The regulation of parallel trade has become a critical issue in the global trading system, as the welfare effects of parallel trade freedom are generally ambiguous. In this paper we investigate the welfare effects of parallel trade freedom for low, intermediate, and high trade costs and different levels of market size. By analyzing a game played between a domestic monopolistic manufacturer of pharmaceuticals and a foreign exclusive distributor we, first, show that parallel trade reduces the profit of the manufacturer and his incentives to invest in R&D. In addition to this first finding, we show, secondly, that the question as to whether parallel trade freedom has positive or negative welfare properties depends on the level of trade cost and the heterogeneity of countries in terms of market size. In particular, we find that parallel trade freedom has a positive effect on global welfare if countries are sufficiently heterogeneous in terms of market size and if trade costs are intermediate and low, respectively. Surprisingly, this result even holds in a situation where parallel trade freedom implies the closure of the smaller market. If, however, countries are virtually homogenous in terms of market size, parallel trade freedom may be detrimental to global welfare for specific levels of trade costs.
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