paper develops a framework within which the impact of the proposed
initiatives of the European Commission for creating an internal market
for pharmaceuticals can be analysed. In a model of third-degree price
discrimination, arbitrage between two markets and price controls through
governments in one market are introduced. The effects of easier
arbitrage opportunities, i.e. lower arbitrage costs, on the prices in
the two markets are analysed. Also, the impact of a reduction in price
controls in the low-priced markets as well as their combined effects are
characterized. The welfare effects of the Internal Market in
pharmaceuticals are ambiguous, since a movement from segmented and
price-controlled markets towards integrated markets does not lead to a
first- or second-best solution.
Completing the European Internal Market is usually thought of as
consisting of the removal of all barriers to trade within the EC such
that market segmentation will disappear and, ideally, equal prices will
prevail. Pharmaceutical markets are still the most segmented markets
exhibiting large price differences between high-priced countries like
Denmark, Germany, and the Netherlands and low-priced countries like
Greece, Italy, Portugal, and Spain. For the European Internal Market in
1992 and beyond, the EC Commission has introduced several initiatives
aimed at reducing this market segmentation. This paper analyses the
likely impact of these measures on prices in the different countries and
their possible welfare effects.
The segmentation of pharmaceutical markets does not emanate from tariffs
and quantitative barriers but from differences in national regulations,
different demand patterns and price controls in certain markets.
Consequently, no real barriers to intra-EC trade exist, but constraints
on arbitrage nevertheless sustain price discrimination between markets.
The European Commission's initiatives to enhance the integration of
pharmaceuticals markets consist of a requirement to make the imposition
of national price controls more transparent (thus increasing political
pressure against discriminatory price controls), and attempts to
harmonize registration procedures for new products as well as for
re-imports or parallel imports by arbitrageurs, in order that price
controls should become less stringent and the cost of arbitrage between
EC members states will fall. (Re-imports are imports that have
previously been exported from the producing firm and parallel imports
are imports by arbitrageurs as well as the producing firm.)
In order to address these issues, this paper develops a model of a price
discriminating firm serving two markets, one of which has price
controls. These markets have different price elasticities, e.g. because
of different income levels between the southern and northern part of the
EC. The two markets are not completely segmented since arbitrage is
possible, but this involves costs that are assumed to increase with the
amount of pharmaceuticals that are re-imported or parallel imported.
Market integration measures by the Commission of the EC are represented
through a parametric shift in the cost function of arbitrageurs.
The model predicts that a reduction of price controls in one country,
e.g. as induced by the Transparency Directive of the EC, will reduce the
price differences, but this may be accompanied by rising prices in the
unrestricted market, contrary to the expectation that both prices move
towards a uniform price somewhere between the original prices. The
specific form of the cost function of arbitrage determines which price
effect will prevail. Similarly ambiguous is the effect of changes in the
regulatory barriers to arbitrage. Easier arbitrage opportunities reduce
price differences between the two markets, but whether prices fall or
rise in a single market depends on the shape of the demand functions. If
demand is very inelastic, as is possible especially in the German
market, prices may fall in the high- priced as well as the low-priced
The impact of market integration on profits and consumer surplus is not
necessarily positive. Whereas a reduction in price controls
unambiguously raises profits, it also lowers consumer surplus in the
price-controlled market and possibly in the unrestricted market.
Facilitating arbitrage also has ambiguous effects on the consumer
surplus in both markets and on firms' profits. As the producer is no
longer able to price discriminate, its profits are likely to fall. The
consumer surplus in the high- priced market always rises, whereas it
rises in the low-priced market only if demand in the high-priced market
is very inelastic.
The overall welfare effects for the two markets cannot be uniquely
predicted. The analysis is complicated by the fact that due to the high
fixed costs of producing pharmaceuticals the welfare maximum with
marginal cost pricing is not attainable without subsidization and a
uniform price is not a second-best solution. Profit-constrained welfare
maxima for example with a zero profit constraint would always involve
price controls in both markets; they could not be achieved through price
controls in only one market.
The analysis has focused on a pharmaceutical producer having a monopoly
in a particular market segment, for example through patent protection.
All the conclusions also hold if the monopoly situation is replaced by
an oligopoly, however, which is more common for the market segments
defined by the different therapeutic groups.
In summary, the reduced restrictiveness in price controls which is
beginning to appear in the EC will reduce price differences. It will not
eliminate market segmentation, however, which is made possible by the
different national registration procedures, which allow firms to
differentiate their products so that they can only be re-imported or
parallel imported at high costs of relabelling, repackaging and
additional registrations. Only a European registration or a mutual
recognition of national registrations will integrate pharmaceutical
Integrating pharmaceutical markets in the spirit of the Internal Market
will redistribute consumer surplus from the low-priced countries to the
high-priced countries. Whether the overall welfare effect of market
integration is positive or negative cannot be answered as it depends on
a complex set of supply and demand conditions.
Pharmaceuticals Who's Afraid of `1992'?
Discussion Paper No. 675, March 1992 (IT)