3. Framework
New Zealand currently has a parallel importing restriction. The existence of this restriction influences the behaviour of participants in the markets for copyright goods. A change in that restriction may alter the way those participants behave. In aggregate, would those changes be good for New Zealand? That is the question this report attempts to address. To be able to answer that question we need to identify the incentives that operate on each of the participants and how they would change as result of a change to the regime. We also need some way of measuring the value of those changes.
The measure we use for analysing changes of this kind is total welfare. Below we use simple linear diagrams to illustrate the concepts involved. While in the real world demand and supply relationships may be non-linear and highly unstable, the linear framework used here captures all the key elements of market behaviour required for welfare analysis.
Welfare is defined as the sum of the consumer surplus and the producers' surplus. Consumer surplus can be described as the value received by those consumers who would be willing to pay more for a good than the market price i.e. if a consumer values an apple at $2 but only has to pay $1, the surplus is $1. It can be represented graphically (see Figure 1 ) as the area below the demand curve but above the equilibrium price of the good i.e. area A. Producers' surplus is the extra value received by those producers who would be willing to sell a good for less than the market price. It is represented by the area above the supply curve (which represents the production cost of the good) and below the equilibrium price of the good i.e. area B.
Figure 1 Basic Market for GoodsDomestic production only |
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| Source: NZIER (ref basic_b) |
All other things being equal, we aim to maximise the sum of these two areas.
If there are imports in the economy, the model gets a bit more complicated. In addition to the domestic supply curve shown in Figure 1 , there is also a world supply curve which represents the price at which the good can be imported into New Zealand (see Figure 2). The world supply curve is horizontal implying that New Zealand can buy as many of the goods as it requires without affecting the world price.1
If importation of goods is unrestricted, the price of a good in New Zealand will be equivalent to the world price of the good. Point h would be the economic equilibrium giving QNR as the quantity of goods demanded and sold and Pw as the price at which the transactions would take place. QD would represent the amount of goods domestically produced and the difference between QNR and QD the amount of goods imported. Area R represents the surplus to domestic producers as they are willing to supply goods up to QD at a lower price than they actually receive. Areas X and Y represent the surplus to consumers as they are willing to buy goods up to QNR at a higher price than they actually pay. Area Z is the amount of revenue received by the international producers of the goods imported into New Zealand. This is not included in the measurement of welfare in New Zealand because it is earned by entities outside New Zealand.
Figure 2 Domestic Market Where Imports and Local Production Are Possible |
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| Note | NR= no restriction |
| Source: | NZIER (ref car1) |
The value of consumer surplus in a particular market is influenced by:
- the price at which the good is sold;
- the willingness of consumers to pay for the good (assuming quality is constant);
- the quantity of the good sold in the market;
Across the whole economy, total consumers surplus is the sum of the consumers surplus in each of the individual markets. Thus the introduction of another product into the economy will increase aggregate consumer surplus if consumers place a higher value on it than the alternative, it is cheaper than the alternative or its availability encourages consumers to increase their spending. Thus, in aggregate, consumer surplus is also influenced by the range of goods that is available in the economy.
The value of producers' surplus in a particular market is influenced by:
- the price at which the good is sold;
- the willingness of producers to supply the good i.e. the cost of producing and selling the good;
- the quantity of the good sold in the market.
Across the whole economy, total producers' surplus is the sum of the producers' surplus in each of the individual markets.
A change in the parallel importing restriction has the potential to influence the cost of supply, the market price and quantity, and the range of goods available. Thus we expect it to impact on the total welfare in the economy. In the framework here, these changes would be represented by shifts in the supply relationships SW and SNZ, and by movements along the demand curve DNZ. The size and direction of the change will depend on exactly how each of the factors identified above changes. The following section discusses the incentives operating on each of the participants in the market given the existence of a parallel importing restriction and how these would change if the restriction was lifted. It then discusses the potential impacts these changes would have on welfare.
3.1 The Expected Impacts of a Change in the Parallel Importing Restriction
A parallel importing restriction allows the copyright holder or innovator to determine the mechanism of distribution for their product within a country. This generally means there is a single "legitimate" channel for the distribution of the innovator's goods for resale, i.e. there is an exclusive distributor.2
Figure 3 provides a simplified illustration of the chain of supply for goods in a parallel import restricted market. The returns from the sale of the goods flow in the opposite direction. Obviously this is not the only structure that could develop under a parallel importing restriction but it is the most basic and is used as the basis for discussion. Other variations may include having several authorised distributors within a single market, or there may be a wholesaler between the distributor and the retailer.
Figure 3 Market Structure With Exclusive Distribution |
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| Source: NZIER (ref struct) |
The following discussion focuses on the expected impact for each of the "players" in the market as a result of a change in the parallel importing restriction. Diagrammatically we would expect the market to change to the form shown in Figure 4 if parallel importing were to occur.
