This view alarms many scholars, especially when such "parallel trade" (meaning the goods in question sometimes travel a parallel route out of the manufacturing country and then back again) involves pharmaceuticals. They note that developing and obtaining regulatory approval for new drugs frequently involve enormous fixed costs and low marginal costs of production. Recovering the fixed costs while maximizing the gains from exchange commonly requires not a uniform price across markets and countries but, rather, adept price discrimination. These scholars claim that "Ramsey pricing"—higher prices in affluent countries where demand for pharmaceuticals is inelastic, and much lower prices in poorer countries where demand is more elastic—would maximize welfare and be more likely to recover fixed and marginal costs. They warn that allowing parallel trade would cause prices to fall toward marginal costs everywhere, disrupting the Ramsey pricing scheme and reducing research and development investment and innovation. To avoid that, the scholars say, drug companies likely would stop giving discounts to low-income nations—or leave them unserved altogether.
As befits a topic that is both controversial and important, volumes have been written about the advisability of allowing parallel imports, but much of this work is theoretical. There have been few assessments of the actual effects of this phenomenon, especially in developing countries. In this brief case study, we contribute to this sparse empirical literature by examining the reasons for and consequences of international arbitrage of medicines in the Republic of Georgia, which encouraged the practice via regulatory reforms starting in late 2009.
We find that the regulatory environment and market conditions in a particular country will be key factors in determining whether parallel trade in pharmaceuticals (and presumably other goods for which intellectual property rights issues are important) might be welfare-enhancing. Specifically, Georgia's experience demonstrates that the nature of institutions in a small, developing nation can lead to noncompetitive pricing in local markets, and that regulatory changes—in this case, outsourcing some key processes—that facilitate arbitrage can deliver major benefits to consumers without, apparently, disturbing manufacturers' pricing policies or adversely affecting cost recoupment for R&D efforts.
The Republic of Georgia
Located south of Russia in the Greater Caucasus mountains, Georgia is a nation of 4.3 million people. That is roughly the population of the Phoenix, Ariz. metropolitan area, the 13th largest in the United States. The Georgian economy tanked in the last days of the Soviet Union and the first years of independence from Russian rule: gross domestic product declined 68 percent and inflation hit 1,500 percent between 1990 and 1994. Since then, however, the republic has grown rapidly, with GDP increasing roughly fivefold in the new millennium, prices and exchange rates of the Georgian lari remaining stable, and foreign direct investment increasing steadily. Still, Georgians' per-capita annual income today is less than $6,000, the official poverty rate exceeds 17 percent, and (like many developing nations) Georgia scores relatively poorly on measures of corruption and income inequality, ranking near countries like Nicaragua and Ivory Coast.
Given their modest average incomes, the great majority of Georgians choose not to purchase health insurance. Those below the official poverty threshold and some state employees receive publicly funded comprehensive coverage, while another 120,000 or so purchase government-subsidized private plans. But in recent years 73 percent of Georgians' total annual health expenditures have been privately funded, and 97 percent of that was out-of-pocket. Almost 40 percent of households' total spending on health care was for pharmaceuticals and medical supplies, which are generally not covered expenses under either government or private insurance programs.
Consequently, cost considerations frequently limit Georgians' access to health care and essential medicines. In a 2000 survey, 39 percent of the population that did not receive treatment despite reported cases of illness cited cost as a reason for declining to seek care on at least an occasional basis. Thirty percent of those who had sought care for one reason or another cited expense as a reason they had declined to use a medical service. In 2005, for example, a quarter of children under 5 years of age suffering from acute respiratory infections—responsible for 18 percent of deaths in that age group worldwide—were never taken to a health facility; only half of the children with diarrhea received oral rehydration therapy. Predictably, then, overall health has not improved as rapidly in Georgia as elsewhere in the developing world; since 1990, average life expectancy has risen modestly in absolute terms, from 70.2 to 72.1 years. As a result, Georgia's world rank on this measure has fallen from 61 to 102.
Georgi's Regulatory Reforms
Until 2009, those seeking to import and sell pharmaceuticals in Georgia faced the same regulatory review process as one would if the drugs were produced domestically. Applicants would pay a registration fee and file a two-part form with the Departmental Registry of State Regulation of Medical Activities at the Ministry of Labor, Health, and Social Protection. The subsequent review involved both expense and delay, with a fair amount of back-and-forth between applicant and bureaucracy as technical examinations led to agency demands for corrections. This process was not intended to exceed about six months, but often took far longer (though no data exist on average regulatory lags). In addition, the government required all importers to obtain trade licenses from foreign manufacturers, adding to their costs.
The upshot is that, in a market as small as Georgia, regulatory institutions tilted the competitive field in favor of larger firms, which could amortize their fixed costs over more units sold and more readily tap sources of financing that would help them endure inevitable bureaucratic delays (occasional changes in packaging, for example, required re-registration). As a result, Georgia's pharmaceutical market became oligopolistic. Three large firms—PSP, Aversi, and GPC—sold about 75 percent of all medicines consumed in the country, prices tended to be high relative to Georgian incomes, and the number of therapies on the market were lower than in many other countries.