Gray market activity has received much attention in academic journals, trade publications, and popular periodicals.  These studies argue that long term gray market activities are harmful to distributor relations, trademark image, profits, (Cavusgil and Sikora, 1988), sales force morale, and customer service efforts (Myers, 1999).  While there are few reliable statistical sources on the level of gray market activity, estimations are as high as $7 billion to $10 billion in the US (Cespedes, Corey, and Rangan, 1988).  Growth estimations for the gray market are as high as 22% (Lowe, McCrohan, 1989).  The focus of the literature has been on causes and remedies of gray market activity.  However, studies have shown the level of gray market activity is controlled more by factors under the control of firms than external factors (Meyers, 1999).

The general definition of “gray market” is the sale of authentic products through unauthorized channels. Gray market sales can come from domestic transactions (Cespedes et al. 1988), but are usually associated with international transactions.  While gray market activity has a number of causes such as product availability and channel integration, its cause is generally associated with large price differentials between markets (Assmus and Wiese, 1995; Cavusgil and Sikora, 1988; Lowe and McCrohan, 1989).  These differentials occur either through price setting by discriminating monopolists or through currency rate fluctuations (Weigand, 1991).

Assmus and Wiese (1995) describe three main categories of gray market transactions: parallel imports, lateral imports, and re-imports.  They write that parallel imports occur when a manufacturer sells product to an authorized dealer in the country of manufacture and to an authorized dealer in an export market.  In their description, if there is a sufficient differential in price between the authorized dealers, an opportunistic dealer in the export country will import product in parallel to the authorized distribution channel.

Assmus and Wiese (1995) describe lateral imports as a manufacturer’s export to authorized distributors in two markets.  In their explanation, if sufficient price differentials exist between the two export markets, then product sales will occur through unauthorized channels from the low priced market to the high priced market.

Two studies describe reimportation (Assmus and Wiese, 1995; Wiegand, 1989).  Both characterize the occurrence of reimportation when an exported product finds its way back to the domestic market.  While both articles mention that reimportation occurs when an opportunistic dealer takes advantage of price differentials between the two markets, Wiegand (1989) mentions retail purchase of a product for personal use or as a gift as another form of reimportation.

Most studies of gray market activity focus on its long-term negative impact on manufacturers, exporters, and their distribution channels (Cespedes et al. 1988).  However, while the short-term effects of gray market activity are mentioned, they remain uninvestigated (Assmus and Wiese, 1995; Cespedes et al. 1988; Ciber Working Papers, 1995).  The authors report short-term advantages of gray market activity include reduced manufacturing costs, increased sales, and increased market share.  Gupta and Wilemon (1990) describe these advantages as typical goals of high technology companies that use fast growth and shortened product introduction cycles as competitive strategies.

The potential revenue impact to these firms from gray market activity can be significant.  STAT-USA (1999) reports the estimated gray market for personal computers (PCs) and related components in Brazil is estimated between 60% and 65% of the country’s total PC market.  Further, the Business Information Service for Newly Independent States (BISNIS, 1998) proposes that authorized channels stand to benefit from gray market activity in developing countries.  The report argues that large markets, such as the Ukraine, have pent up demand, which has created many opportunities for both authorized and unauthorized distribution activities.  It further suggests that such large gray markets will increase the population’s purchasing power, which in turn will create additional opportunities for firms that do not participate in the gray market to establish market niches.

Previous studies on gray market activity considered broad product sectors (Palia and Keown, 1989).  Other studies that focused primarily on technology companies included wide ranges of technology from automobile parts manufacturers (Cavusgil and Sikora, 1988; Weigand, 1991) to disk drives for PCs (Cespedes et al. 1988).  These studies have not focused specifically on the high technology manufacturers, such as telecommunications equipment, network equipment, servers, and workstations.  These manufacturers have rapid development cycles, limited market windows, and shortened product lifecycles (Bayus, 1998; Gupta et al. 1990).  Drastic changes in market conditions, such as privatization of government owned networks, rapid technology changes, and the emergence of customized network operators drive these market conditions (Sarkar, Cavusgil, and Auklakh, 1999).

