Gray marketing: does it hurt the manufacturers?

Introduction

Parallel importing has attracted increasing interest in the international practice, and concern to manufacturers and retailers since the mid-1980s (Mitchell 1998; Eagle et al. 2003). In the case of Silhouette in July 1998, the European Court of Justice (ECJ) arrived at a judgment that relaxed the definitions of cartels, price controls, and market manipulation. With the support of the European Commission and many EU governments, the court has effectively limited gray imports into the EU market (The Economist 1998). The so-called parallel importation or gray marketing arises when a marketer imports branded products from abroad, then diverts and sells them through unauthorized channels (Inman 1993). Gray markets are not generally considered illegal, in contrast to the black market of stolen or counterfeit goods. Rather, gray goods are genuine in terms of their manufacturer, but their distribution is unauthorized. Only when the gray goods violate either the product regulations or the licensing contract of the trademark owner, gray-marketed goods are illegal (Palmeter and Remington 1988). In the paper, parallel importing and gray marketing are used interchangeably and indicate the same meaning.

Although there is no official data on the size of international gray markets, parallel importation is generally considered a significant phenomenon (Chen and Maskus 2005). The estimated market size of international gray goods range from $7 billion to $10 billion U.S. dollars (Mathur 1995; Eagle et al. 2003). According to the estimates of National Economics Research Association (NERA), parallel imports account for between 5% and 20% of trade within the EU for such goods as consumer electronics, cosmetics and perfumes, musical recordings, and soft drinks (NERA 1999). Some IT companies, including 3Com, Apple and HE established a so-called 'Anti-Gray Market Alliance' in order to lobby against the importation of gray market goods in September 2001. They argued that the prevalence of gray goods has substantially reduced their profits. Recently, Levi's retailers resorted to law to restrain the largest retailing store Tesco to sell Levi's jeans, because Tesco imports the jeans from other markets and sells them in the UK market at a low price. However, in order to compete with the gray goods, Levi's announced in late April of 2003, that its Signature Series was to be sold in some discount stores such as Wal-Mart. (Voyle 2003). In sum, there is evidence of tension between attempts to open parallel imports and attempts to protect trademark owners from its impact (Mitchell 1998).

As gray goods are not counterfeit goods, the question of whether the importation of gray goods with genuine trademarks should be restricted has raised fierce debate. As mentioned earlier, the decision by the ECJ was ruled upon the request of some trademark owners including product manufacturers and their authorized retailers. Their arguments are summarized as follows: First, the manufacturers stated that they have the fight to determine channel structures for their products and subsequently to ban the imports of gray goods into the EU. Second, gray marketers often maintain significantly higher gross profit margins simply because they not only take away the market share of authorized retailers, but also free-ride on the marketing communications performed and customer services provided by their authorized counterparts. Therefore the sales through gray channels will likely hurt authorized channels. Some works have been done in solving these problems. For example, Gallini and Hollis (1999) employed a contractual structure model to harmonize the benefits between authorized retailers and gray marketers. Third, since the prices of gray goods are usually lower than their authorized counterparts, this may hurt not only the existing consumers but also potential consumers due to a lower level of service by authorized retailers and lower investments made by manufacturers in product improvement and advertisement.

However, the impact of gray marketing on manufacturer's profit is still rather vague. As argued by Bolton and Bonanno (1988) when one manufacturer is dealing with many retailer's (parallel importers are one type of retailer) vertical restraints, (e.g., resale price maintenance and franchise fees) they do not restore vertical efficiency. Moreover, Shepherd (1997) proved that if manufacturers can use price discrimination to sell their products according to demand elasticity, they can increase both their market shares and profits, reducing the competition among brands. In the international context, however, Mitchell (1998) argued that gray marketing has an unexpected impact on branding and brand equity, which may actually assist in the penetration of foreign products into a domestic market, increasing the market share of the products. This explains why only a few manufacturers in EU joined forces against parallel importation into the EU market. On the other hand, it is widely perceived that authorized retailers could provide better services (e.g., warranty of product quality, product display, and customer service, etc.) than gray marketers. Therefore, the main purpose of this paper is to examine the profits of manufacturers when their authorized retailers are subject to parallel importation.

