Impacts of gray market selling on the supply chain under product upgrade and pricing flexibility decisions

Abstract

Abstract Gray markets are infamous for unauthorized diversion of authentic products at lower prices to harm the manufacturer's authorized distribution channel. Hence, manufacturers are becoming more proactive in shaping strategies that can counter gray markets. By considering the risk of unauthorized selling through gray markets, we analyze the manufacturer's strategic channel choice and product upgrade decision. We analytically explore the provision of granting flexibility to the legitimate retailer to adjust price during the selling season as a strategy to cope with gray market. We find that unauthorized selling through gray markets has a severe negative impact on the manufacturer's profitability depending on the degree of channel differentiation and product brand equity. We counter‐intuitively reveal that the overall decentralized supply chain can be better‐off, owing to higher product leakage, especially because the legitimate retailer gains an increased sales volume through product diversion to the gray market. However, the manufacturer's loss is more severe in such a decentralized supply chain. We show that the manufacturer can eliminate unauthorized sales through gray market by offering price adjustment flexibility to the retailer. Another compelling finding exhibits that the manufacturer's decision to launch an upgraded product can intensify the diversion of an existing product. However, unfair competition from the unauthorized channel cannibalizes the sales of an upgraded product, thereby making the manufacturer worse‐off. Interestingly, despite the cannibalization of upgraded product sales, the manufacturer can be better‐off in terms of overall profitability via price adjustment flexibility if both the degree of upgrade and brand equity are higher. Overall, in addition to deploying monitoring mechanisms for supervising legitimate retailers, price adjustment flexibility can reduce product diversion if the degree of upgrade is moderate and channel differentiation is higher.