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Gray-market sales: They’re not a black-or-white bane

Legal or not, companies often view third-party sellers as serious threats to revenue and profits. Associate Professor of Information Systems John Zhang's research shows that’s not always the case.

2017-11-01

Plenty of students bring in a few bucks selling textbooks as soon as a class wraps up. Supap Kirtsaeng, a math student from Thailand, took that money-making gig a step further.

He had friends and family members back home in Thailand buy the same textbooks he was using at Cornell and the University of Southern California. After folks shipped the books his way, Kirtsaeng’s sold them on eBay, pocketing some $100,000 in profits during his college years.

Textbook publisher John Wiley & Sons won a $600,000 judgment against Kirtsaeng in lower courts, but the young Thai entrepreneur prevailed in the Supreme Court, where the first sale doctrine prompted justices to side in his favor.

The first sale doctrine holds that once you buy something, it’s yours. You can do what you want with it, including selling it in a gray market, which is what eBay served as for Kirtsaeng.

“Almost always, courts rule in favor of gray markets,” says Associate Professor of Information Systems John Zhang. “That’s why they’re called gray markets. Products are sold through unauthorized channels. We cannot say that it’s completely legal — or illegal.”

Legal or not, companies often view gray markets as serious threats to revenue and profits. Zhang says that’s not always the case. “What I demonstrated in my research is that in some situations, a reasonable level of gray-market activities can increase a company’s profit,” he notes.

Opportunity knock-offs

How do gray markets arise? They stem from price gaps, the kind that exists when there’s a huge difference between what something costs in one market versus another.

Zhang illustrates this using a brand-name polo shirt as an example, explaining that it might sell for $50 in the U.S. and the equivalent of $150 in China. “A gap like this motivates some sellers to buy in a low-priced market and resell the product in a high-priced market,” he says.

It’s not just luxury items that fall into these gaps. The tax, audit, and advisory firm KPMG teamed up with The Alliance for Gray Market and Counterfeit Abatement to study how gray-market activity impacts the information technology sector. These researchers estimated the 2007 IT gray market at $58 billion worldwide, with an average impact on tech company profits between $8 billion and $10 billion.

More recently, a 2016 KPMG survey of IT-related original equipment manufacturers found that 63 percent of respondents felt gray-market activity had increased since 2008. The survey report’s subtitle says it all: “Unauthorized sales continue to raise costs and damage brand reputation.”

But, gray markets don’t just serve bulk buyers, the ones who might buy circuitry and silicon chips on the cheap for use in other electronic products. There’s also the individual buyer afoot, such as people who skip over the U.S.-Canadian border to buy prescription drugs.

According to a 2016 story produced by Seattle’s NBC affiliate, the U.S. Centers for Disease Control estimates as many as 5 million Americans fill prescriptions internationally each year. The story also noted that the Canadian International Pharmacy Association, the organization that regulates online pharmacies in Canada, estimated at least one million American customers get prescriptions through its member companies.

Filling the gaps

How can companies combat gray markets? The most obvious — and likely the easiest way — is through price, Zhang says. “Instead of pricing the same product very differently in different markets, companies can price identical products similarly across different regions.”

Zhang notes that a lot of factors come into play in pricing products for various parts of the world. “It has to do with purchase power, exchange rate, the economic development of a particular region,” he explains. But, he adds, “A gray market exists because there is a huge price difference in absolute dollar amount across the different regions for the same item.” So, while prices may vary, companies can “differentiate the price in a way that makes the gray market no longer attractive to resellers.”

That means reducing the price spread. Going back to his polo shirt example, Zhang says that if the shirt costs $50 in the U.S., a price of $60 in China wouldn’t provide the incentive to buy products stateside and resell them in China. “A $10 price difference doesn’t justify the hassles,” he says.

Companies also can block some gray-market activity with product differentiation, and it doesn’t need to be dramatic. Zhang reports that he’s seen it done with simple changes to serial numbers that are assigned to specific regions.

While such measures might help companies track gray-market activity, they don’t always address the motivators for it. As Zhang points out, today’s information technology makes it much easier for buyers to uncover pricing information and gain access to different markets.

What’s more, gray markets have become mainstream. Sites like eBay provide a venue. The Chinese e-commerce site Taobao does, too. And then there’s “daigou” a Chinese phrase that means “buying on behalf of.” Through this channel of commerce, a person outside China buys and ships goods to someone on the mainland. Usually, it’s luxury goods, which may run 30 to 40 percent higher in China. According to analysts at Bain and Co, 2015’s luxury daigou purchases reached some $7.6 billion, which accounts for nearly half of China’s luxury buys that year.

Follow the money

Given the opportunities, the demand, and the ease with which gray markets can pull sales out of authorized distribution channels, it’s no wonder firms are concerned. Zhang, however, thinks observation should precede hand-wringing. Why? Because he created a mathematical model to evaluate the impact of gray market activity given various pricing schemes, as well as an analysis of how that model worked for an actual electronic firm.

His research shows that people who were initially priced out of the market for a given product may be able to afford it on the gray market. If that happens with net new customers rather than defection of customers who had been paying full price, then the firm will sell more products than if no gray market interference occurred. “In other words, by having a gray market, you may increase the demand for the product,” Zhang says. “That’s what I call market leakage.”

He continues: “It’s a trade-off. You lose some consumers to the gray market, but you also attract new customers who otherwise couldn’t afford to buy your product.”

Not all firms will benefit in this manner, which is why Zhang says companies need to come up with ways to accurately track product flows in the entire supply chain. How many people who originally bought from the authorized channel are now buying from the gray market channel? How many people who originally couldn’t afford to buy the product are now coming in to buy from the gray market? Those are two key questions Zhang says companies need to answer to see if the gray-market activity is helping or hurting the bottom line. Serial number differences can help with this effort, he adds.

Price flexibility will help as well, which Zhang notes is an easy way to impact gray markets themselves. “Companies can do experiments, try different price gaps and see how their revenue is changing,” he says.

And, most important, keep an open mind. Zhang’s research showed that even though large pricing gaps from one region to another often create gray markets, those markets might not create corporate losses.

What matters, of course, is company sales results. “As long as the revenue brought into the company by new consumers outweighs the loss to gray-market sales, then there is a benefit to the manufacturer,” Zhang concludes.

The takeaways

• Gray markets are unauthorized sales channels that appear when large price gaps exist between one market and another.
• Though not illegal, gray markets siphon sales away from authorized distribution channels.
• Companies can lose revenue and profits to gray markets, but loss isn’t inevitable.
• In some cases, gray markets open new markets for goods, thereby boosting company revenues overall.

KnowIT Managing IT Faculty Marketing