Gray Markets and Supply Chain Incentives

‘Gray markets’ are unauthorized channels that distribute a branded product without the manufacturer's permission. Since gray markets are not officially sanctioned by the manufacturer, their existence is assumed to hurt the manufacturer. Yet manufacturers sometimes tolerate or even encourage gray market activities. We investigate the incentives of a manufacturer and its authorized retailer to engage in (or tolerate) gray markets. The firms need to consider the trade‐off between the positive effects of a gray market (price discrimination and cost savings) and the negative effects (cannibalization of sales and a loss in consumer valuation). Generally, gray markets can be categorized into two types: (i) a ‘local gray market,’ where a retailer diverts products to unauthorized sellers operating in the same region as the retailer; and, (ii) ‘bootlegging,’ where the retailer diverts products to unauthorized sellers in another market where the manufacturer sells through a direct channel. We characterize the equilibrium in each type of gray market and identify conditions under which the retailer will divert products to the gray market. Incentive problems are more complicated when the retailer bootlegs and, in this case, we show that conflicting incentives may lead to the emergence of a gray market where both the manufacturer's and retailer's profits decrease.