Vertical Pricing and Parallel ImportsYONGMIN CHEN & KEITH E. MASKUSDepartment of Economics, University of Colorado at Boulder, Boulder, CO 80309, USAABSTRACT We generalize an earlier model of international vertical pricing to explainkey features of parallel imports, or unauthorized trade in legitimate goods. When amanufacturer (or trademark owner) sells its product through an independent agent inone country, the agent may find it profitable to engage in parallel trade, selling theproduct to another country without the authorization of the manufacturer. Althoughparallel imports can be deterred when the manufacturer’s wholesale price is sufficientlyhigh, there is a trade-off between improving vertical pricing efficiency and reducingparallel imports. In equilibrium, parallel imports can come from a country with higherretail prices, which is consistent with some factual data. While countries have varyinginterests in such a policy, restricting parallel imports tends to increase global welfarewhen trade cost is high, but may reduce welfare when trade cost is low. This findingsuggests that open parallel trading regimes may be most appropriate within regionaltrade agreements.KEY WORDS: Parallel imports, vertical price formation, intellectual property rights1. IntroductionParallel imports are goods brought into a country without the authorizationof the original trademark or copyright owner, after those goods have beenplaced into circulation legitimately in another market. For example, Coca-Cola syrup provided by a bottler in Belgium may be authorized for sale onlyin Belgium. If the Belgian dealer or an independent agent were to ship thesyrup to Spain without the authorization of Coca-Cola Co., the shipmentwould be called parallel imports. Although there are no official statistics onthe volume and nature of parallel imports, pa rallel trade is considered asignificant phenomenon. Accor ding to some recent estimates, parallelimports account for 5 to 20 per cent of trade within the European Unionfor such goods as musical recordings, consumer electronics, cosmetics andperfumes, and soft drinks (NERA, 1999). Another study found that morethan 50 per cent of certain high-volume brand-name pharmaceuticalCorrespondence Address: Keith E. Maskus, Department of Economics, UCB 256, University ofColorado, Boulder CO 80309-0256, USA. E-mail: [email protected]. Int. Trade & Economic DevelopmentVol. 14, No. 1, 1 – 18, March 2005ISSN 0963-8199 Print/1469-9559 Online # 2005 Taylor & Francis Group LtdDOI: 10.1080/0963819042000333225products sold in Sweden come from parallel imports (Ganslandt andMaskus, 2004).A country’s policy regarding parallel imports stems from its specificationof the territorial exhaustion of intellectual property rights (IPRs). Under thedoctrine of national exhaustion, rights are exhausted upon first sale within anation but the ability of IPRs owners to prevent parallel trade betweencountries remains intact. Under the doctrine of international exhaustion,rights are ended upon first sale anywhere and parallel imports are permitted.An intermedi ate policy is regional exhaustion, in which rights are exhaustedwithin 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 ofgrounds (Barfield and Groombridge, 1998; Maskus, 2000; Maskus andChen, 2002). Many developing countries prefer to maintain openness toparallel imports in the belief that this policy permits them to sourcegoods at lowest cost. This issue is central to the negotiations at theWorld Trade Organization over achieving access to essential medicines.However, the position taken by poor countries in this regard is curiousbecause standard economic analysis of market segmentation wouldsuggest that a policy of preventing parallel imports would generate lowprices in those nations (Malueg and Schwarz, 1994; Richardson, 2002). InAustralia, a decision was taken in 1998 to deregulate restrictions onimports of recorded music in view of the high retail prices in evidence atthat time, while New Zealand partially deregulated its import restraints incopyrighted goods. The United States government is consideringremoving its ban on parallel imports of branded pharmaceuticals fromCanada.In the European Union, the issue of parallel imports has been raised inmany legal cases, and the European Court of Justice (ECJ) has, throughits rulings, essentially adopted the doctrine of regional exhaustion,permitting parallel imports within member countries but not from outsidethe region. Key rulings were Merck v Stephar, C-187/80; Dior v Evora, C-337/95; and EMI v CBS, C-51/75. These decisions often stem from acompetition policy interested in preventing market segmentation by patentand trademark holders (Ganslandt and Maskus, 2004). For example, inRhone-Poulenc Rorer (case C-94/98), the ECJ held that manufacturerscannot partition the single market by introducing a new variety of apharmaceutical product, which could have the effect of replacing marketauthorization for the prior variety, where the product is subject tocompetition from parallel imports.Despite significant policy interests in parallel imports, there has beenvery limited economic analysis on this issue. Malueg and Schwartz (1994)were the first to conduct a formal analysis of parallel imports. Theypresent a model in which parallel imports occur due to international third-degree price discrimination by a manufacturer (or copyright owner).2 Y. Chen & K. E. MaskusSubsequently, Anderson and Ginsburgh (1999) further considered con-sumer arbitrage costs in parallel imports, in a framework with both third-degree and second-degree international price discrimination by a mono-poly manufacturer. Less formal literature discussed the problems thatemerge when parallel traders free ride on the marketing and serviceinvestments of authorized distributors (Chard and Mellor, 1989; Barfieldand Groombridge, 1998). In essence, the ex isting explanations viewparallel trade as arising from international price differences and theresulting price arbitrage by parallel traders.While the existing studies have provided important insights, they miss twoimportant features of such trade. First, frequently a parallel trader either isan authorized wholesaler himself or obtains the good directly from anauthorized wholesaler.1Thus, it is the wholesale price, not the retail price,that