Figure 4 Market Structure with Parallel Importing |
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| Source: NZIER (ref struct2) |
By definition, the parallel importing restriction only "bites" if it allows the innovator to achieve better returns by protecting the domestic distributor from competition from international distributors. Simply removing the parallel importing restriction will not necessarily result in the importation of parallel goods. To make parallel importation worthwhile, it must be possible to purchase the good in another country, pay transport costs and local taxes and still be able to sell the good for a lower price than the incumbent distributor, and other local competitors. If these conditions are not met it is unlikely that parallel importing will occur. There are many markets where the removal of the restriction will not present any new opportunities. In some cases the local market may be quantity constrained i.e. the domestic distributor is unable to supply all that is demanded at the going price. In those cases, some consumers may be willing to pay a premium for parallel imported products.
If parallel importing does occur, market participants will react in different ways and alternative market structures may arise. There may also be a difference between the initial reaction and the on going changes that occur in different markets. The following discussion illustrates the possible changes and the implications for the different players in the market if parallel importing does occur.
The empirical analyses presented in the following sections (4-6) will flesh out the arguments presented below, and will help us judge which effects are more likely to occur.
3.1.1 The Innovator
a) Incentives to Invest
Creating incentives to innovate is the key rationale for the existence of intellectual property rights generally and for copyright in particular. Without the ability to capture the benefits from the investment needed to create a copyright good, the innovator would be unwilling to make that investment. There would be an under supply of copyright goods and total welfare would fall. Goods for which the aggregate willingness to pay by consumers exceeded the total cost of production may not be made because the innovator could not appropriate sufficient returns to make it worthwhile.
Since a restriction on resale would only be desired by innovators if it increased their returns, the key issue is whether such an increase represents monopoly rents, or if its absence would materially alter the incentive to innovate. In other words, the prospect of additional return from goods that would otherwise be parallel imported must tip the scale in favour of investing for an innovator.
There are two competing views on the issue. The first suggests that the innovator's incentive is unaffected by parallel importing because goods that are parallel imported are, by definition, genuine or authorised reproductions. Thus at some point in the process, the innovator has earned a return on that product, which is all the intellectual property right provides for. This is often described as the principle of exhaustion because the copyright owner is said to "exhaust" the intellectual property right by choosing to release the product onto the market (Rothnie, 1994, p2). Thus, if goods have been marketed by the copyright owner or with their consent, the copyright owner cannot interfere with the subsequent disposal or use of the goods (Chard, et al, 1988, p.6).
The opposing view is that innovators have a right to earn a return for the use of the innovation in separate markets.
"Just as the copyright owner is entitled to a separate royalty on reproduction of a copy in book form and for performances in public from that copy, so a separate price should be payable for the right to use the copyright in each of the USA and Australia" (Rothnie 1994, p.19).
On a worldwide scale, it is possible to imagine that the reduction in returns associated with the principle of exhaustion may be sufficient to justify concern about the level of innovation. For a small country like New Zealand, which makes up only a small fraction of the sales of most innovators, the possibility of having some parallel imported products sold in New Zealand is unlikely to weigh heavily in the investment decisions of international innovators. Consequently, the issue for New Zealand is not whether parallel importing is likely to discourage innovation. Rather, there is a question, on which we are unable to comment, of whether New Zealand's trade diplomacy may be affected by the removal of the restriction. It is also possible, though perhaps unlikely, that some innovators would be prepared to withdraw their products from the New Zealand market in protest at the removal of the restriction. While this action would result in the loss of potential profits in the New Zealand market, it may be a profit maximising strategy in the long term if it sends a signal to other, larger countries not to lift their restrictions. Consumers may lose the opportunity to purchase those withdrawn products.
Thus for most innovators, we would not expect the existence of a parallel importing restriction, or the lack thereof, to affect their decision to invest in the production of copyright goods. It is possible that the threat of parallel imports could make the distribution of the goods unprofitable. This is discussed further in section 3.1.2 .
b) Pricing Strategies
Returns to innovation are directly related to the pricing strategies available to the innovator (or its agents), and the costs involved in producing and distributing the good and the supporting services. Since the parallel importing restriction allows the innovator to price discriminate, price differentials between New Zealand and other countries which cannot be explained by factors such as local taxes, exchange rate movements and the costs of distribution and marketing are likely to lead to lower welfare. The issue of whether copyright holders price discriminate against consumers by virtue of their location is the crux issue of the welfare analysis of parallel importing. If copyright holders have sufficient market power to be able to charge different prices to different consumers and that difference does not reflect costs incurred in getting the product to the consumer, then parallel importing will provide an arbitrage opportunity that will provide a check on the producer's behaviour.
Price Discrimination
When producers sell two units of the same good to different consumers at different prices they price discriminate (Tirole, 1988, p.133). Price discrimination requires relatively weak inter-brand competition or limitations in consumer search (Bucklin, 1993, p.39) to give the producer a degree of market power. International price discrimination requires that the price elasticity of demand differ between the countries to which the product is exported. In countries with a low price elasticity of demand, the price can be set at a higher level than if there was a single world price. In countries with a high price elasticity of demand, the price will be correspondingly lower. For example, in a survey of UK manufacturers, the reason most cited for a price differential between countries was a "variation in what the market will bear". Nearly 82% of all firms that supplied goods overseas cited this as an explanation (Chard, et al, 1988).
