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Regional Pricing and the Grey Markets

Companies often establish the price of its products and services tailored for specific markets willingness to pay based on different levels of perceived value. Although this is a valid strategy to try to maximize profits, there is a risk behind it which can jeopardize the ability of the firm to sustain premium prices at most profitable markets. A good example of this issue is the pharmaceutical products price differences between Canada or Mexico and the United States. Or electronics prices in Panama compared to Venezuela or Brazil .

The problem could be increased when products are priced for optimization of volume. This strategy may be helpful to increase market share in a global basis, but can lead to a massive price reduction with the current trend of easier and reduced costs of communication and transportation across the globe, reducing transaction costs.

These situations are complicated, but they are still under a company control. At least, it has the ability to set prices accordingly with its strategies and goals. A worse scenario may arise when we start to see gray market practices due to other causes than prices set by the firm. In fact, very often grey market opportunities are out of control.

Grey Market Opportunities

In a traditional market dynamics processes, a manufacturer would buy raw material, build the product, and sell to a distributor, retailer or final customer. The same processes would apply for an exporter or a transnational company shipping its products to its affiliates across the globe, setting the target and minimum prices for each of its markets. Given the above process, grey markets could happen in the following situations:

Diversion

An independent legal merchant (import/export company) could find a product that is sold in a developed market, cheaper in another, more price sensitive country, and legally import it to where the customers pays a premium for it. (Figure 1 - Diversion)

Figure 1: Diversion

Note in the figure 1 above that the arbitrage would be $40 ($100 - $60) from country B to country of origin; $30 ($60 - $30) from country C to country B; and $70 ($100 - $30) from country C to country of origin.

Illegal Diversion

In this case, the product is brought to the high paying country illegally through consumers or illegal import or export transactions, usually seen in less developed countries, with low customs control.

Other Grey Market Opportunities

Stolen Goods

Other possibility to create a grey market is when some merchandise is stolen. Having access to products for "free" allows the opportunity to have those items into the same market for a much lower price.

Selling Samples or Donations

It is known that in certain industries with low variable costs, samples distribution is a common practice to promote a new product or to give a boost in selected brands. However, seldom a manufacturer has a strong control of the distribution of those samples and cannot guarantee if all were given away or if some were sold as regular products.

There are still other opportunities, like counterfeit products, but those are out of the scope of this article.

Assessing the Risk

Out of the grey market opportunities shown above, the one that could bring more problems to a company is the first one, diversion caused by its own pricing policies (or lack of them). After all, how could you justify that a product, imported legally to a less price sensitive country can be found cheaper through an independent channel than through your own distribution channel? This practice if widespread can harm all pricing initiatives that the company might have to this high price, premium market.

It is not enough to just look at company selling prices across countries (or regions) to determine the risk of diversion. It is imperative to take into consideration transaction costs. That is, costs incurred such as transportation, taxes, fees, customs, storage, etc. Looking again at figure 1, and assuming that transactions costs for any of those imaginary countries would be $30, immediately we could assume that diversion from country C to country B would not exist simple because there will be no profit left out of this commerce. On the other hand, the risk of happening between country C and country of origin can be assessed as still very high.

What to Look for

The first step in order to better understand the risk of diversion a business has is to analyze the current average selling prices across countries. The goal is to look for huge differences. Figure 2 below shows the average selling prices of one product being sold across Latin America of a transnational pharmaceutical company.

Figure 2: Average Selling Prices across Latin America and Reference Price in the US

Note inside the circle the countries with the lowest average selling prices. Hence, we could expect that if there is any risk of diversion, the highest rates would be on those countries.

The second step to better understand and evaluate the diversion risk involves a volume analysis. This is done in two phases. The first one compares the volume per capita of the product across those countries. See figure 3 below showing volume per capita.

Figure 3: Volume Per Capita

Note that even Peru's consumption per capita is lower than the US, however, much bigger than its neighbors. In fact, Peru volume is above the group mean plus one standard deviation.

The second phase narrows the volume analysis to where the problem seems to exist. It is unlikely that a developing country like Peru has almost the same consumption per capita than the USA. Therefore, a historical volume is run to determine if this is a sustained volume or if any surge or drop in units occurred recently. In this specific case nothing was found, as volumes were fairly constant over time. However, this is a good indicator when a significant change in volume can be identified.

The final step is to estimate the potential that is under risk. That is, how much volume can be coming back from