This is an exploratory study.  Its purpose is to develop hypotheses for later research.  It compares industry segments that require rapid technological advancement to meet customer demand and the possible level of gray market activity allowed.  The intersection of gray market as a distribution channel and the demand for high technology products raise two questions.  First, do factors such as size or rapid technology change contribute to the level of gray market activity?  Second, is there a relationship between a company’s willingness to encourage gray market activity and its ability to stop such activity?

Review of the Literature

While there is an abundance of literature on gray market activities, there are few empirical studies.  Palia and Keown (1991) separate the available literature into four categories: descriptive studies, the legal aspects of gray market activity, strategic studies, and trade publications.  The focus of this review is on descriptive, legal, and strategic literature.

Descriptive studies focus on the reasons for gray market activity (Palia and Keown, 1991).  The authors’ view is these articles look at the external and internal the factors that drive gray market activity.  In their study, along with those by Cavusgil and Sikora (1988), Lowe and McCrohan (1989), and Meyers (1999), these external factors include exchange rate volatility, availability of information, and the ease at which products can be adapted for local use.  The authors contend that companies have little control over these factors.  Therefore, they believe there are times when some gray market activity will occur.

Internal factors are generally under the control of firms (Assmus and Wiese, 1995; Cavusgil, 1996; Palia and Keown, 1989).  Internal factors include pricing policies, the degree of distribution control, channel integration (Meyers, 1999) and cost differentials between markets (Cespedes et. al. 1988).  Weigand (1989) describes opportunistic behavior, by members of authorized distribution channels, as an additional cause for the gray market.  One factor mentioned briefly in two studies is product scarcity (Cavusgil, & Sikora, 1988; Lowe and McCrohan, 1989).  The examples in these studies were luxury items.  However, the gray market can help any manufacturer reach customers outside its normal channels (Champion, 1998).

The first legal issue investigated in the literature is the legality of sales activity by unauthorized channels (University of Toronto, 1996; Palia and Keown, 1991).  The first attempt to stem gray market activity in the United States through legal means was the case of Appolinaris Co., Ltd v. Scherer in 1886 (Ciber Working Papers, 1995; Weigand, 1991).  Since this time, owners of legal trademarks argue gray market activities infringe on their rights, while gray marketers argue the benefits of lower prices to consumers (University of Toronto, 1996).  Although the United States Supreme Court upheld the legality of a wide range of gray market activities, there are legal ambiguities (Ciber Working Papers, 1995; Palia and Keown, 1991). Manufacturers and exporters are expected to solve the problem through market forces, not legal remedies (Palia and Keown, 1991; University of Toronto Working Papers, 1996).

Cavusgil and Sikora (1988) mention product liability as a second legal aspect to gray market activity.  They state that safety features required on products manufactured for usage in the U. S. may not be present in products manufactured for use in developing countries, are generally lower in cost, and frequently appear on the gray market.  At the time of their study, there was a question as to manufacturer liability if a gray market product caused major injury or death.

Strategic studies focus on prevention and remedies to gray market activity (Palia and Keown, 1991).  Cavusgil and Sikora (1988) catalog a variety of proactive and reactive strategies to combat gray market transactions.  They contend the best strategy is prevention and provide a number of strategies, such as market information systems, dealer education and development, and after sales service differentiation to prevent gray market activity.  Should the volume of gray market activity increase beyond a firm’s expectation however, the authors provide a number of reactive strategies that include confrontation, participation, price-cutting, collaboration, etc.  Weigand (1991) offers additional approaches to keep gray market at a minimum such as price changes and second currency price quotes.  While he holds that regular price changes lower the price differential between markets, his strategy raises the question of which member of the supply chain- the manufacturer, distributor, or retailer will feel the largest impact of any price reduction.  His other recommended strategy, second currency quotes, are effective for sales made into countries with unstable currencies.