If New Zealand has relatively low price elasticity of demand for copyright goods, we would expect that the ability to price discriminate would result in higher prices relative to a situation where there was a single world price. The higher prices would be achieved by reducing the quantity supplied to the market in New Zealand. This is because a contraction in the supply of a good to a market with a low elasticity of demand will result in a greater than proportional increase in price. Overall this would mean an increase in the revenue (i.e. price times quantity) received by the supplier.
If, on the other hand, New Zealand had high price elasticity of demand, price discrimination would allow us to enjoy lower prices than would prevail under a single world price. However, if New Zealand alone removed its parallel importing restriction while the rest of the world continued to impose their own restrictions, New Zealand consumers could continue to benefit from low prices. The innovators would still be able to charge high prices in countries with a low elasticity of demand because their exclusive distribution network provides protection from parallel import competition there while market conditions will not have changed in New Zealand. If the innovator is charging a low price, it is unlikely that the opportunity will exist for parallel importers to enter the market. Figure 5 illustrates the effect of price discrimination on an economy with relatively low price elasticity (which could be New Zealand). In this hypothetical example, and introduction of the parallel importing restriction would shift the world supply curve to SW'. New Zealand can still buy as many of the goods as it likes but it now has to pay the new higher price. The new equilibrium is point h' where consumers pay PNZ for a quantity of QPI. The bold line represents the effective supply curve, so New Zealand producers will produce quantity QD', while imports will fall to the distance between QPI and QD'.
From the consumers point of view, they have lost part of their surplus (what they are willing to pay minus what they actually pay). The loss of surplus equates to areas A, B, C, and D in Figure 5 . Area C is transferred to foreign producers. Area B is the extra cost to the economy of making the goods at home that could have been imported cheaper. Area D is the uncompensated loss of consumer surplus. Areas B and D are the deadweight losses to the economy as a result of the import restriction.
Figure 5 Effect of a Contraction in Supply |
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| Source: NZIER (ref basic2) |
While area A appears to be a simple transfer from domestic consumers to domestic producers it may in fact signal further deadweight loss to the economy. This would occur if the domestic producer reduces some of the profits by increasing costs. This is not necessarily a conscious decision by the producer but their market strength may lead them to be less than rigorous in the control of costs or they may incur extra costs in trying to maintain their position in the market place.
In the United States, the parallel importing law dealing with trademarks attempts to recapture lost area C by drawing a distinction between distribution by an overseas manufacturers' subsidiary and distribution by an independent domestic company. The latter is protected from parallel importing while the former is not. We do not think this is likely to achieve the intended effect. Under either scenario we would expect that the overseas innovator would appropriate any rents available from the product. With a subsidiary, it doesn't matter whether the excess profits are earned by the parent company or the local agent. However, if the distributor is a local independent agent, and there are rents to be made in the local market, it is likely the overseas manufacturer would increase the supply price to the agent. This is because the copyright good is unique, while the market for agency services is likely to be highly competitive.
Cost Differences
If the interbrand competition is strong enough to constrain the actions of a copyright holder, prices will reflect long run marginal costs of production, including a normal return on the investment in innovation. If the innovator tried to increase price above those long run costs, consumers would switch to a competing product. In that case, price differentials between countries would simply reflect different underlying costs. Exclusive distribution would allow the innovator to choose to supply the optimal level of support services without the threat of other suppliers free riding on the costs incurred in each of the individual markets.
However, interbrand competition is unlikely to eliminate price discrimination. By definition, the copyright prevents perfect substitutes for the product. The purpose of intellectual property rights is to provide owners of those rights with the market power needed to price above the marginal cost of reproduction. The question then is how far above marginal cost can copyright owners price. The answer will depend on how substitutable other products are. Is there a market for a particular brand or is there a broader market for the generic product? There is no general answer to this question, it depends on the circumstances of the case.
If New Zealand consumers have a low elasticity of demand such that charging a relatively high price is profitable for producers, interbrand competition may not eliminate those profits. We would expect that each producer would be aware of the demand elasticity of their consumers, so it would be in the collective interest of each of the producers to charge high prices. If one were to lower their price in an attempt to increase their market share, other producers would match the price fall to prevent the loss of their market share and all producers would be worse off. Instead of price competition in such a market we would expect competition to occur in non-price forms such as marketing campaigns, give aways to consumers and other add on services.
Support for this view comes from Rey and Stiglitz (1988) who present a model which suggests that vertical restraints, such as the setting up of exclusive territories, reduces competition between producers. Their theory suggests that producers can use exclusive territories to reduce interbrand competition in an imperfectly competitive market.
"..if one considers a situation where there is imperfect competition among producers.. vertical restraints may be used to decrease competition between producers; this usually has a negative impact on social welfare, the gain in additional profits being overwhelmed by the loss of consumers' surplus." (Rey and Stiglitz, 1988, p.14-15).
