation where parallel imports occur at a highert.

13

SupposeLis restricted to purchase no more thanqB 0

, the profit-maximizing output inB. But atqB

0

,Lmay want to divert some of the output back toA, since a marginal diversion has a second-order effect onL’s profit inBbut a first-order effect onL’s profit fromA. Thus, ifM wants to deter parallel imports, it will have to limit the purchase ofLto less thanqB0, which

leads to a trade-off that is somewhat similar to ours: accommodating parallel imports or having too little output (too high price) in marketB. On the other hand, ifLis required to purchase at leastqB0,Lwould have the incentive to engage in parallel imports.

14 _{This may suggest an economic rationale for the ECJ’s approach to allow parallel imports}

within the Single Market but not across its borders. We also note that the policy implications of our analysis share similarities with those of Malueg and Schwartz (1994), although for very different reasons. We mention again that our welfare results need to be qualified, as discussed at the end of Section 4.

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