Another strategy to reduce or halt gray market activity is through development and implementation of control systems (Cavusgil and Sikora, 1988; Cespedes et al. 1988).  The authors consider the ability to identify products by tracking serial numbers, warranty registrations, service requests or other information as a tool to help a company identify the level and location of gray market activity.  They contend these methods can determine which distributors create leaks in the supply chain through regular participation in gray market activities.  Lotus Development Corporation tracked bar code numbers on boxes of Lotus 1-2-3 software as and threatened termination of distributor rights if a distributor made volume purchases and supplied unauthorized dealers with product (Cespedes et al. 1988).

Ahmadi and Yang (Ciber Working Paper, 1995) provide theoretical support that a firm can use gray market activity to increase sales volume, growth, and profits.  Moreover, there is evidence that gray market activity may have a place in a company’s growth strategy (Cespedes et al. 1988).  Several studies indicate some firms will actually create situations to encourage gray market activity to increase sales (Dana 1998; Danzon 1997; Kuhn, 1998; Vickers, 1997).

Cespedes, Corey, and Rangan (1988) describe a typical situation at a disk drive manufacturer.  They reported the manufacturer’s large customers bought more units than required to take advantage of volume discounts.  They described how the customers then sold the excess inventory to unauthorized dealers.  As the authors explained, the manufacturer benefited from incremental business and reduced unit production costs in the short term.  However, they contend, the manufacturer created morale issues within the sales organization in the long term.

Previous studies looked at various independent variables, such as pricing strategies, product standardization, market volatility, etc., to find their relationship to gray market activity, (Assmus and Wiese, 1995; Cavusgil, 1996; Meyers, 1999).  These studies indicated that gray market activity is affected more by internal factors under the control of firms than by external market forces (Myers, 1999).  Cavusgil and Kirplani (1993) investigated the effect of internal variables, such as size and scope of entry strategy, on export performance but not their effect on gray market activity.  However, evidence suggests several factors that contribute to gray market activity can be utilized to increase revenues and market share, such as channel integration, pricing strategies, and product availability (Assmus and Wiese, 1995; Meyers, 1999; Weigand, 1991).

In an exploratory study, Cavusgil and Kirpalani (1993) hypothesized that large and small firms were more likely to be successful in international ventures than medium sized firms.  Additional studies looked at various characteristics of the firm, such as management’s level of experience and export sales goals, to predict export performance (Bello and Gilliand, 1997; Cavusgil and Zou, 1994; Cavusgil, Zou, and Naidu, 1993).  These studies, however, did not look at gray market activity as a predictor of export market success.

Kirpalani and Macintosh (1980) performed an exploratory study on the export effectiveness of technology oriented small firms.  They looked at a broad range of technology products ranging from simple automobile parts to more advanced avionics and numerical control equipment.  Their goal was not to test specific hypotheses, but to test a large number of variables to determine their relationship to the export success of the firm.  One variable tested was the relationship between research and development (R&D) activity and the export success of the small firm.  The authors looked at various measures of R&D activity, such as expenditures as a percentage of sales, the number of professionals involved in the R&D process, and the level of new product export success.  What they found was a small, negative relationship between R&D activity and export success.  This unexpected result questioned the widely held belief that R&D activity is important to the success of exporting companies.  The authors mentioned a previous study by Hanel (1976) that showed a positive relationship between R&D expenditure and export performance.  However, the Hanel study used industries as a unit of analysis and focused on large firms.  Therefore, while this study indicates R&D is important to large firm success, it appears R&D is not important to small firms.

Earlier studies looked at technology in the broad sense, but did not emphasize factors that influence firms focused on such high technology markets as personal computers or telecommunications equipment (Kirpalani and Macintosh, 1980; Bello and Gilliand, 1997).  Firms that service these markets face accelerated technology change and increased customer demand for new features, functions, and services (Gupta and Wilemon, 1990).  The authors contend these markets create an environment for equipment manufacturers where product development is driven by factors that include increased global competition, new technologies that obsolete existing products, ever changing customer requirements, and higher development costs.  Fast time to market, even at the risk of going over development budget, allows a company to charge a premium price for up to date technology and respond to market niches and changes in customer requirements.  Further, products based on the latest technology enjoy longer overall life spans (Bayus, 1998).

