When Gray is Good: Complementary Goods and Emerging Markets

• In Event: Concurrent Session 4.2: Managerial Discretion and Reporting Offenses

Abstract

Gray markets arise when one firm buys product in a lower-priced, emerging market and resells it to compete with the original manufacturer in a higher-priced, more developed market. Evidence suggests that gray markets make the original manufacturer worse off globally by eroding profit margins in the more developed market (KPMG 2008). However, some firms aggressively fight gray market encroachment while other firms do little to curb it. Our analysis suggests that one possible explanation for this outcome lies in the interaction between firms selling complementary goods and firms investing to develop emerging markets. We find that when gray markets are present, the motivation to invest in emerging market development is amplified because higher emerging market prices increase the gray marketer's cost base and thereby reduce the gray market's ability to cannibalize sales in the higher-priced, developed market. In general, the gray market is profit-reducing but investments to build the emerging market can mitigate the impact. Moreover, when the end-market is characterized by complementary products, market-building investments confer a positive externality on the competitor's demand. Because investments are strictly larger in a gray market setting, the positive externalities that accrue to each complementary firm are also larger. We find that, for a wide range of complementarity levels, the increase in net profits brought on by investment in the emerging market more than offsets the lost profit in the domestic market brought on by gray market cannibalization. In this setting, the original manufacturer is better off with gray markets than without them. These results provide a possible explanation for the relatively muted response from firms to curb gray market activity in sectors where products are complementary (e.g., the technology sector) and, more broadly, the proliferation of gray markets in the economy.

Authors

• Francesco Bova, University of Toronto

• Romana L Autrey, University of Illinois at Urbana–Champaign

• David Soberman, University of Toronto