Copyright

Xueying Liu

2020
 ABSTRACT

Pricing Strategies in Competitive Environments

by

Xueying Liu

This thesis studies multiple pricing strategies in different competitive

environments. It provides an in-depth analysis of pricing, customization, and

product quality in oligopoly settings. The first essay investigates the pricing and

optimal customization level in different market structures. The second essay

examines the optimal product quality and pricing for different channel structures in

the presence of gray markets.

The continued development of new technologies has allowed firms to

address the individual needs of their customers better. The first study in this

dissertation examines firms’ choices regarding the range of customized products

they offer and their impact on optimal pricing and profits in a competitive

environment. Customization is increasingly important; with the development of

manufacturing and information technologies, firms can customize products to fit

their consumers’ individual needs at a reasonable price. Most of the research about

customization characterizes optimal pricing. In this chapter, I address not only

pricing but also the optimal “amount,” or level, of customization.

Firms decide on the optimal amount of customization (called the “range of

customization lengths”) that they offer their consumers. I investigate different

competitive situations and the range of customization and pricing strategies that

arise in them.

I show that when two firms compete, they may find themselves in a

“prisoner’s dilemma” type of situation. Both will offer customized products in

equilibrium, leading to lower profits than without customization. This chapter

further shows that, when more than two firms compete, the symmetric a-priori

firms can end up in a state of asymmetric customization equilibrium, a phenomenon

that few researchers had previously directly explored.

It is important to note that customization costs have two components:

technology (convex) and per-product (linear). My most important finding is that

equilibrium outcomes depend on cost in a particular way. If the per-product

customization cost is low enough, firms will offer a range of customized products

regardless of how expensive the customization technology is. As the per-product

customization cost increases, there are fewer firms customizing in the equilibrium.

In the second study, I explore pricing in the presence of gray markets. Gray

market products are original products that are sold through an unauthorized

channel. They tend to have lower prices because consumers view them as lower

quality even though they are authentic. Taking this into account, very little research

has ever examined whether manufacturers should change the offered products’

quality, given their knowledge that gray markets exist.

Most papers examine manufacturers’ pricing in the presence of the gray

market and show ambiguous results. The manufacturer can be better off because
gray markets increase the demand for their products and allow for better

segmentation. However, they can be worse off because gray markets also lower

their sales, the loss of which is not compensated for by the gain of selling through

the gray marketer. This chapter expands on the previous literature by making

quality choices endogenous. I show that, when the manufacturer sells directly to

consumers, gray markets have a negative effect on both price and quality of

products as well as manufacturer profits. However, when the manufacturer sells

through a distribution channel, the quality of the offered products and the

manufacturer’s and retailers’ profits can increase regardless of the source of the

gray market goods. My study further shows, as expected, that gray markets always

increase the total consumer surplus.

 Acknowledgments
I am indebted to my committee chair, Professor Amit Pazgal. His guidance

and encouragement helped me overcome many difficulties during my doctoral

studies. I would also like to express my appreciation to Professor Sharad Borle,

Yuxin Chen, Dinah Cohen, and Peter Hartley for their invaluable support and advice.
 Contents
Acknowledgments ...................................................................................................... v
Contents ................................................................................................................... vi
List of Figures ...........................................................................................................viii
List of Tables .............................................................................................................. x
Competitive Product Customization in a Multimarket Environment ............................ 1
1.1. Introduction .............................................................................................................. 2
1.2. Literature Review ..................................................................................................... 7
1.3. Benchmark model .................................................................................................. 12
1.3.1. Firms ................................................................................................................ 12
1.3.2. Timeline ........................................................................................................... 13
1.3.3. Customers ........................................................................................................ 15
1.4. Equilibrium analysis ................................................................................................ 15
1.4.1. Subgame CC ..................................................................................................... 16
1.4.2. Subgame CN ..................................................................................................... 20
1.4.3. Subgame NN .................................................................................................... 21
1.4.4. Equilibrium customization strategies .............................................................. 21
1.4.4.1. Competitive customization in a three-firm environment ......................... 23
1.4.4.2. Three symmetric firms are competing in three markets .......................... 24
1.4.4.3. Three asymmetric firms competing in two markets ................................. 32
1.5. Model Extensions ................................................................................................... 35
1.5.1. Four symmetric firms ....................................................................................... 35
1.5.2. Uniform pricing for customized products ....................................................... 37
1.6. Conclusion .............................................................................................................. 42
The Impact of Gray Markets on Product Quality and Profitability .............................. 47
2.1. Introduction ............................................................................................................ 48
2.2. Literature Review ................................................................................................... 53
2.3. Model and Analysis ................................................................................................ 57
2.3.1. Gray Market ..................................................................................................... 64
2.4. Distributing via Retailers ........................................................................................ 67
 vii

