Parallel imports have become a topic of intense debate, particularly when it comes to pharmaceuticals. Parallel traders import drugs from cheaper markets, such as those with price controls, and sell them in countries with fewer or no controls. This form of arbitrage has caused concern in the US over prescription drugs from Canada, and in Europe where countries that have relatively freer pricing, such as Germany, Britain and Sweden, have seen imports or even re-imports from countries with stricter price controls or caps, such as Spain, France and Italy.

The lower prices might seem to benefit consumer welfare but the pharmaceutical lobby has argued that they impede investment in research by undermining profits derived from intellectual property rights (IPR) protection. However, Edwin L.C. Lai of HKUST and Gene M. Grossman have developed a model that shows parallel trading may not in fact be a threat.

The key to their argument is the interaction of arbitrage and price controls. They show that when a market with a high degree of innovation allows parallel trading, it can actually lead those foreign countries with price controls to set their prices higher.

The reason is that the price-controlled country does not want to be shut out by manufacturers in the innovating country, who might decide not to trade there because they fear their prices will be dragged down by cheaper parallel imports, not only in their own country but in all their international markets.

"When the potential for arbitrage exists, the manufacturer may earn higher profits by selling only in the unregulated (or high-price) market than by serving both markets at the lower, foreign-controlled price. Accordingly, a switch from a regime which bans parallel trade, under national exhaustion of IPR, to one that allows parallel trade under international exhaustion of IPR, can induce an increase in the controlled price as the foreign government seeks to ensure its consumers are adequately served," they say.

In fact, they argue, deregulation of parallel imports in a highly innovative economy will always induce the government of a less-innovative trade partner to loosen its price controls. "Typically the more innovative country gains from parallel trade whereas the less innovative country loses," they say.

"Even a small country has incentive to set a reasonable price ceiling when the innovative country is open to parallel trade because the smaller country's policy influence extends via arbitrage to the larger market and because doing otherwise might lead the innovative country to set prices that preclude sales to the smaller market."

This can even happen when the innovative country is dealing with several less-innovative trading partners.

The authors say the results of the model counter the argument of the pharmaceutical industry that parallel imports harm its profits, and are consistent with observations in Europe following the growth of parallel trade. Low-price countries such as France, Portugal and Italy have relaxed their controls and now tolerate prices closer to the European average.

"Many argue that if international arbitrage [as seen in parallel trading] will undermine IPR and dull the incentives for investment in research-intensive industries such as pharmaceuticals. We challenge this orthodox view and show that the pace of innovation often is faster in a world with international exhaustion of IPR than national exhaustion," they say.

"The key to our conclusion is to recognize that governments will make different choices of price controls when parallel imports are allowed by their trade partners than they will when they are not."