In summary, a review of the literature shows the negative impact of long-term gray market activity while it also shows potential benefits to firms that encourage or allow short-term gray market activity (Assmus and Wiese, 1995; Cespedes et al. 1988).  There may even be situations where authorized distribution channels can benefit from the existence of gray market activity (BISNIS, 1998).  Further, current gray market studies do not take into account the size of the firm, rapid product development caused by rapid technology changes, fast time to market strategies, limited authorized distribution channels, or fast growth strategies.

Conceptual Model and Hypotheses

Economic theory states prices paid by buyers will tend towards a minimal per unit cost, information on goods in the market is freely available, and producers are free to enter or leave the market at will (Jackson, 1996).  Several points of market “friction,” however, preclude the existence of a purely competitive market (Spencer and Amos, 1993).  The authors assert that producers tend to produce goods that are not identical, market information is not always available, and while producers may be free to leave a market, there may be sufficient barriers to enter some markets.

Producers create friction to increase profits (Spencer and Amos, 1993).  They explain that as opportunistic monopolists, producers may charge a higher price in some markets.  As profit seekers, gray market participants will take advantage of price differentials and market demand (Assmus and Wiese, 1995; Cavusgil and Sikora, 1988; Lowe and McCrohan, 1989).  To find these conditions, gray market participants take full advantage of information technology, such as CD-ROM databases and fax (Assmus and Wiese, 1995).  Gray market participants can then make large purchases, in some instances an authorized dealer’s excess inventory, and resell the product at a lower price than authorized dealers, moving prices closer to a minimal per unit cost (Cespedes et al. 1988).  Therefore, the main concern with the gray market is that it does not create demand for a specific product, but moves all products of a particular type towards a commodity model (Lowe and McCrohan, 1989).  This effectively reduces the market friction created by the manufacturer, who must lower prices to compete or find other ways to differentiate the product (Cespedes et al. 1998).

A potential predictor of gray market activity is product availability, but a relationship was not empirically tested (Assmus and Wiese, 1995; Meyers, 1999; Weigand, 1991).  Champion (1998) mentions market coverage as one aspect of product availability.  The product development cycle also plays an important role in the availability of products (Gupta and Wilemon, 1990).  The authors indicate that while rapid product development results in higher costs, respondents to their survey indicated competitive pressures and rapid technology changes as reasons for an accelerated new product development.

Based on the market demands in the high technology market and the challenges faced by these firms, it is possible to develop a conceptual framework and determine variables that may predict the level of gray market activity.  These variables fall into three sets of factors that include market demand factors, product specific factors, and firm specific factors.  Figure-1 illustrates a conceptual framework based on these factors.

Market Demand Factors

Several studies indicate that companies have little control over external factors that influence gray market activity (Cavusgil and Sikora, 1988; Lowe and McCrohan, 1989; Meyers, 1999).  However, these studies did not look at two market demand factors, rate of technology change and changes in customer requirements and their potential influence on gray market activity.

Rate of Technology Changes

The rate of technology change required by a market affects the rate that current products become obsolete (Sarkar et al. 1999).  The authors discussed how customers demand more capabilities from their work stations, data servers, and telecommunications equipment.  Moreover, they described how the convergence of technologies, such as computers, packet networks, and telephone switch equipment has created new markets and new competitive pressures that challenge established telecommunications providers.  These conditions were not part of previous gray market empirical studies (Meyers, 1999; Palia and Keown, 1991).  With rapid product development cycles, it is possible that companies will focus more on sales revenue than controlling their distribution channels (Meyers, 1999).  Therefore, as the rate of change in technology increases, a company may be willing to allow higher levels of gray market activity to occur.  This leads to the first hypothesis:

H₁:  There is a positive relationship between rate of technological change and gray market activity.