In general, removing parallel importing restrictions will not affect price differentials between countries if they are due to cost differences. However, we have to be careful in our assessment since short term market fluctuations and distortions may still create arbitrage opportunities. These may include:
- short run exchange rate movements
i.e. the parallel importer can take advantage of a sharp rise in the domestic currency to undercut the authorised distributor who imported their goods before the exchange rate movement.
Chard et al (1988)3reports that US evidence indicates the exchange rate is a critical factor. Before the increase in the value of the dollar in the 1980s, parallel importing activity was negligible. A survey by the Commerce Department indicated that parallel import volumes and dollar values increased dramatically in 1981 while the dollar was appreciating. The depreciation of the currency in 1985 saw parallel imports decline significantly according to the respondents to the survey. - price controls
Price controls which artificially reduce the price of a product may provide an opportunity for a parallel importer to buy the good at relatively low prices in price control countries and resell them in other countries where prices are considerably higher. The common example of this type of activity is in the pharmaceutical market within the EU. - licensing or other regulations
Regulations imposed on suppliers can increase the costs associated with doing business in a particular country. A system of licensing which may involve expensive safety or other checks may increase the price of any goods subsequently sold in that country . A priori price comparisons may appear to signal opportunities for parallel importing but these regulations are likely to apply to both "authorised" and parallel imported goods. - providing less extensive "support services"
This is the free riding argument discussed below in section 3.1.2.
The problem from a policy point of view is that without inside information it is very difficult to identify whether the price charged in a market reflects the actual costs or whether the supplier is practicing price discrimination. The price comparisons in the market analyses give some indication of whether price discrimination is a possibility but cannot confirm that it does exist.
c) New Zealand Innovators
As New Zealand is a net importer of copyright goods, the discussion of the impact on innovators has concentrated on overseas innovators. However, New Zealand innovators may also be affected by a change in the parallel importing restriction. If innovations are sold domestically as well as internationally, it is possible that exported products could be re-imported back into New Zealand to compete with the domestic sales. The same questions must be asked with respect to domestic innovation i.e. will the threat of parallel importing discourage investment in innovation or will protection from parallel importing encourage additional innovation? The answer, as with international innovators, is, probably not. What it could discourage is expansion into other markets, if innovators consider that there is a significant threat to their domestic market from the reimportation of their goods.
d) Pirate Copies
The sale of pirated products undermines the incentive to innovate by reducing the return received by the innovator. Copyright holders argue that the existence of parallel imports will increase the likelihood or the opportunity for pirated products to be introduced. A system of exclusive distribution supported by a parallel importing restriction improves monitoring of the entry and sale of goods, because there is only a single "authorised" distributor. If a good appears outside this distribution channel it is either a pirated copy or a parallel import.
We will investigate the risks of parallel distribution channels increasing the availability of pirated copies in each of the in depth analyses below.
e) What Innovators Can Do to Protect Their Interests Without a Parallel Importing Restriction
Irrespective of whether the restriction on parallel importing is welfare enhancing for the country, it will almost certainly increase the return to the innovator and/or its agents. Thus if a blanket prohibition was not available, we would expect to see some actions being taken by the innovators to achieve the same effect.
The impact on the innovator as a result of the introduction of parallel imports will depend, at least in part, on the structure of distribution the innovator chooses to use. The innovator has a number of options if it wishes to sell its goods in another country. It may export the goods from existing domestic production facilities or it may set up a production facility in the target market. The decision will depend on transport costs and trade laws as well as the innovator's business strategy. If the innovator chooses to set up a local production unit it has a further choice of licensing its technology to a local firm or setting up a subsidiary to undertake the production. The advantage of the subsidiary option is the low cost of technology transfer and the ability to maintain direct control over the production and sales of the product. This control would enable the innovator to maximise global returns. However, licensing the technology to a local company may be more beneficial when knowledge of the local market is a major factor and/or regulations exist which limit the investment possibilities of foreign firms (Chard, et al, 1988, p.16).
The degree of control the innovator has over the producer in a foreign market could have important implications for the possibility of parallel importing. In the absence of a comprehensive parallel importing restriction, the innovator would need to take steps themselves to protect their markets from the threat of parallel importing. Strict control over producers and distributors will reduce the availability of the product for parallel importers. If the local agent is not a subsidiary the control required by the innovator would need to be exerted through the use of a tight licensing agreement or supply contract. A UK study found that a majority of licensers limit the markets available to their licensees by, for example, imposing export restrictions (Chard, et al, 1988). However, the use of such contractual terms may be limited by some countries' competition laws. For example in the EU, a firm may be prevented from enforcing clauses which require that their licensees or authorised distributors do not sell products to purchasers for resale abroad or which terminate the contract if the licensees or distributors knowingly sell to parallel traders.
In the absence of parallel importing restrictions, the innovator can recreate their effect either by vertically integrating into marketing or contracting with distributors to limit re-sale to specified retailers worldwide. This is frequently practiced with exclusive luxury products. If parallel importers have to purchase products from retailers rather than wholesalers, the returns and therefore the threat of parallel imports are decreased.
Another option is for the innovator to choose not to supply their products to a country that they believe will be a source for parallel importing, or if they believe their return would be significantly affected by parallel importing. This action could reduce the availability of copyright goods for consumers in that country. This is explored further under "availability" in the consumer and domestic agent sections.
