Gray Markets

We’ve all heard of black markets, but ‘gray markets’ now cost companies billions in sales each year. How do you define the term, and which product categories does it affect most?
David Soberman: Gray markets occur when a product is designed and destined for a particular market, and an intermediary known as a ‘gray marketer’ brings that product to a second market to sell it for less than its list price in that second market. In contrast to black marketing which involves counterfeit or illegal goods, gray marketing is completely legal. In some cases, scarcity drives this behaviour. For example, when the iPhone was first launched, there were shortages in the UK, so people were bringing iPhones in from other markets. But scarcity-driven gray marketing is really an aberration. The standard gray-market situation is driven by price: someone brings products from a market where the price level is lower to a place where the price for the exact same product is higher.

Of course, for certain kinds of products, this simply doesn’t work.  In Switzerland, a Big Mac costs around $7, and in Canada, it’s around $4. The price differences for the Big Mac are highlighted by the well-known Big Mac index that is published regularly in the Economist.  Technically, you could take Big Macs from Canada and sell them in Switzerland for $6, making $2 per Big Mac. But Big Macs are highly perishable so this isn’t possible. Nevertheless, this example indicates the basic motivation behind gray marketing. Gray marketing thrives in durable good and non-persihable categories such as clothing, luxury products, IT products, mobile phones and some over-the-counter pharmaceuticals.  Gray market sales are estimated to comprise nearly 10 per cent of all pharmaceutical sales in the European Union, and 25 per cent of on-patent pharmaceutical sales. In the cell phone industry, Fortune reported that in 2007, as many as 1 million iPhones (out of 3.75 million sold) are estimated to have been diverted to the gray market.

Consumer advocates and governments have actually applauded the increasing role of gray markets. Why is this?
DS: There is an assumption in Economics -- and I think it’s borne out in reality -- that higher prices generally lead to less total welfare. When prices are high, a number of people might like to buy the product, but they can’t afford it. The real issue is that if the cost of making a product is less than value that somebody gets from consuming it, you can increase the welfare by having that consumer consume the product. What companies often do is, they employ price discrimination: if they’re selling a product in Canada, they will sell it a higher price than if they were selling it in Malaysia. Clearly, the purchasing power of Canadians is higher than that of Malaysians, but the fact that the higher price is charged in Canada means that less people will purchase the product than otherwise would. And assuming that the cost to produce the product is equivalent across the two countries – which is true for many products – there is a basic loss in welfare.

Generally the government and the Department of Consumer Affairs try to ensure that the prices for products are competitive and this is why there are strict laws against practices such as price collusion. Of course, there are products where low (or competitive) prices are not in the public interest, that is with products known as ‘vice goods’ -- things like tobacco, where there is actually  a disincentive for lower prices. But for most products, both consumers and the government want to try to keep prices fairly low. And that’s what gray markets do.

Francesco Bova: Gray markets are clearly not good for multinationals. If, for example, I’m Pfizer and I’m selling patented pharmaceuticals at a high price in America and a lower price in Canada, I’m obviously not a fan of the American gray market for Canadian pharmaceuticals. Specifically, I don’t like the fact that, for example, American consumers are trying to purchase their drugs in Canada because it cannibalizes my sales in America and leads to far less profit for the firm as a whole. But clearly, consumers really like gray markets. Think about a patented pharmaceutical. Because the pharmaceutical is patented, there’s often no cheap generic competitor for the drug. Additionally, in some cases, consumers need that pharmaceutical to survive. Given these two points, you can imagine that certain consumers might be willing to pay almost anything to obtain the product. So, think about how much benefit those consumers derive from having even one other option to obtain the exact same pharmaceutical at a lower price via the gray market. From a societal perspective here is the trade-off with respect to gray markets: firms are worse off because gray markets are going to cannibalize higher priced sales. The net result is that gray markets make firms less profitable; but consumers are strictly better off by having an option to purchase a cheaper alternative of the same good via the gray market.  Moreover, in general, more consumers will buy when the prices of a product are lower. These are the trade-offs governments need to consider when assessing the pros and cons of gray markets.

When Americans buy health medications from Canada, does that qualify as a gray market or a black market?
FB: Technically, the American gray market for Canadian pharmaceuticals is illegal; Americans are not supposed to be able to buy their medication in Canada, but officials in the U.S. have turned a blind eye to it. It’s become a ‘charcoal’ market if you will: not a black market that is illegal, and not a gray market, which is legal, because no American politician wants to be the one to enforce the law on, for example, a group of seniors taking a bus to Toronto to get their medicine.

Is there anything companies can do to preclude or ‘punish’ gray market activity?
FB: There are a number of things companies can do. For example, they can centralize pricing – i.e., set the same  price for products across international jurisdictions. However, that’s not ideal, because different countries have customers with different purchasing power.  Another thing firms have started doing is differentiating their products across countries.  For example, a firm may change the outer contour of its product to make it more aesthetically desirable to consumers in a foreign market than to consumers in an American market. This makes it more difficult to resell a product purchased in a foreign market to consumers in the U.S.

Another thing multinationals can do is inflate the cost of products transferred to foreign subsidiaries. So if an American company ships product to an affiliated foreign retailer, it might charge them a higher transfer price if it is worried about the gray market “leaking products” back from the foreign country to the U.S.. A higher transfer price is going to lead to higher retail prices in that foreign country and make it more costly for the gray market to reimport the product back to the U.S.

