Gray Markets, a Product of Demand Uncertainty and Excess Inventory

Abstract

Diverting large quantities of goods from authorized distribution channels to unauthorized or “gray market” channels, albeit legal, significantly affects both firms and consumers due to effects on price, revenue, service and warranty availability, and product availability. In this paper we consider mechanisms by which the uncertainty surrounding inventory ordering decisions drives gray markets. We start with a minimal stochastic supply chain model composed of a producer and a retailer; then we restructure the model to add a distributor whereby the distributor and authorized retailer have the option of diverting inventory to a gray market. Our analysis sheds light on three issues: impacts of diversion on the various supply chain participants, strategies producers could use to combat or exploit gray markets, and important considerations for authorized retailers trying to set optimal order quantities in the presence of a gray market. Our analysis yields new insights into the behavior and impact of gray markets, which can inform management strategies and policies for confronting them.