3.1.2 The Domestic Agent
The domestic agent of an international copyright holder could take a number of forms. It could be the manufacturer of the product under licence or it could have the rights to import the good. The domestic company may be owned by the copyright holder or it may be a completely separate company which is allocated or buys the right to distribute the good in New Zealand.
At present, the domestic agent is usually given the exclusive right to distribute the product in New Zealand. The exclusive distributor currently faces inter-brand competition and for durable goods, competition from used goods sold on the second hand market. Although the degree to which the used goods compete with the new market varies considerably, in some circumstances the degree of substitutability is relatively high. Allowing parallel imports would provide for a third level of competition, intra-brand competition and could strengthen competition from the second-hand market.
The main functions of the domestic agent vary depending on the structure of the relationship with the international copyright holder, e.g. whether it is independent or a subsidiary, and the characteristics of the good, e.g. whether the provision of repair facilities is necessary. There is a large range of structures and relationships possible and many of them are evident in New Zealand.
a) Availability and Incentives to Invest
The security provided by a parallel importing restriction may encourage overseas innovators to bring their products to New Zealand sooner than otherwise. The survey conducted by Chard et al (summarised in Appendix B ) indicated that innovators indeed use a variety of means to supply overseas markets, including direct export, operating a local subsidiary or licensing a local company to manufacture the product. The survey indicated that many firms would be cautious in opening a subsidiary without the security of having sole distribution rights. Local firms would also be less willing to purchase a license to manufacture a product if sole rights could not be assured.
The removal of the parallel importing restriction could, therefore, result in fewer local firms manufacturing or distributing copyright products of overseas innovators. The threat of parallel imports could result in a narrower range of goods than if exclusive distribution could be assured. There would also be less local production, affecting output and employment in those industries.
The likely impact on local firms must be taken into account in the analysis but we would expect the change in producers' surplus as a result of changes to the parallel importing restriction to be relatively small in comparison to the consumers' surplus changes. However, if existing or potential domestic agents do not import copyright goods as a result of the threat of parallel imports, and the international copyright holder chooses not to export directly to the New Zealand market, consumers may lose the option of purchasing those goods altogether. This would be a loss in both consumer and producers' surplus.
An article by Bucklin (1993) indicates that global firms suffer "little unreasonable loss" as a result of parallel importing but domestic purchasers of international rights "fare less well". Local firms are particularly vulnerable when promotional expenditures are important in influencing consumers. However, the author considers that the fortunes of these firms is not sufficient justification to warrant continued protection from gray market competition. He outlines strategies which can be employed to limit the potential damage to local companies and indicates that a reduction in the fee for the distribution right will be sufficient to spread the loss between the manufacturer and the domestic distributor.
b) Local and International Trade
A parallel importing restriction allows the construction of an exclusive distribution or marketing network for a product for each country. An important question to ask is why protection on an international basis is necessary when such blanket protection is not available domestically. There is no restriction in the Copyright Act that prevents an entrepreneur from purchasing a stock of copyright goods domestically and selling them in competition with the "authorised" resellers. This is particularly evident in the second hand market where "parallel" trade thrives.
The relative homogeneity of consumers within a domestic market is used to explain the anomaly. It is argued that there are fixed costs associated with introducing a product into a country that do not exist, at least not to the same extent, within a country. Differences in cultures, tastes, government policies and distribution networks increase marketing and distribution costs which some believe should be recovered from local consumers. It should also be noted that the same differences that increase the costs associated with distributing a product also increase the scope for price discrimination as there is likely to be a greater disparity of demand elasticities between countries than between regions within a country. Thus the opportunities for arbitrage are much lower between regions within a country than they are between countries.
This highlights an important question: is parallel trade within a country limited because the arbitrage opportunities are not high or are arbitrage opportunities within a country low because of the threat of parallel trade? The answer to this question could provide valuable insights into whether parallel trade between countries would be beneficial or detrimental. Unfortunately, there is no clear way of knowing.
c) Second Hand Markets
For durable goods, the anomaly is even more evident as second hand markets are an almost inevitable outcome of a durable goods market. The sale of used goods will impact to varying degrees on the market for new goods. The extent of the effect will depend on how substitutable consumers consider new and used goods to be. The substitutability between new and used cars, for example, is likely to be a lot higher than between new and used CDs.
A second hand market for goods which have a high degree of substitutability between new and used provides some control on the market power than can be exhibited by the producers or distributors of new products. If producers tried to increase the price of new products, some consumers may purchase used instead of new goods, making the price increase less profitable for the producer.
Within a country the Copyright Act cannot be used to restrict the competition provided by the sale of used goods in the second hand market, yet the Copyright Act has been used to stop international trade in second hand goods. The rationale for this distinction is similar to that for new goods but is less convincing. For new goods, it is argued, the differential costs of marketing and distribution in a different country make it necessary to protect the domestic agent from international intra-brand competition. The price differences that are created by the differential costs in new good markets in different countries will flow on to the market for used goods. The importation of relatively cheaper used goods would increase competition in the domestic second hand and new markets and hence undermine the ability of the domestic agent of the copyright holder to recover its investment.
d) Local Production
The main role of the parallel import restriction is to protect the domestic agent of the copyright holder from intra brand competition to allow them to recover their investment in the marketing and distribution of the product in the local market.