2.5. Model Extensions ................................................................................................... 77

2.6. Discussion and Conclusion ..................................................................................... 83
References ............................................................................................................... 87
Appendix A .............................................................................................................. 93
Appendix B............................................................................................................. 115
Appendix C ............................................................................................................. 138
 List of Figures
Figure 1.1 The timeline of the game. ............................................................................... 14

Figure 1.2 Illustration of the "both firms customize" scenario (CC) in the
benchmark model. Both firms offer partial customization ranges, meaning
that there are consumers (in the middle of the Hotelling line) who have to
p cha e he con en ional p od c When he fi m c omi a ion ange
co e he Ho elling line comple el e a fi m offe f ll ange
c omi a ion ....................................................................................................................... 17

Figure 1.3 Illustration of the "only F_1 customizes" (CN) scenario in the
benchmark model .................................................................................................................. 18

Figure 1.4 Optimal customization ranges in subgame CC (t=1) ............................. 20

Figure 1.5 Equilibria in the benchmark (duopoly) model (t=1)............................ 22

Figure 1.6 Several firms/markets configurations are analyzed in the paper .. 24

Figure 1.7 Equilibria outcomes in case of three symmetric firms competing in

three markets (t=1) ............................................................................................................... 27

Figure 1.8 F3's profits in subgames CCC and CCN (a=0.8, t=1) ................................ 29

Figure 1.9 𝑭𝟏's profits in all subgames (a=0.8, t=1) ................................................... 31

Figure 1.10 𝑭𝟏's customization range lengths in subgames CCC and CCN (a=0.8,
t=1) .............................................................................................................................................. 32

Figure 1.11 Equilibria outcomes in case of three firms competing in two

markets (t=1) ........................................................................................................................... 34

Figure 1.12 Equilibrium outcomes for the case of four symmetric firms
competing in six markets (t=1) ......................................................................................... 37

Figure 1.13 Illustration of the "both firms customize" scenario (CC) in the
model with uniform pricing ............................................................................................... 38

Figure 1.14 Different customization scenarios in the equilibrium CC, the model
with uniform pricing (t=1).................................................................................................. 40
 ix

Figure 1.15 Uniform vs. differentiated pricing: profit comparison ..................... 42

Figure 2.1 The parameters of the market model ............................................................ 63

Figure 2.2 The set of parameters for which quality and profits increase in the
presence of gray markets (without loss of generality we assume 𝑵𝟏 𝟏, 𝜽𝟏
𝟏) .................................................................................................................................................. 70

Figure 2.3 The set of parameters for which the manufacturer and both
retailers are better off .......................................................................................................... 72

Figure 2.4 The parameter set for which models with the quality dependent
marginal cost when the manufacturer sells directly to the market ..................... 79

Figure 2.5 The parameter set for which the market model exhibits consumer
heterogeneity .......................................................................................................................... 80
 List of Tables
Table 1.1 Key model elements for the related paper on customization. ............ 12

Table 2.1 The variables in the model (𝒊 𝟏, 𝟐) ........................................................... 64

 Chapter 1

Competitive Product Customization in

a Multimarket Environment

The continued development of new technologies has allowed firms to

address the individual needs of their customers better. For example, in 2018, fast

fashion firm Uniqlo introduced customized clothing to fit their consumers’ unique

needs, which allows Uniqlo to gain a competitive advantage by offering customized

fashion at a reasonable price.