How should a firm go about determining the optimal ‘transfer price’ for a product?
FB: There are two factors here. Firms want to set an optimal transfer price to a foreign market so that the foreign subsidiary can set a retail price that maximizes profits for the multinational. However, domestic governments and tax authorities, don’t want firms to set those prices too low. If firms set transfer prices to low, they keep a lot of the multinational’s profit in the foreign affiliate’s country, and the domestic government doesn’t get its fair share of tax revenue. As a result, domestic tax regulators, like the Canada Revenue Agency, mandate that multinationals charge an ‘arm’s length price’ – the same price that you would set if you were selling a product to an unaffiliated third party – when transferring product to affiliated foreign subsidiaries. In this way, the Canada Revenue Agency makes sure that it gets its fair share of the international tax base.

There have been some high profile cases of arm’s length enforcement in Canada. For example, the Canada Revenue Agency recently charged Chrysler Canada $500 million dollars for not setting transfer prices to American-affiliated subsidiaries high enough. Chrysler was setting low transfer prices so that larger profits could be kept in the U.S. – a comparatively low tax rate jurisdiction. How do gray markets fit in? Well, there’s also a Canadian gray market for American cars, as cars are often priced more expensively in Canada. This disparity in pricing provides an incentive for Canadian consumers to cross the border to buy American cars. Of course, you have to pay a tax when you come back over the border, but even with the additional taxes, there’s still a disparity there, creating a healthy Canadian gray market for American cars.

So here’s the tension, from my perspective.  The Canadian Revenue Agency enforces the arm’s length standard, which means higher transfer prices for Chrysler and larger tax revenues for Canada, and this tax revenue goes into our collective pockets. The problem is that higher transfer prices to U.S. affiliates are going to lead to higher retail prices for Chrysler products in the U.S. As a result, Canadian consumers are worse off because the cheaper alternative in the U.S. will now become more expensive. So while Canadians are better off with larger tax revenues, they are also worse off because a gray market good has become more expensive. Governments should probably be mindful of these trade-offs when enforcing the arm’s length standard.

Once a firm decides to enter a low-cost market, is it better to operate independently via ‘decentralized management’, or should the new operation be managed from the domestic head office (‘centralized management’)?
DS: This is what our research looked at. Generally, you would think that if there is a gray market issue, you would always be better off to manage it in a centralized way, because you could set the price or at least set the quantity of product that is sold in the new market where prices are lower, such that you manage the amount of gray marketing to maximize your profits. You can’t stop gray marketing from happening, but with centralized management you  control the quantities in the two countries from a single head office, and that allows you to minimize the effect of gray markets. This goes back to the teachings of Economist Arthur Cecil Pigou, who said that when there are externalities between parties in a market, you can actually create higher welfare by centralizing control.  

However, we studied this in a competitive context, whereby there is a second firm competing with you in the domestic market that may  also compete with you in the foreign market you have entered. We found that in these conditions, it is better to decentralize the management structure  when the competing products are very close substitutes with each other. For example, Coke and Pepsi or Lee and Levis jeans are perceived to be  close substitutes, and in such cases, we found that de-centralization is best, which goes against the accepted thinking. Here’s why: when you are in a situation where your competitor’s product is a close substitute, the number one threat to your business is not the gray market, it’s your competitor. And when you de-centralize, it makes both your domestic company and your foreign subsidiary much more aggressive: the foreign subsidiary is probably going to produce more than it otherwise would, because it benefits from the gray market. The fact that the foreign subsidiary becomes more aggressive -- while it does affect the profits of the domestic company, also has a negative effect on the foreign competitor and on your domestic competitor. What you do by de-centralizing is you unleash  aggressive subsidiaries on your competitor, and having two independent subsidiaries that are more aggressive actually creates an advantage for you.

It’s a different story when the products are not close substitutes but are instead well differentiated -- for example, if BMW were competing against Hyundai in a particular market. In this case, the biggest threat to your market is the gray market, not the ‘competitor’, so you would benefit from centralization.

In what ways does centralized control internalize the negative effect of the gray market?
DS:  Say I have two people working for me and there is a common tool that they need to use -- they both need to use a circular saw in a workshop. If I am de-centralized, they’re both fighting over the saw, and chances are I’m going to get less output than if I took control of these two people and said ‘Okay, you’re going to use the saw in the morning, and you’re going to use the saw in the afternoon; plan your schedules accordingly’. They might not like that but they’re going to adapt and overall I’m going to be better off. That’s what centralized control does for gray marketing. It basically says to the domestic producer, ‘I want you to produce this much’; and it says to the foreign subsidiary, ‘I want you to produce this much’. The foreign subsidiary might say, ‘No, I want to produce more, because I know the gray market will absorb  this extra production leading to higher profits and volume for us’. I would say, ‘Yes, but if the gray market brings all this product back into the domestic market, that is going to hurt my domestic branch’.

By centralizing I actually can limit the quantity or jointly optimize the quantities that the branches produce, and with a de-centralized structure I can’t do that.  Thus, the negative effect of the gray market is ‘internalized’ because the central planner, i.e. the head office, can control the amount produced in both countries.

Globally, what is the official stance on gray markets?
FB: In general, the governments of the world have given very little recourse to firms to crack down on gray markets once a product has been sold. So if I buy a product in Canada, in most cases the rights for me to resell that product to whomever I want to and for whatever price are mine. In general, governments have more or less turned a blind eye to the rights of the copyright holder once an initial sale has been made, so which ‘side’ governments have taken in the gray market debate is pretty clear.

David Soberman is the Canadian National Chair in Marketing and professor of Marketing at the Rotman School of Management.  Francesco Bova is an assistant professor of Accounting at the Rotman School.  They are co-authors, with University of Illinois professor Romana Autrey, of the paper, “Organizational Structure and Gray Markets,” which can be downloaded as ssrn.com. 

[This article has been reprinted, with permission, from Rotman Management, the magazine of the University of Toronto's Rotman School of Management]