If sufficient competition is provided by similar goods or by the second hand market, domestic agents will be unable to increase the price above the combined import and marketing costs i.e. they will earn a normal competitive return. However, if the domestic agent has a degree of market power, interbrand competition may not provide sufficient incentives for the agent to contain costs. It is often argued that exclusive agents will "bundle" or "gold-plate" services and thus charge consumers for services they do not receive a benefit from or do not want.
Currently, domestic agents invest in New Zealand to varying degrees. With added pressure from parallel importers, it is possible that that investment in New Zealand by these companies could be curtailed. The impact on the total welfare in New Zealand will depend on the degree to which the investment adds to total welfare, rather than enhances the rent seeking ability of producers. If the investment in New Zealand was profitable in its own right, the change in parallel importing restrictions is unlikely to have an impact on it.
e) Pre Sales Service
Where there is a high level of pre sales service required, a non-exclusive distribution regime may result in lower than optimal investment. For example, if a product requires pre sales information, an authorised distributor may have to make a significant investment in providing that information and promoting the product. If other firms are able to sell the product in the market, they can free ride on the promotional activities of the authorised distributor. They would be able to offer the product at a cheaper price because they do not have to fund the promotional activity. This allows the consumer to benefit from the promotional activity of the authorised distributor and then purchase the product at a cheaper price elsewhere. If this occurs, the authorised distributor would not invest in the same level of promotional activity.
If this is the case we would expect to see parallel importing occurring more frequently in markets where the marketing costs were significantly higher than the costs of transporting the goods to the market. It is reported in Chard, et al (1988)4 that in some heavily promoted products such as cameras, perfumes, batteries and tyres, marketing expenditures ranged from 8 per cent to 25 percent of the distributor's US sales price. Transport costs on the other hand were only 1 per cent of the distributor's US sales price.
For the purposes of this analysis we must investigate the degree to which copyright goods require investments in pre sales service or information. If this is so, allowing exclusive distribution networks could be welfare enhancing. An interesting comparison would be to look at the degree to which the level of pre sales investment differs between copyright and non-copyright goods. We look at this question in more detail for each of the markets under investigation.
The distribution cost argument is dismissed in an analysis by Bucklin (1993) who undertakes a theoretical analysis of the profits of manufacturers and resellers of branded goods. In the article, Bucklin concludes "that high distribution costs do not stimulate damaging gray market activity as long as authorised channel efficiency is not grossly uncompetitive" (p.400). Indeed he finds that an increase in promotional cost causes reseller gross margins to fall and thus inhibit the gray market.
If the parallel importing restriction is lifted, domestic agents may fear that parallel importers will free ride on their investment in promotional and marketing activity. The most likely reaction to this is to reduce such activity or target it more closely.
f) After Sales Service
A similar argument could be applied to after sales service. The reputation of the creator could be enhanced by the provision of a warranty with repair services provided by the local distributor. If there is an alternative source for the product, the authorised distributor may be obliged to complete warranty repairs irrespective of whether they received the revenue for the original sale. The consumer and alternative distributor could free ride on the authorised distributor's investment in repair services. If on the other hand the authorised distributor attempted to distinguish between their own or parallel imported products in terms of satisfying the warranty, there could be negative reputation effects.
Again we will look at the extent to which post sales service is required by consumers of copyright goods and whether parallel importing would result in a sub-optimal amount of investment in such services.
This argument must also be discussed in the context of New Zealand's consumer protection legislation. The Consumer Guarantees Act requires retailers and manufacturers to provide goods of an acceptable standard. After sales service to repair a faulty product must be provided by the organisation from which the consumer purchased the product. This could present a problem if the parallel importer is an organisation that has no concern about reputation or closes down before any action can be taken.
If the warranty given by the distributor provides the consumer with more protection than that provided by the legislation a parallel importer may still free ride. However, such additional services could be construed as "gold plating" or "bundling". This is the situation in which the price paid by the consumer includes the cost of additional services that may not be required or wanted by all consumers.
g) Economies of Scale
In small markets, such as New Zealand, it may be possible for a single organisation to bring a product to the market at lower cost than two or more organisations. This could occur if there were high costs associated with distributing the product in New Zealand. Welfare is enhanced in this circumstance if a single organisation can get the goods to market at a lower cost than multiple distributors.
Are economies of scale present in the distribution of copyright goods in New Zealand? If so, are there characteristics of these goods which are separately identifiable e.g. the importance of brand recognition? We will investigate this further in the individual markets.
