Parallel Imports, Product Innovation and Market Structures

Parallel Imports, Product Innovation and Market Structures

Hong Hwang, Cheng-Hau Peng and Pei-Cyuan Shih

To presented at the Department of Economics, NCCU

2014/11/03

2

What Is Parallel Import?

• Parallel import (PI) occurs when a genuine product is sold back by licensed foreign distributers without the permission of the domestic intellectual property owner who, we call it the manufacturer, also serves the domestic market.

• Examples:• DVD• Textbook• Automobile• Medicine

Aomori Summer Workshop 2014/8/18

Aomori Summer Workshop 2014/8/18 3

Motivation

• Evidences have shown that there is a burgeoning trend in parallel imports around the world.

• Ganslandt and Maskus (2004) show that EU loses approximate $3 billion sales per year owing to the occurrence of PI.

• The value of PI in the US rose from 7–10 billion USD in the mid-1980s to 20 billion USD in the 1990s (Cespedes et al., 1988; Computer Reseller News, 2001)


Related Literature

• Trade cost : Maskus and Chen (2004), Chen and Maskus(2005), Mueller-Langer (2012)

• Labor union: Mukherjee and Zhao (2012)

• Process R&D:• Li and Maskus (2006)

• Product R&D:• Li and Robles (2007)• Matteucci and Reverberi (2014)


Aims

• Consider the effect of PI on the manufacturer’s product innovation by assuming the manufacturer sells its product to the foreign distributor via two-part tariff pricing.

• Explore the effect of local rivals in the domestic market, which is commonly observed in the real world but has been overlooked in this line of research.

• Examine the case in which the manufacturer has multiple distributors in the foreign market.


Preview of the Findings

• PI necessarily decreases the manufacturer’s product R&D if the domestic market is monopolized by the manufacturer.

• PI definitely stimulates product innovation of the manufacturer if it faces local rivals.


Preview of the Findings

• If the manufacturer can authorize its product to multiple foreign distributors, its product innovation can be either positively or negatively affected by PI, depending on consumers’ preferences for innovation in the domestic and the foreign markets.


Outlines

• Section 2 introduces the basic model and examines the optimal product innovation with no parallel imports.• Section 3 investigates the effect of parallel imports on the

manufacturer’s product innovation. • Section 4 explores the product innovation of the manufacturer when

it faces domestic rivals or authorizes its product to multiple distributors. • Section 5 concludes the paper.


The Model

• Assume there are two countries, H and F, hosting one firm each. Variables with a star are those associated with the foreign firm.• In the home country, there is a manufacturer with marginal cost

selling its product, in the home market and authorizing a foreign distributor to sell its product, in country F.• The distributor can sell back to the home country through parallel

import, , and the transport cost is nil. • The manufacturer and the distributor compete in quantity in the

home country if PI is permitted.

cx

*y

x


The Model • The inverse demand functions for countries H and F are

and with , , , and

the second derivatives of the demands are assumed to be zero.

• The manufacturer engages in product innovation with the cost

function , , and .

• The manufacturer adopts two-part tariff pricing (the per-unit wholesale

price, , plus a fixed fee, ) when selling the product to the distributor.

*,p p x x

,p p y * 0x xp p * 0yp 0p * 0p

( )V 0V 0V

w T


Game Structure

• The game in question consists of three stages.

Stage1: The manufacturer determines its optimal product R&D.

Stage 2: The manufacturer determines its optimal two-part tariff

pricing contract.

Stage 3: The two firms determine their optimal sales in the two

markets with or with no PI.


The No-PI Regime

•The profit functions of the manufacturer and the distributor can be expressed respectively as follows:

(1)

(2)

( ; , , ) , ( ) ( ),x w T p x c x w c y T V

( ; , , ) ( ) .y w T p w y T


No-PI regime—The Third-stage Game

•The FOCs (3)

(4)

• The second-order conditions are satisfied given the linear demands and constant marginal cost.• The comparative static effects are derivable as follows: .

0,x xp c p x

** 0.yy

p w p y

* ** *2 0, 2 0, and 1 2 0x y w yx p p y p p y p


No-PI Regime—The Second-stage Game

• The profit function of the manufacturer for the second-stage game is as follows:

(5) where

• The FOC:

(6)

Max ( , ( ), , ; ) ( ) ( ) ( ) ( ),w

x y w w T p c x w c y w T V

( ( ( )) ) ( )T p y w w y w

( ) 0w

d y Tw c y

dw y w w T w


Proposition 1

If the manufacturer adopts two-part tariff pricing and parallel

trade is prohibited, product innovation has no effect on the

wholesale price.

Intuition: Under two-part tariff pricing, the manufacturer always sets its wholesale price w = c. Product innovation affects only the demand, yielding no effect on the equilibrium price.


