The escalating healthcare costs have become a pressing global challenge, with pharmaceutical expenditures as a major driver (Baltagi et al., 2017, Ben-Aharon et al., 2017). In 2021, pharmaceutical costs accounted for 14.02% of total healthcare spending in the U.S. (Tichy et al., 2021) and 17% across OECD countries, while in China, drug expenses made up 37.5% of outpatient costs and 25.1% of inpatient costs.2 Studies report an essential-medicine affordability index of 0.88 in China (Liu et al., 2024), near the WHO upper bound.3 This growing burden all over the world has led to regulatory interventions aimed at curbing drug prices (Garber and Skinner, 2008, Chandra and Skinner, 2012, Kyle and Williams, 2017). Across countries, policy levers to restrict intermediaries’ markups are worth considering, while such interventions may potentially risk disrupting supply chain efficiency.

In China, the Two-Invoice System (TIS), introduced in 2016, offers a salient policy experiment.4 TIS was designed to streamline the pharmaceutical supply chain by restricting the number of intermediaries between drug manufacturers and hospitals, thereby improving transparency and containing inflated drug prices. The TIS mechanisms we study, removing stacked markups versus edging out the efficient distributors, travel beyond China and speak to ongoing global debates on drug price regulation and supply-chain reforms.

Previous studies have shown that a significant portion of drug prices in many countries is captured by intermediaries in the distribution chain (Kanavos et al., 2011, Aitken, 2016, Lee et al., 2020). In the U.S. and Europe, distributors retain around 20%–25% of the retail drug price (Sood et al., 2017, EFPIA, 2022). This phenomenon is particularly pronounced in China, the Chinese pharmaceutical distribution sector absorbs up to 53%–55%.5 Given that pharmaceuticals constitute one-third of medical costs in China, this implies that nearly 18% of healthcare spending, or 1.3% of China’s GDP, is attributed to the pharmaceutical distribution sectors. Thus, a policy tackling issues of this scale merits a comprehensive evaluation.

The TIS in China’s pharmaceutical distribution sector provides a unique market setting to examine how a regulatory policy that rigidly changes market structure reshapes market outcome, which sheds light on the existing literature about the arrangement of a cost-saving distribution system (Liu et al., 2009, Oguoma et al., 2010, Wang et al., 2017, Joosse et al., 2023). It also offers a clean policy laboratory for a general question central to reforms elsewhere: While regulatory suppression of intermediaries’ profits may reduce retail prices by alleviating double marginalization, it remains unclear whether such reductions sufficiently offset the upward price pressure induced by efficiency losses among intermediaries or by increased market power. These considerations extend the relevance of our analysis beyond China: from U.S. pharmacy benefit managers (PBMs) reforms6 to European margin regulation7 and low and middle-income countries (LMICs) public channels,8 removing layers may simply reallocate market power unless pass-through and service-coverage safeguards are built into policy design.

Before the implementation of the TIS, China’s pharmaceutical distribution was characterized by a complex, multi-tiered structure extending from manufacturers through various levels of wholesalers to hospitals. This network ensured broad availability across a vast and heterogeneous geography but also carried risks—counterfeit circulation, commercial bribery, opaque cost management, and multiple markups along the chain (Yu et al., 2010, Hasan et al., 2019, Ran et al., 2022). As depicted in Fig. 1, TIS streamlined the distribution process by imposing only one invoice from manufacturers to distributors and another one from distributors to hospitals, introducing a paradigm shift towards a single-tier distribution model.

A direct consequence of this policy is a noticeable shortening of the supply chains, as smaller entities that were struggling to compete were forced to exit supply chains to public hospitals. Administrative mandates by TIS create two opposing forces at play. First, the shift to a simplified single-tier distribution model aims to reduce transactional costs by eliminating multiple intermediary layers and improving transparency, potentially reducing multilevel markups and lowering drug prices (Berto Villas-Boas, 2007, Gil, 2015, Crawford et al., 2018, Rubens, 2023). Second, this streamlining suffers from the risk of price increases due to loss of efficiency from shortened supply chains, especially if smaller distributors with local information and networks are edged out. As illustrated in Fig. 2, after the TIS, larger distributors have increased their share of operating revenue, suggesting that consolidation of the distribution sector favors larger state-owned distributors. Given these competing forces, the overall effect of TIS on drug pricing and market dynamics remains uncertain, underscoring the need for further theoretical and empirical studies to fully evaluate the policy impact.9

Despite the nationwide impact and practical implications of TIS, empirical studies on the effectiveness of TIS remain limited and fragmented.10 To investigate the effects of TIS, we first develop a theoretical model to capture the strategic responses of manufacturers and distributors. Our model indicates that streamlining the distribution chain influences pricing strategies and promotional activities in several important ways. First, whether retail prices decline as intended by the policy depends on which driving force prevails. Specifically, in supply chains with already low markups, the disruptive effects on efficiency may outweigh the benefits of eliminating double marginalization, potentially leading to an unexpected increase in retail prices. Second, overall marketing activities are likely to contract as efficiency disruptions raise marginal costs. At the same time, as manufacturers’ relative efficiency may improve within the supply chain, they internalize functions that were previously outsourced, prompting an expansion of their marketing efforts.