3.1.3 The Retailer
As with the domestic agent, the structure of the retail segment of various markets will vary. Some retailers will be owned by the domestic agent while others will be independent. Some will be exclusive dealers selling only the domestic agent's products, while others will sell a range of competing brands. It is difficult to generalise how the removal of the parallel importing restrictions could impact on retailers but the discussion below will attempt to draw out the issues.
a) Support from Distributor
If the distributor is facing pressure from parallel imported goods, the distributor may reduce the level of support it currently gives to retailers. As discussed above, this support may take the form of a coordinated advertising and promotion campaign, or after sales service.
Without this support the retailer may be required to carry much more of the risks associated with the product. Without back up from the distributor, the retailer may be stuck with stock that is difficult to sell. Taking on this risk will make retailers much more cautious about the stock carried. In some instances, this will result in retailers carrying less stock to reduce the risks. Alternatively, the retailer could take on much more of the responsibility for promoting and advertising the product themselves.
b) Market Segmentation
Another possible outcome of parallel importing is segmentation of the retail market. At present with some exclusive arrangements, consumers are not able to trade off product characteristics such as price and pre-sales service. With parallel importing, the retail market could segment according to the degree of consumer service. A range of options could be available to the consumer from the high price, high service option to the low price, low service option. The argument that consumers will free ride on the service provided by the former and benefit from the discount provided by the latter, is likely to hold true for some consumers. There is some doubt, however, that such practices will destroy the market completely. There is evidence in other markets that different segments can operate successfully within the same market. Indeed, some stores even offer different price and service mixes on the same products e.g. LV Martin specifies a different price depending on the length of warranty and payment option chosen by the consumer.
3.1.4 The Consumer
Parallel importing will only be viable if certain conditions exist:
- the product can be sourced in another country at a price below the market price in New Zealand;
- transportation and other importation costs are low enough to make the price of the product competitive once it is landed in New Zealand; and
- consumers are willing to pay for the bundle of characteristics offered by the parallel imported product.
While price is likely to be the main factor that consumers base their purchasing decision on it is just one of the characteristics that consumers compare when purchasing a product. Other factors will include quality, the repair cost (if applicable) and pre or after sales services.
a) Price
The main impact of changing the current parallel importing restriction is expected to be on price. If a parallel importer is going to enter the New Zealand market, it is likely that they will do so at a lower price than the current distributor. If they cannot source goods at a price low enough to under cut the exclusive distributor, we would not expect them to enter the New Zealand market and the current structure and operation of the market is likely to remain the same.
So, in markets where a parallel importer is able to enter the New Zealand market, we would expect the price for the products to fall. The magnitude of the price fall will vary across product and will depend on market conditions both in New Zealand and in the source country as well as other factors such as the exchange rate. However, it is important to recognise that the price falls in some parts of a market may trigger price rises in other parts of the market. For example, if a product requires maintenance, the domestic agent of the innovator may be the only option for getting repairs. While the initial price of the product may fall with the introduction of parallel imports, the maintenance cost could increase. Similarly, if a market has several sub-parts, it is possible that the entry of parallel importing into one part could raise the price in others that are less attractive to parallel importers.
There are few empirical analyses in the literature which calculate possible price changes but the few that do exist suggest the price falls could be significant as a result of parallel importing. One estimate puts the price reductions at between 10 and 50 percent. In a detailed study of the liquor market, price discounts from parallel trade were estimated to be 25% (Bucklin, 1993, p.389).
The market analyses below explore in more detail the expected impact on price for each of the specified markets. Where possible we will also discuss the possible interactions between markets or parts of markets in terms of price impacts.
The price impact may also be felt less directly in other parts of the economy if the parallel import restriction also allows the prices of inputs to fall (NZMF, 1997, p.7). Lower priced inputs would reduce the production cost of a range of other products in New Zealand allowing producers to either reduce prices or increase profits. Both options would result in a net welfare increase for New Zealand.
b) Availability
The speed with which products are introduced into New Zealand is of concern to some consumers. The current exclusive distribution arrangement allows the innovator to determine when to introduce a product into different countries. Removal of parallel importing restrictions could result in products being released sooner than they would otherwise have been released or it may discourage innovators from releasing them in the New Zealand market at all
Consumers would suffer if the innovator chose not to introduce their product into New Zealand because of the risk of parallel importing. This could occur especially if the introduction of a product requires a large investment in marketing and/or distribution. It would be possible for a parallel importer to enter the market and undercut the innovator or its domestic agent. The innovator may choose not to enter the market due to the threat of this action.
However, as with the price impact, it is possible that the different parts of the market will be affected differently. Where competition from parallel imports is strong, availability of the goods could be improved but for parts of the market where parallel importing is less attractive, the availability of goods could be diminished.
c) Quality
Given that parallel imports are authorised copies, there is generally an assumption that there is no difference in quality between the legitimate and the grey market goods. However, this may not necessarily be true. A product manufactured in separate locations may be made to different design specifications which may vary by market. There may also be different quality control procedures which may result in products of variable quality, even if the design specifications are the same. A third problem identified in Chard et al (1988) is that product quality may vary after production due to inappropriate handling etc. This problem could be particularly relevant when discussing used goods.
