Gray Markets and Multinational Transfer Pricing
Executive Summary — Gray market goods are brand-name products that are initially sold into a designated market but then resold through unofficial channels into a different market. Gray markets can arise when transaction and search costs are low enough to allow products to "leak" from one market segment back into another. Examples of industries with active gray markets include pharmaceuticals, automobiles, and electronics. Understandably, reactions to gray market encroachment are mixed. On the one hand, consumer advocates and governments have applauded the increasing role that gray markets have played in improving competition for domestic goods. On the other hand, multinationals have decried the increasing role of gray markets in the economy, with an estimated $40 billion in cannibalized sales resulting from gray markets in the information technology sector alone. This study investigates the optimal price of a multinational's internal transfers and the consequences of regulations mandating arm's-length transfer pricing. Key concepts include:
- A shift to arm's-length transfer pricing erodes domestic consumer surplus by making the gray market less competitive domestically.
- In the presence of a gray market, 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.
- Arm's-length standard enforcement efforts targeting multinationals that observe little product leakage from foreign markets or that operate in domestic markets that are sufficiently competitive may lead to net welfare gains for the domestic economy.
- At the same time, focusing arm's-length standard enforcement efforts on multinationals that work in industries where gray markets provide the only means of domestic competition may make the domestic economy worse off.
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 exceeds marginal cost, but decreases in the competitiveness of the domestic economy. Moreover, we illustrate that gray markets may cause unintended social welfare consequences when domestic governments mandate the use of arm's length transfer prices between international subsidiaries. Specifically, a shift to arm's length transfer pricing erodes domestic consumer surplus by making the gray market less competitive domestically. Under certain circumstances, the domestic welfare destruction arising from this erosion dominates the 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. Keywords: Transfer pricing, gray markets, regulation.