No-PI Regime—The First-stage Game

• The profit function of the manufacturer in the first-stage game can be expressed as follows:

(7)

• The FOC: (8)

• From (8), we can derive the optimal product innovation level under the no PI regime.

Max ( ( ( ), ) ) ( ) ( ( ), ) ( ).p x c x T y V

0d dT

p y p x Vd T d

N


The PI Regime

• Now let us consider that country H adopts international exhaustion (i.e.,

the PI regime).

• Under the PI regime, the foreign distributor can engage in PI if it is

profitable.

• All the assumptions and model settings are the same as those in the

previous section, except that the foreign distributor competes with the

manufacturer in Cournot fashion in country H.


PI Regime— The Third-stage GameThe profit functions of the two firms under the PI regime can be written respectively as follows: (9)

(10)The FOC: (11) (12) (13)The SOCs and the stability condition are satisfied.

( , , ; , , ) , ( ) ( ),x x y w T p x x c x w c x y T V

( , , ; , , ) , ,x x y w T p Q w x p y w y T

0,x xp c p x

* 0.xxp w p x

*

* 0.yyp w p y


PI Regime-- The Second-stage GameThe profit function of the manufacturer for the second-stage game can be expressed as follows:

(14)The FOC:

(15)

Max ( ( ), ( ), ( ), , ; )w

x w x w y w w T

( ( ( )) ) ( ) ( ) ( ) ( ) ( )p Q w c x w w c x w y w T V

d x y dT

dw x w y w w T dw

( ) 0x w w w x wp x x w c y x p x x


PI Regime– The Second-stage Game

• We can derive from the FOC:

and also the comparative static effect as follows:

,

where .

* ( ) 2 (2 ) 5xw p x x c

0w www

9 0w xp p


Proposition 2

If the manufacturer adopts two-part tariff pricing and parallel

import is permitted, the wholesale price is necessarily higher

than its marginal cost and is positively related to the product

innovation level.

Intuition: The manufacturer raises the wholesale price to lower the competition in its home market.


PI regime– The First-stage Game•The profit function of the manufacture firm is as follows:

(16)•By differentiating the above equation with respect to , we can derive the first-order condition for profit maximization as follows:

(17)

Max ( ( ( ), ), ( ( ), ), ( ( ), ), ( ), ( ( ), ), ; )x w x w y w w T w t

*( ) ( ) ( ) ( )p x x c x w c x y T V

d w y x T x T

d w y x T x T

**

( ) 2( ) ( )0

3 3 2x y

w c x x w cp p y V

p p


Product Innovation with and without PI

• Assume that the inverse demand functions of the home and the foreign markets take respectively the following linear forms as and . By evaluating the above equation at the product innovation level derived under the no-PI regime, we obtain:

( ) ( )p a b x x ( )p a b y

( ) 0.2(4 9 )N

pda c

d b b


Proposition 3

If the manufacturer adopts two-part tariff pricing, parallel

import definitely reduces the product innovation of the

manufacturer.

• Intuition: (1) duopoly in the home market (2) w is too high • Matteucci and Reverberi (2014)• Li and Maskus (2006)


Product Innovation and Market Structures

• In the existing literature on PI, it is commonly assumed that there are

only two firms- one manufacturer and one distributor- in the models.

• In this section, we shall relax this assumption to investigate if the

domestic or the foreign market becomes oligopolistic, how it affects

the manufacturer’s product innovation with and with no PI.


The Existence of Domestic Rivals

• All the model settings are the same as those in the previous sections

except that now there are homogeneous rivals in the domestic

market whose product innovation is predetermined and whose

outputs are sold to the home market only.

• The inverse demand functions under the PI regime are

and , and if there is no PI.

n

1( )

ni

ip a x x x

, ( )p p y a y 0x


The First-stage Game with No PI

• The second- and the third- stage games are akin to the previous section, we need to work out the first-stage game.• With no PI, the profit function of the manufacturer for the first-stage

game is as follows:

• FOC: (18)

Max ( ( ), ( ), ( ), , ( , ), )ix x y w T w

( ( ( ), ) ) ( ) ( ( ( ), ) ) ( ) ( ).p Q c x p y c y V

0ix

dnp x x p y p x V

d


The Second-stage Game with PI

• The third-stage game is the same as before, we need to work out the first and the second-stage games.

• Proceeding as before, we can derive the optimal wholesale price as follows:

.

• It can be shown that the optimal wholesale price is equal to (lower than) if .

2 2 ( ) ( 1) ( ) (3 7)w x c n x w n c

c ( )1n


Proposition 4

If the manufacturer faces domestic rivals, parallel import reduces

the wholesale price to a level lower that the marginal cost. If there

is only one rival in the domestic market, PI has no effect on the

wholesale price (i.e., w = c).

