The Dynamics of Domestic Gray Markets and Its Impact on Supply Chains

Abstract

Gray markets are created by those unauthorized retailers selling manufacturer's branded products. Similar to international gray markets, domestic gray markets are a growing phenomenon whose impact on supply chains is not clear. Based on this observation and our own experience, we consider a supply chain with one manufacturer and several authorized retailers who face a newsvendor problem and a domestic gray market. While a gray market provides an opportunity for these retailers to clear their excess inventory (inventory-correction effect), it also can be a threat to their demand (demand-cannibalization effect). We first characterize the emerging equilibrium by assuming an MSRP environment, where the authorized retailers cannot change the primary market price. Comparing a decentralized and centralized system, we show that a wholesale pricing contract is quite efficient in a gray market environment; we explain the underlying mechanism and note some of the operational decisions that could hurt that efficiency. We also derive the conditions under which a gray market emerges and the condition under which gray market does not emerge. We show that the gray market price determines the degree of both the negative effects of demand-cannibalization and the positive effects of inventory correction, which in turn determines the net impact of gray markets on the retailer's stocking choice and, ultimately, the manufacturer's profit. We then study the authorized retailers' problem as a price-setting newsvendor. We observe that the gray market creates price competition between the authorized and unauthorized retailers, causing a drop in the primary market price. However, this price competition can be counteracted by the authorized retailers' stocking decision. Interestingly, we observe that the overall supply chain becomes even more efficient when the authorized retailers optimize not only their stocking decision but also their prices. Finally, we extend our model to consider the cases where the demand can be correlated across retailers.