Gray Markets and Multinational Transfer Pricing

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.