Topics in Economic Analysis & Policy
Volume 5, Issue 1 2005 Article 16
Price Discrimination and Smuggling of AIDS

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Price Discrimination and Smuggling of AIDS
Richard A. Hornbeck
Patent-holding pharmaceutical companies are shown to be imperfectly able to charge differential
prices for AIDS drugs due to the potential for black market exchange. Thus, greater
segmentation in the international market through additional barriers to smuggling would induce
firms to charge lower prices for AIDS drugs in poorer countries. Without these additional barriers,
widespread drug distribution through mandated lower prices or weakened patent protection in
the developing world would result in smuggling, undercutting demand in developed markets and
reducing firms’ research incentives. By contrast, further market segmentation would allow policy
makers to go beyond the induced price cuts and remove patent protection in many markets where
the benefits to increased distribution would likely outweigh the losses to research incentives.
KEYWORDS: price discrimination, differential pricing, AIDS, arbitrage, smuggling

I thank David Autor, Gary Becker, Steve Cicala, Valentin Estevez, David Genesove, Daniel Gottlieb,
Thomas Hubbard, Victor Lima, and anonymous referees for helpful comments.

I. Introduction
Within the debate over proper responses to the AIDS epidemic, one contentious
issue is how to encourage both the discovery and the distribution of medicines
able to treat the disease. Without government intervention, there would be few
incentives to research new medicines. As a consequence, governments encourage
research by granting patents to pharmaceutical companies, allowing invented
medicines to be priced far above their marginal cost of production. There has
been considerable investment in developing AIDS drugs to the benefit of many,
yet firms’ chosen prices have made them unaffordable for millions worldwide.
If these firms were able to charge different prices to different groups of
consumers, i.e., price discriminate, it could be possible to spread the use of AIDS
drugs considerably while maintaining research incentives. The economics of
price discrimination have been studied in depth (Phlips, 1983; Tirole, 1988) and it
has been successful in distributing low-cost vaccines in the developing world
(JFK, 1997). Price discrimination (a.k.a. Ramsey pricing, differential pricing,
tiered pricing, equity pricing) is an intuitive mechanism for improving the
distribution of AIDS drugs, as well (Hammer, 2002; Scherer and Watal, 2002).1

However, price discrimination is only possible to the extent that AIDS drugs sold
at low prices could not be resold to those targeted for high prices.
Exporting cheap medicines from low-income countries to high-income
countries is generally now contrary to domestic and international law, though the
effectiveness of these laws is unclear. It is relatively easy to protect higher-priced
markets from “generic” AIDS drugs produced elsewhere: more easily observed
production and distribution are prevented by international law, production
methods often remain secret, and consumers in richer markets are hesitant to use
unknown drugs. However, if patent-holding firms were to distribute the same
AIDS drugs to countries at vastly different prices, there would be large incentives
to acquire the drugs in low-price countries and sell them in high-price countries,
reducing firms’ profits. Thus, in order to charge high prices in wealthy countries,
pharmaceutical companies may be forced to charge higher prices than they would
otherwise choose in poor countries. Alternatively, there could be little potential
for arbitrage and firms do not find it in their interest to distribute drugs widely.
Ultimately, this is a question to be answered by examining the available evidence.
Scherer and Watal find some evidence that firms in the 1990’s charged
lower prices for AIDS drugs in poorer countries, as one might expect of a
successfully price-discriminating firm, though this effect diminished over time.
Still, this finding leaves unanswered the crucial question of whether firms are
fully able to charge differential prices. If so, then efforts to lower prices further

For a collection of policy-oriented discussions on these issues, see also Granville (2002).
Topics in Economic Analysis & Policy
Hornbeck: Price Discrimination and Smuggling of AIDS Drugs 1
must focus on reducing firms’ market power through price controls or selectively
removing patent protections, a.k.a. “compulsory licensing.” Alternatively, if
firms are constrained in their ability to charge lower prices in poorer counties,
then prices could be lowered by increasing firms’ ability to price discriminate.
Outterson (2005) argues that the potential for