Organizational Structure and Gray Markets
46 Pages Posted: 4 Feb 2011 Last revised: 5 Jun 2014
Date Written: June 2, 2014
Conventional wisdom suggests that when firms face a negative externality like gray marketing (i.e., the selling of branded goods outside of the manufacturer's authorized channels), an effective strategy to reduce the negative impact is to centralize decision-making (Varian 1992). Nevertheless, in industries with significant gray marketing, we observe many firms with decentralized decision-making. Our study assesses whether decentralized decision-making can be optimal when a manufacturer faces gray market distribution. We consider a market where a focal firm competes with an existing competitor that produces a differentiated product and a gray marketer that sources an identical product from a lower-priced foreign market. We find that decentralization is optimal under quantity-based competition, provided the gray market is relatively uncompetitive and the level of competitive intensity between the focal firm and competitor is high. Decentralization leads a firm to make aggressive production decisions which leads to lower prices, yet it also leads to higher market share for the firm compared to centralization. When the level of competitive intensity between a firm and its competitor is high, the gain in market share more than offsets the loss due to lower prices. As a result, the focal firm is better off decentralizing its operations independent of a) whether the competitor operates in the foreign market and b) the competitor's organizational structure. This finding contradicts the belief that centralized decision-making is always optimal when authorized manufacturers attempt to limit the negative impact of gray markets. The findings also provide insight to understand why firms might employ decentralized decision-making in industries where gray markets are active.
Keywords: Gray Markets, Diversion, Foreign Market Entry, Organizational Structure
JEL Classification: M30, M31, M40, M41, D40, D43
Suggested Citation: Suggested Citation