While existing literature has focused solely on price competition between

customized products, we investigate firms’ choice of the range of customized

products and their impact on pricing in equilibrium. In a three firms model, we find

that a-priori symmetric firms may employ asymmetric customization strategies in

equilibrium, and we demonstrate that the presence of per-product customization

(PPC) cost (in addition to the overall cost of customization technology) drives this

result.
1
2
We also demonstrate that as long as the PPC cost is reasonable, all the firms

offer a range of customized products in equilibrium, regardless of how expensive

the customization technology is. As the PPC cost increases, fewer firms customize in

equilibrium.

Furthermore, in a two-firm model, the equilibrium where both firms offer

customized products is a prisoner’s dilemma. This result is generalizable to an

oligopoly setting where all firms make the highest profit if none of them customizes.

1.1. Introduction

Modern consumers are more and more looking for products that better

match their unique individual preferences, and the continued development of

manufacturing and information technologies has allowed firms to satisfy this need.

For example, in 2018, fast fashion firm Uniqlo strengthened its partnership with

Shima Seiki, a Japanese maker of machinery, in order to introduce customized

clothing to fit their consumers’ individual needs. This technology allows Uniqlo to

gain a competitive advantage by offering customized fashion at a reasonable price.

This approach is an example of what the literature calls “mass customization.”

With more and more firms engaging in the creation of customized products

for their customers, studying mass customization in a competitive environment

becomes increasingly important. For example, most major sporting shoe

manufacturers (Nike, Adidas, Reebok, New Balance, etc.) allow customers to

customize the running shoes to match their preferences.

3
Much of the extant research on mass customization in a competitive setting

have focused solely on price competition. In contrast, we investigate firms’ choice of

the range of customized products and their subsequent impact on pricing in

equilibrium. For example, Mars, Incorporated has initially decided to allow

customers to customize only the color of their M&M. Later on, with the development

of the technologies, they extended the range of customization to allow for

personalized writing, font, and even adding clipart or an image. However, they chose

not to enable the customization of size or flavor mixture. 1 Clearly, deciding on the

range of allowable customizations is an important decision preceding the pricing

stage. It involves learning about consumer needs and desires, as well as a hefty

investment in the technology that would allow seamless customizations. The

customization cost structure is another distinctive feature of our model. First, in

order to be able to offer customized products to customers, the firms need to invest

in customization technology. The longer the range of customized products the firm

can offer, the more expensive it is to the firm. We assume that firms incur a

customization technology cost, which is convex in the length of the customization

range. Think about the cost involved in acquiring the technology allowing Mars,

Incorporated to offer customization on multiple attributes of the candy. Second, we

assume there is an extra per-product cost to produce a customized product. In the

1 See https://www.mymms.com/
4
M&M example, that would be the cost of customized ink and packaging that comes

on top of the regular candy production cost.

Furthermore, in a competitive setting, this decision is not just cost-related

but has a strategic effect. If one firm offers a larger customization range, it will

appeal more to consumers and may sway them to buying from this firm. In

response, the competing firms will be tempted to increase their customization

ranges. But as we will demonstrate, this “customization race” may be detrimental to

all the customizing competitors.

In this paper, we take a game-theoretic approach and develop a model where

firms compete in a generalized Hotelling setting. We consider a four-stage game: In

the first stage, firms simultaneously decide whether to offer a single product or a

range of customized products. In the second stage, the firm(s) who decided to offer a

range of products choose(s) the length of the range. After observing each other’s

customization decisions, the firms make pricing decisions in stage 3. Finally,

consumers make purchase decisions in stage 4.