Changes in Customer Requirements

The second market demand variable under consideration is changes in customer requirements.  While some high technology markets may not experience high levels of changing customer requirements, such as pharmaceuticals, other markets do experience frequently changing customer requirements, such as PC manufacturers and telecommunications equipment vendors (Gupta and Wilemon, 1990).  As technology changes, it provides the basis for additional services (Sarkar et al. 1999).  The authors write that firms providing those services may require new products or modifications to existing products to serve their customers better.  They suggest these product changes can involve new features, different options, advanced capabilities, etc, and therefore manufacturers are under additional pressure to meet these new requirements.  Further, Meyers (1999) found that standardized products did not contribute to gray market activity.  Modified products may create additional gray market opportunities for product that may not reach all authorized channels (Champion, 1998).  Therefore, the second hypothesis in this study states:

H₂:  There is a positive relationship between the rate of change in customer requirements and the levels of gray market activity a company will allow to occur.

Product Specific Factors

Product specific factors attempt to identify those variables that may drive gray market activity. There are two product specific factors considered: the product development cycle and product availability.

The Product Development Cycle

The first variable considered is length of the product development cycle.  Some high technology firms are in markets, such as pharmaceuticals and aerospace, where slower development cycles are appropriate (Gupta and Wilemon, 1990).  However, the authors discovered these firms have found that shortened product development cycles have provided them a competitive advantage.  Their study further showed that aggressive high technology firms find this competitive advantage has its own risks, such as poor product definition, product quality issues, lower product reliability, and technological uncertainties.  The authors find that as a company’s competitors shorten their development cycle, the company can not slow theirs.  To assure product reaches the largest possible number of customers, any distribution channel may be used.  This leads to the third hypothesis:

H₃: There is an inverse relationship between the length of a company’s product development cycle and its willingness to encourage gray market activity.

Product Availability

Product availability is the second product specific variable in this category.  Several studies mentioned product availability, but neither empirically or in the context of an antecedent to gray market activity (Cavusgil and Sikora, 1988; Lowe and McCrohan, 1989). If an authorized channel is not available in a particular market to satisfy a market’s demand, an authorized or unauthorized dealer in another market may try to meet that demand (Champion, 1998).  Further, some authorized dealers may try to fill this market’s demand by selling product outside their authorized territories (Weigand, 1989).  The fourth hypothesis considers the potential relationship between product availability and the gray market:

H₄:  There is an inverse relationship between product availability in a market and the level of gray market activity allowed by a company.

Firm Specific Factors

The last group is the firm specific factors.  There are four firm specific factors considered as predictors of gray market activity.  These include the size of the firm, its growth strategy, channel development requirements, and control systems.

Size of the Firm

Several studies have looked at potential proxies for firm size, such as available resources and management experience (Meyers, 1999; Kirpalani and Macintosh, 1980).  While these proxies may relate in some way to company size, large firms also face limited resources or may be new to the export market.  Company size is an important variable to consider because studies have shown a correlation between firm size and export marketing effectiveness (Kirpalani and Macintosh, 1980).  Smaller firms, with less developed distribution channels, may have fewer problems with upset distributors because these distributors have fewer competitors.  The fifth hypothesis links company size to gray market activity:

H₅: There is an inverse relationship between company size and the level of gray market activity allowed by the company.

Growth Strategy

The next firm specific variable to consider is growth strategy.  Some firms, particularly in the high technology market place, use a high growth strategy to obtain market share (Gupta and Wilemon, 1990).  These firms may develop the strategy to use gray market activity and trade short-term profits to increase market share (Cavusgil and Sikora, 1988; Cespedes et al. 1988; Ciber Working Papers, 1995; Meyers, 1999).  Further, in a rapidly changing technology environment and rapid product development cycles, a short-term trade off may span the entire lifecycle of some products.  With this in mind, the sixth hypothesis states:

H₆:  There is a direct relationship between a company’s growth strategy and gray market activity.

