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A Silver Lining in Gray Markets? It’s Complicated.

Although manufacturers can derive some short-term benefits from unauthorized retailers, outright bootlegging is harmful to profits and reputation.

Bottom Line: Although manufacturers can derive some short-term benefits from unauthorized retailers, outright bootlegging is harmful to profits and reputation.

Gray markets have long been viewed by manufacturers as a scourge. These distribution channels, where unauthorized vendors buy goods from authorized retailers and then resell the products to consumers, aren’t necessarily illegal (unlike the black market), but they are not the original manufacturer’s preferred retail outlet. Indeed, a number of prominent firms have filed complex lawsuits against gray-market distributors.

Not only can a gray market cut into authorized sales, it may sully consumers’ perceptions of a brand when goods appear in downscale bazaars rather than boutique shops. It can also hurt a manufacturer’s relationship with its authorized partners who play by the rules. But legitimate retailers may have incentives to steer products toward gray markets to create secondary markets where they can sell items for less than the manufacturer’s suggested price while incurring very low overhead costs.

Although manufacturers almost never sell to gray markets directly or deliberately, they may have reasons for looking the other way or tacitly encouraging the practice. After all, gray markets can allow them to reach consumers who might be attracted by a lower price point or to shed overstocked inventories.

Not only can the gray market cut into authorized sales, it can also sully consumers’ perceptions of a brand.

A new study explores gray markets and the impact they have on profits. Based on an analysis of empirical studies of gray markets, lawsuits originating from firms’ attempts to shut them down, and the authors’ own mathematical model, the research weighs the trade-offs for manufacturers and retailers.

In doing so, the authors considered two scenarios: local gray markets, in which a retailer steers products to unauthorized vendors in its same region; and bootlegging, which they define as a retailer selling products via an unauthorized vendor in a different market where the manufacturer also sells directly to customers, in effect competing head-to-head with the manufacturer.

In both scenarios, the industries most vulnerable to gray markets are those in which the consumer is likely to have a high opinion of the product regardless of where it’s sold, believes in the brand, and wants to avoid the higher cost of shopping through authorized retailers. This jibes with previous research that has found gray markets most significantly impact high-end products, including electronics, industrial and commercial machinery, cars, jewelry, designer clothing, and pharmaceuticals. Authorized retailers in these sectors typically incur the costs of supplemental services such as advertising, customer returns, and product demonstrations in addition to overhead, so they can have an incentive to turn to the gray market. They know gray market consumers will be receptive to high-priced items sold at a discount by unauthorized vendors who don’t have to absorb those additional costs, the authors write.

Local gray markets rarely impact manufacturers in a significant negative way, the authors found. Although the retailer generally makes off with higher margins than does the manufacturer, the two firms’ goals are still more or less aligned — sell the product to consumers who think highly of the brand, and move more merchandise as a result.

That’s not the case with bootlegging, however, which tends to drive down manufacturers’ profits significantly. When a retailer sells to bootleggers, it cannibalizes the manufacturer’s primary market. That doesn’t mean as much to the retailer, of course, since the cannibalization affects another market entirely. If the firm wants to keep selling for the manufacturer in the long-term, however, bootlegging is not the answer. The best way to deter bootlegging is for the manufacturer to set a high wholesale price, but that is a delicate gamble: Set the price too high, and the gray market will all but disappear — but so will profits for both manufacturer and retailer because fewer distributors will be buyers at a too-high price and the higher cost will dent margins.

Indeed, the majority of legal cases involving gray markets are aimed at stopping bootleggers, the authors note, specifically those moving goods across international borders. One reason for this is that the scale of these parallel imports, as they’re known, dwarfs that of local gray markets. But it may also be because, as the authors found, there’s a fundamental supply-chain conflict when retailers turn to bootlegging, a conflict that doesn’t necessarily exist in local gray markets.

By carefully setting their wholesale prices, manufacturers at the upstream end of the supply chain can effectively control local gray markets. But if a retailer is bootlegging, legal action might eventually be required to stave off this harmful cannibalization. The authors stress that even if firms are temporarily benefitting from gray markets, their very existence points to an underlying incentive problem in the supply chain’s distribution channel. “Therefore, the manufacturer should be careful when taking advantage of the gray market; and in the long-run, the manufacturer should re-examine and adjust its distribution strategies,” they write.

Source: “Gray Markets and Supply Chain Incentives,” by Jing Shao (University of International Business and Economics), Harish Krishnan (University of British Columbia), and S. Thomas McCormick (University of British Columbia), Production and Operations Management, Nov. 2016, vol. 25, no. 11

Matt Palmquist

Matt Palmquist is a freelance business journalist based in Oakland, Calif.

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