Beyond price mechanisms: How much can service help manage the competition from gray markets?
Gray marketing, the selling of branded goods outside of manufacturer-authorized channels, is a factor in many industries. Using a model of differentiated Cournot competition, we analyze how gray markets affect the strategy used to enter low-priced foreign markets. In particular, we examine how much autonomy a firm should give its foreign subsidiary. When production in the foreign country is determined at head offi ce, the firm has a centralized organizational structure. In contrast, when the subsidiary has autonomy to set its own production, the firm has a decentralized organizational structure. In the presence of gray markets, we find that organizational structure has a significant effect on firm profitability. When competing products in the domestic market are highly substitutable, foreign entry accompanied by decentralized management is advantageous. The finding holds in a situation where only one firm enters the foreign market but also in a situation where both firms do so. The advantage of decentralization is not explained by lower gray market volume under decentralization: gray market quantities can also be higher. The advantage of decentralized management comes from the different incentives it creates for decision makers. Under decentralization, every division makes production decisions locally. This leads to aggressive production in the domestic market because the decision maker does not account for reduced gray market sales (this "hurts" the foreign subsidiary). Aggressive domestic production both limits the impact of the gray market and weakens the domestic competitor. The same mechanism also applies when both firms enter the foreign market. As a result, both firms adopt decentralized control but in contrast to the single firm case, the equilibrium is a Prisoners’Dilemma: profits are reduced versus an outcome where both firms operate under centralized control. The results suggest that in competitive categories where gray marketing is significant, the likelihood that foreign subsidiaries operate independently is higher. These results echo the findings of McGuire and Staelin (1983) who find that manufacturers in bilateral duopolies benefit by decentralizing operations when downstream products are close substitutes. However, contrary to the finding for bilateral duopolies, here manufacturers suffer as a result of their decentralized structure.