Channel Development

Channel development is important to firms that do not vertically integrate their distribution channels.  Bello and Gilliand (1997) found that monitoring a distributor results lead to higher export channel performance.  However, they also found that firms that did not invest adequate managerial and financial resources were less able to influence their distributors marketing methods and procedures.  In a separate study, Myers (1999) found two channel variables that led to increased gray market activity.  First, he found that a reduced amount of distributor control would increase gray market activity.  Next, he found that lower channel integration also increased gray market activity.  Therefore, if a company decides not to integrate fully and does not apply enough resources to control of the distributor, the result could be increased gray market activity.  With the higher costs associated with rapid new product development and increased competition a company may invest in product development rather than distributor controls (Gupta and Wilemon, 1990).  A company that does not invest in distribution channels to maintain or increase revenues may use any channels available, even the gray market.  Therefore:

H₇:  There is a direct relationship between the resources required to establish authorized distribution channels and a company’s willingness to encourage gray market activity.

Control Systems

Long term gray market activity is associated with problems for firms and their distribution channels (Cavusgil and Sikora, 1988, Meyers, 1999).  Other studies have shown that external factors, such as currency fluctuations, usually mean some gray market activity will be present  (Meyers, 1999; Palia and Keown, 1991).  At some point, because the level of gray market activity has become intolerable, a company will want to curb the level of gray market activity (Cavusgil and Sikora, 1988).  The authors provide a number of strategies within a firm’s control to prevent or curb gray market activity.  They mention various control systems such as warranty registrations, serial number tracking, etc. to track gray market activity and then take steps to curb it when levels reach intolerable levels.  Therefore, if most of the mechanisms required to control gray market activity are internal to the firm, the strength of a firm’s control systems may be a predictor of its willingness to engage in the gray market.  Therefore:

H₈:  There is a direct relationship between a company’s willingness to encourage gray market activity and its ability to stop or control gray market activity.

Table 1 below summarizes the operational definitions for this conceptual framework.  The one dependent variable is the level of gray market activity.  The eight independent variables include the rate of technology change, customer requirement changes, development cycle, product availability, firm size, growth strategy, required channel development resources, and control systems.

Table- 1

Variables and their definitions

Table 2 below lists the North American Industry Classification System (NAICS) codes (Office of Management and Budget, 1998) used to identify high technology products for this study.

Conclusions

Management in high technology manufacturing firms is under pressure to increase revenue in the short term and protect brand integrity in the long term (Lowe and McCrohan, 1989; Meyers, 1999).  This is a difficult balance to achieve, particularly in a rapidly changing environment with conflicting deliverables.  Companies may not enforce contracts written to prevent gray market activity in order to reduce unit costs through increased production levels (Cespedes et al. 1988).  As the authors relate, this allows large customers to sell excess inventory to low volume unauthorized dealers for more than their cost thus reducing their costs and unloading the extra inventory at a small profit.

It is important for management to understand the different mechanisms that control the gray market.  The general belief holds that price is a main driver for gray market activity (Assmus and Wiese, 1995; Cespedes et al. 1988; Lowe and McCrohan, 19890).  However, other factors such as product availability and the level of technology change can increase demand in established markets or create new markets (Sarkar et al. 1999).  This in turn can lead to gray market activity to meet market demand that is not satisfied through authorized channels (Champion, 1998; Meyers, 1999).

This study focused on the marketing issues of gray market activity.  Future studies could include the effects of gray market sales on after sales support, logistics, manufacturing, and other operational functions within the firm.  While this study explored the effects of gray market on high technology products, future studies could investigate the effect of gray market activity on high technology services.

It is obvious there is demand for gray market goods.  Future studies, therefore, should consider the demand side of the gray market phenomenon.  Conventional wisdom focuses on price as the primary variable for gray market demand (Assmus and Wiese, 1995; Cespedes et al. 1988; Lowe and McCrohan, 1989).  However, other variables should be investigated such as product availability, a country’s level of economic development, country of origin stereotypes, designer labels, perceived quality, product uniqueness amongst others.  Management can benefit by a better understanding of the demand drivers for gray market activity.  In this way, it can better control the phenomenon to meet company goals.

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Russell E. Blahetka

Doctoral Candidate, Business Administration,

California Campus of the University of Sarasota

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