Romana L. Autrey () (Harvard Business School, Accounting and Management Unit) Francesco Bova () (Rotman School of Management, University of Toronto)
Abstract
Gray markets arise when a manufacturer's products are sold outside of its authorized channels, for instance when goods designated for a foreign market are resold domestically. One method multinationals use to combat gray markets is to increase internal transfer prices to foreign subsidiaries in order to increase the gray market's cost base. We illustrate that, when a gray market competitor is present, the optimal price for internal transfers not only exceeds marginal cost, but is also a function of the competitiveness of the upstream economy. Moreover, the presence of a gray market competitor may cause unintended social welfare consequences when domestic governments mandate the use of arm's length transfer prices between international subsidiaries. When markets are sealed, arm's length transfer pricing strictly increases domestic social welfare. In contrast, we demonstrate that when a gray market competitor is present, mandating the use of arm's length transfer pricing decreases domestic social welfare when the domestic market is sufficiently large relative to the foreign market. Specifically, a shift to arm's length transfer pricing erodes domestic consumer surplus by making the gray market less competitive domestically, which in turn may offset any domestic welfare gains that accompany a shift to arm's length transfer pricing. Finally, the analysis illustrates that in a gray market setting, the transfer price that maximizes a multinational's profits may also be the same one that maximizes the social welfare of the domestic economy that houses it.
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Find related papers by JEL classification: M41 - Business Administration and Business Economics; Marketing; Accounting - - Accounting - - - Accounting D43 - Microeconomics - - Market Structure and Pricing - - - Oligopoly and Other Forms of Market Imperfection F23 - International Economics - - International Factor Movements and International Business - - - Multinational Firms; International Business
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