Empirically, we employ a staggered Difference-in-Differences (DiD) approach, leveraging the phased rollout of TIS across Chinese provinces. We find a modest short-run increase in drug prices, underscoring the complexity of its market effects and highlighting trade-offs inherent in the reform. The heterogeneity analysis supports our model’s prediction that supply chains with thinner margins are more vulnerable to efficiency disruptions. Specifically, drugs with lower retail prices or those sold in economically developed regions—where competition is more intense—exhibit greater price increases.

We further explore the broader economic consequences of this policy shock on China’s pharmaceutical supply chain, focusing on financial data from listed pharmaceutical manufacturers compared to other healthcare firms, mainly API producers and medical device manufacturers. In particular, pharmaceutical manufacturers have significantly increased their sales and marketing expenses, suggesting possibly an expansion of their in-house distribution activities as an adaptation to regulatory disruptions. This aligns with anecdotal evidence pointing to a longstanding issue in China’s pharmaceutical sector: commercial bribery. Historically, a substantial portion of drug spending was transferred to prescribing physicians. By enhancing transparency in intermediary profits, TIS aimed to address this issue. However, our findings imply that these practices may have shifted upstream, with manufacturers absorbing these costs instead.

To the best of our knowledge, our research is the first comprehensive study to examine the national impact of TIS on drug prices. Previous studies have focused on provincial or city-level data (Ye and Ying, 2017, Qiao et al., 2018), or on case studies and interviews (Zheng et al., 2018). However, these studies provide inconclusive results. Qiao et al. (2018) found that ex-factory prices increased while retail prices decreased, whereas Zheng et al. (2018) reported that 15% of sales managers disagreed with claims of price reductions. Moreover, these studies lacked rigorous causal analysis. Our study fills this gap by offering a national-level evaluation of the causal effects of TIS on drug prices, while also exploring the conflicting mechanisms driving these outcomes.

Our study contributes to the broader health policy discourse on controlling escalating healthcare expenditures. Besides examples including generic compulsory substitution in the U.S., reference pricing in Europe (Bardey et al., 2010, Brekke et al., 2011), studies suggest that improving distribution systems could help control rising drug prices (Agwunobi and London, 2009, Schneller et al., 2023). Our findings indicate that, without properly balancing efficiency losses, administrative measures to reduce double marginalization may fail to achieve their policy objectives.

Our paper also contributes to the broader IO literature on transaction costs and vertical integration. According to pioneer studies in transaction costs theory (Williamson, 1975, Williamson, 1979, Williamson, 1985, Klein et al., 1978), vertical integration occurs when trading relationships become inefficient. When contracts are incomplete, and the value of internal transactions exceeds that of market exchanges, firms may internalize transactions. Our study examines how regulatory interventions like TIS can force vertical integration by reducing trading opportunities in the market. Because the regulation is exogenous, the internal efficiency trade-off is muted; integration may therefore be less efficient, as evidenced by our findings.

Finally, our paper may contribute to the ongoing policy debate about government intervention in addressing market failure. In light of the seminal work of Arrow (1963), numerous regulatory measures have been introduced in several countries to address market failures in healthcare (Anis and Wen, 1998, Wright, 2004, Dubois et al., 2021, Lauenroth et al., 2020, Brekke et al., 2023, Cao et al., 2024). In China, distributors are potentially implicated in commercial promotions and bribery in the name of sales expenses, which inflates drug prices (Yu et al., 2010, Hasan et al., 2019, Ran et al., 2022). Our analysis of TIS presents evidence of an intervention in the Chinese pharmaceutical distribution sector aimed at alleviating double marginalization and marketing activities. We suggest that mechanically altering market structures can generate unintended consequences alongside potential gains.11

Our paper is structured as follows. Section 2 describes the implementation of TIS in China; Section 3 proposes an illustrative theoretical model; Section 4 presents data and summary statistics; Section 5 outlines our empirical framework; Section 6 discusses the empirical findings; and Section 7 concludes.