Intuition: If n = 1, the effective output of the manufacturer is the same as that of the Stackelberg leader. It is optimal to set w =c. If n >1, the Stackelberg leader’s output is higher. It means that the manufacturer needs to set w to a lower level (i.e., lower than c).


The First-stage Game with PIIn the first stage, the manufacturer faces the following maximization problem:

The FOC:

Max ( ( ( ), ), ( ( ), ), ( ( ), ), ( ( ), ), ( ), ( ( ), ), )ix w x w y w x w w T w

( ( ( ), ) ( ( ), )

( ) ( ( ), ) ( ( ), ) ( ( ), ) ( )

p Q w c x w

w c y w x w T w V

( ) 2( ) ( )0

( 3) ( 3) 2

d w c x x w cp p y V

d n n


Product Innovation with and with No PI

• By evaluating the above equation at the product quality level derived under the no PI regime, we can derive:

2( 2) ( 1)

( 1)( 2)N

Npdn x n x

d n n

2

2 2

2 ( ) (2 2 1)0

( 2) ( 10 13)

p a c n n

n n n


Proposition 5

If there are rivals in the domestic market, parallel import

stimulates the product innovation of the manufacturer.

Intuition: If there are rivals in the domestic market, PI increases the market share of the manufacturer, raising its marginal benefit from innovation and thus the investment.


Multiple Distributors

• For simplicity, we assume that all the distributors are symmetric and

can engage in PI if it is permitted by the home country.

• The inverse demand functions for country H and country F under the

PI regime are and , and

if there is no PI. 1

( )n

i

ip a x x

1( )

ni

ip a y

10

ni

ix


The Second-stage Game with No PI

• The third stage game is similar to that in Section 3. Proceeding as

before, we can derive the optimal wholesale price as follows:

with . *

*( 1)Nyw n p y c 0N

nw


The First-stage Game with No PI

• The profit function of the manufacture firm is as follows:

• The FOC:

Max ( ( ), ( ), ( ), ( , ), )x y w T w

( ( ( ), ) ) ( ) ( ( ( ), ) ) ( ) ( ).p x c x p y c y V

( ) ( )0

2

a c p a c pdp y p x V V

d


Proposition 6

With no PI, the optimal wholesale price increases with the number of

authorized distributors in the foreign market. However, the equilibrium

outputs of the two markets, the optimal product R&D and the profits of

the manufacturer are not affected by the number of the authorized

distributors. Intuition: With no PI, the home market is unaffected by n. Since the distributors are symmetric, the manufacturer can always set the output at the first-best level, via two-part tariff pricing.


The Second-stage Game with PI

The third stage game is similar to that in Section 3. Proceeding as

before, we can derive the optimal wholesale price under the PI regime

as follows:

2( 1) (2 )( 1) ( 2)(1 )

(3 4)

n x n n x n n yw c

n


The First-stage Game with PI

The objective function of the manufacturer for the first-stage game is as

follows:

The FOC:

Max ( ( ( ), ), ( ( ), ), ( ( ), ), ( ), ( ( ), ), )x w y w x w w T w

( ( ), ) ( ) ( ( ), ) ( ( ), )

( ( ), ) ( ).

p c x w n w c y w x w

nT w V

( ) 2( 1) 2 ( ) 20.

( 2) ( 2) ( 2) ( 1) ( 1)

d w c n n x nx w c yp np V

d n n n n n


Product innovation with and with No PI

By evaluating the above first-order condition at the product quality

level derived under the no-PI regime, we can obtain:

2

( ) ( )(1 ) ( 1) 0 if ( 1) .

2(2 6 5)N

a n a n c n p npdn p np

d n n


Proposition 7

If the manufacturer authorizes its product to multiple distributors in the

foreign country, parallel imports may increase or decrease its product

innovation, depending on the consumers’ quality valuations in the two

countries.


Intuition: PI has two effects on innovation:

• A negative effect: With PI, the domestic market becomes oligopolistic which

discourages product innovation.

• A positive effect: The manufacturer has an incentive to do more product R&D

as it can raise the wholesale price, mitigating the amount of PI.


Conclusions

• Product innovation of the manufacturer is definitely stifled by parallel import if the domestic market is monopolized by the manufacturer. • Contrarily, if there are rivals in the domestic market, permitting

parallel import necessarily enhances the production innovation. • If the manufacturer authorizes its product to multiple distributors in

the foreign country, parallel import may increase or decrease the product innovation depending on the consumers’ preferences for product innovation in the two countries.


Thank youComments and suggestions are welcome

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Parallel Imports, Product Innovation and Market Structures