The fact that the quality of parallel imported goods is inferior is not necessarily a problem per se. The problem arises if the consumer is misled into believing that the product they are purchasing is of a higher quality than it is. Where such quality differences could arise, appropriate labelling of the products as originating in the authorised or unauthorised channel could overcome the difficulty. In fact, labelling of products has been suggested as a appropriate solution to the parallel importing debate.
The quality argument is disputed by those studying the Taiwan economy, who argue that competition from parallel imports encourages local authorised licensees to improve their quality. They also indicate that for some goods, the parallel imported product is seen as the quality alternative to the locally produced authorised good (Chang, 1993).
Consumers in New Zealand have some protection against the supply of inferior goods in the form of the Consumer Guarantees Act and the Fair Trading Act. However, the effectiveness of these acts in protecting consumers is not clear, especially in the case of the Consumer Guarantees Act which consumers must enforce themselves.
d) After Sales Service
For those products that require maintenance consumers will need to compare not only the up-front cost of the product but also the expected value of future repair costs. If repair costs are likely to be higher because the quality of the parallel imported product is lower or the authorised distributor is unwilling to honour the warranty of the parallel imported product, then the consumer must factor that into their purchase decision.
3.2 Summary
Copyright holders may choose to set up exclusive distribution networks for a variety of reasons. Some of the reasons increase consumer welfare, others do not.
If political concerns could be ignored, a country that was being economically rational would only restrict parallel imports when the welfare impact from the restriction was positive. That is, where the positive welfare gains outweighed the detriments of such a policy.
There are a number of situations where a country would gain from a restriction on parallel imports:
- when the restriction on copying alone does not provide sufficient incentive to innovate i.e. there is a sub-optimal level of investment in such copyright goods even with the restriction on reproduction provided by the copyright; or
- when free riding on promotional and other investments, which are valued by consumers, is possible and the absence of an exclusive arrangement could reduce investments in these activities; and
- it is more expensive to achieve these benefits through private contracting.
If these conditions are not met, a parallel importing restriction could be detrimental to consumers. It would allow innovators to segment markets according to national boundaries and price discriminate between consumers in different countries according to the perception of the elasticity of the consumers' demand subject to the control provided by other products in the market. If the innovator is successful at price discriminating it could achieve super normal profits and may thus provide incentives for excessive investment in copyright goods.
The current parallel importing restriction in the Copyright Act provides a default option for innovators. It assumes that the benefits of precluding international trade in copyright goods outweigh the detriments and further that a statutory ban is more efficient at achieving these welfare gains than the available alternatives, such as contract based enforcement by the innovator or their agents. Interestingly, no such assumption is made about domestic trade in copyright goods.
The discussion above has highlighted the difficulty of providing a general argument about products and markets with different sets of characteristics. There is a range of possible responses from innovators, distributors, retailers and consumers. The market outcome that prevails will depend on a range of factors. The net impact will depend on which effect is stronger. This will depend on the characteristics of the good and the nature of the distribution mechanism.
A general assessment of the welfare effects of the parallel importing restriction is difficult given the heterogeneity of copyright goods sold in New Zealand. Most copyright goods are likely to be imported directly from overseas innovators/manufacturers rather than made under licence. The price elasticity of demand for such goods will vary but typically it would be relatively low as a result of New Zealand offering fewer substitutes than other countries due to the problem of economies of scale. Relative to non-copyright goods we do not expect that copyright goods would require a greater degree of pre or after sales service. If these generalisations indeed hold, we would expect that exclusive distribution arrangements would reduce consumer welfare without a significant corresponding increase in producer welfare. If these assumptions hold in general then removing the parallel importing restriction would improve the net national welfare of New Zealand.
Sections 5 , 6 , and 7 explore three markets (motor vehicles, books and CDs) in more detail to try to identify the characteristics of the products or the markets that make it possible to identify the likely reactions of market participants and consequently the relative balance between the detriments and benefits of a parallel importing restriction. It should be noted that these three markets have been chosen as examples of copyright goods that may be affected by a parallel import restriction. The focus of the investigation is on what these three markets can tell us about the general effects of changing a parallel import restriction, not specifically on the impacts in these markets.
For our empirical analysis we concentrate on calculating the area of the triangle D in Figure 5. To make such calculations for the markets we wish to study we must identify any two of the following three factors:
- the change in price that would occur as a result of parallel imports (PNZ - PW);
- the change in quantity of copyright goods due to parallel imports (QNR-QPI);
- the price elasticity of demand for copyright goods (the slope of the demand curve DNZ).
The current price and quantity should be readily observable in the market place, though quantity estimates may be difficult to obtain due to commercial sensitivity. Much more difficult to estimate are the prices and quantities that would prevail if parallel importing were permitted. As an estimate of the prices it is possible to look at the prices overseas consumers are paying as a rough guide to the prices that could be possible with parallel importing, although admittedly this is not a perfect measure.
Estimating the price elasticity of demand is a more difficult task especially given the diverse nature of copyright goods. The factors that we must take into account are:
- the availability of substitutes;
- the proportion of income spent on the goods;
- the nature of the goods i.e. whether they are necessities or luxury items.
We investigate these issues for each of the markets analysed below in order to test our generalisations.
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