This 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 market.
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 markets.

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'?
Gernot Klepper

Discussion Paper No. 675, March 1992 (IT)