Numerous studies have been successful in investigating the issue of parallel importation. For example, Landes and Posner (1987) analyzed the structure of trademark law by using an economic model. They found that tort law could be used to promote economic efficiency. Some literature has investigated effects of parallel importation from the perspective of arbitrage on price discrimination or free ride on intellectual property right. Telser (1990) argued that the parallel importing is characterized by a free-rider problem. He examined two arguments (i.e., monopoly and producers' cartel) associated with different market structures to explain why some manufacturers may impose resale price maintenance on distributors. Malueg and Schwartz (1994) are the first to conduct a formal analysis of parallel importation. They proposed a model which assumed the parallel imports were caused entirely by international third-degree price discrimination by a manufacturer, not by free-riders. They found that a uniform pricing strategy could be disadvantageous to small countries, and that a mixed system could improve the global welfare. Given this, they argued that international trading rules should not be built on the basis of an individual country. Anderson and Ginsburg (1999) further considered consumer arbitrage cost in parallel imports, in a background of both third-degree and second-degree international price discrimination by a monopoly. Richardson (2002), on the other hand, proved that many small countries (e.g., Singapore, New Zealand, and Australia) allow parallel importations. He also indicated that even though the mix system can improve the world welfare, each individual government is not interested in improving the world welfare, and that it is very difficult for the governments to harmonize their benefits by multilateral trade negotiations. Finally, Chen and Maskus (2005) concluded that restricting parallel imports tends to increase global welfare when trade cost is high, but it may reduce welfare when trade cost is low. Therefore, open trading regimes may be most appropriate within regional trade agreements.

In sum, literatures on the economic impacts of parallel importation have mainly focused on analyzing price discrimination and global social welfare. To our best knowledge, there has been very limited economic analysis on examining the efficiency of parallel importation on manufacturers and authorized channels. This paper aims to bridge this gap by setting up a theoretical model to examine the effects of parallel importing on the bundled service level provided by authorized retailers and the profits of authorized retailers and manufacturers. We shall show that the bundled service levels provided by the authorized retailers may fail if gray-market distributors provide the good with less service. In some cases, this will decrease demand for the manufacturer's product and profits from a particular regional market. Our findings can be used to explain why some manufacturers are against the parallel importation of products into the EU, while others are not. In building the model, we follow Richardson (2002) to analyze the parallel importation issue from the viewpoint of an individual country. Therefore, this study emphasizes free rider behavior of gray marketers and the impact of free riders on authorized retailers rather than on world welfare.

The rest of the paper is organized as follows: In the next section, a two-stage sub-game perfect equilibrium model is established with one manufacturer selling its product to one authorized retailer (and also directly or indirectly to gray marketers) which examines the relationships between gray marketers, authorized retailers and manufacturers. This is followed by derivation of the authorized retailer's second-stage equilibrium and analysis of the effects of gray goods on the authorized retailer's sales and service levels. The penultimate section is devoted to the analysis of the manufacturer's equilibrium; the main task of this section is to examine the effects on wholesale prices and the manufacturer's profits through a change in the quantity of gray goods. We conclude this paper with a discussion on some of the findings, limitations and possible extensions of this research.

The Basic Model

In the open economy, there is a product that is solely produced abroad by a foreign manufacturer and sold to the home market by a retailer authorized by the manufacturer and also by a parallel importer not authorized by the manufacturer. As mentioned earlier, a parallel importer is also one type of retailer in the home market who has secured the product from markets in other countries. The two retailers, (the authorized retailer and the gray marketer), are therefore selling the same product. The authorized retailer is assumed, as normally true in practice, to provide better services and to charge a higher price to customers than the parallel importer (Telser 1990; Mathewson and Winter 1984; Bolton and Bonanno 1988). Let the sales of the authorized retailer and the gray marketer be x and g respectively, the marginal cost of the product be c and the wholesale price of the product be [omega]. We further assume the service level rendered by the authorized retailer is denoted by S and the cost of providing such service takes the following functional form F(S) with [f.sub.s]>0 and [f.sub.ss]>0. The latter shows that the marginal cost of services increase as the service level increases.

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