In a benchmark model, we consider a Hotelling line duopoly where

consumers’ tastes are uniformly distributed along a unit-length line. Usually, in a

Hotelling model, firms offer a single product each, located at the endpoints of the

Hotelling line. In our model, we allow each firm to decide whether to offer such a

single product (no customization) or to offer a continuous range of products (we

will refer to theses as customized products) anchored at the endpoints of the line. In

the benchmark model, we obtain the following results. Firstly, the per-product
5
customization cost is what determines whether firms choose to offer customized

products in equilibrium or not. If the per-product customization cost is low enough,

firms will provide a range of customized products regardless of how expensive the

customization technology is. That is, once the customization technology is available

to firms, they will choose to use it, as long as the per-unit customization cost is

reasonable. Intuitively, the more expensive is the technology, the smaller is the

range of customized products that firms offer, but firms always choose to offer some

customized products. Figure 1.1 illustrates this finding. Secondly, we demonstrate

that the equilibrium where both firms offer customized products is a prisoner’s

dilemma: both firms would be better off if they did not customize.

In the main model, we consider three firms, where every two firms compete

with each other on a Hotelling line. We demonstrate that similarly to the duopoly

setup, once the customization technology is available to firms, at least one of them

will choose to customize in equilibrium, regardless of how expensive the technology

is (but still assuming reasonable per-product customization cost).

Our main finding is that there exist asymmetric equilibria (where only one or

only two firms choose to customize) for a-priori completely symmetric firms. To the

extent of our knowledge, this finding is new to the literature. It is the inclusion of

realistic cost structure, the structure which incorporates both customization

technology and per-product customization cost, that allows us to observe this novel

result. The model without one of the cost components cannot explain the rich set of

strategies we observe in the real world – where some firms offer customized
6
products, and others in the same industry do not. That is, if there is no additional

per-product production cost for customized products, then the unique (and

symmetric) equilibrium is for all firms to offer a range of customized products.

As the per-product customization cost increases, fewer and fewer firms

choose to customize in equilibrium: that is, the gradual transition from the

equilibrium where all firms customize to where none customizes is observed. In one

of the extensions, we demonstrate that this result also holds for four firms

competing with each other, and can be extended to even more competing firms.

Further, we also demonstrate that the structure of the competitive market is

also important in the determination of equilibrium strategies. For example, the main

result of the paper (symmetric firms – asymmetric equilibria) only holds when each

of the firms competes with all other firms (i.e., when ALL the firms are symmetric).

If this is not the case, for example, in a three firms model where only firm 1

competes for each of firms 2 and 3 (while firms 2 and 3 do not compete with each

other), the symmetric firms 2 and 3 always employ symmetric strategies in

equilibriums: they either both customize or both don’t customize. Even though the

outcome where only one firm customizes or the outcome where only one firm does

not customize could occur in equilibrium, it is always firm 1, which chooses the

strategy different from that of the other two firms. And in this market structure, firm

1’s choice of a strategy being different from those of the other two firms is not

surprising, as firm 1’s competitive environment differs from those of firms 2 and 3.
7
The rest of the paper is organized as follows. We review the relevant

literature in the next section. In Section 1.3, we present the benchmark model to

highlight the strategic effect of the customization range decision in a duopoly

setting. In Section 1.4, we analyze the main model where 3 a priory symmetric firms

compete in several markets to demonstrate the effects of incorporation

customization cost and market structure. Section 1.5 presents two extensions: one

where the firms employ uniform pricing for their customized products (as opposed

to differentiated pricing considered in the main model), and another where we

increase the number of competing firms to show that the main results still hold.

Section 1.6 concludes the paper. Technical derivations are relegated to the Appendix

A.

1.2. Literature Review

In this section, we review marketing, economics, and operations

management papers related to our research.

Generally speaking, the notion of “product customization” is very broad and

includes all kinds of instances where a standard product offered by a firm is altered

in some ways to fit the individual needs of a customer. The concept of “product

customization” we focus on in our research is most closely related to that in Dewan

et all (2003): When the firm produces a single product, it is represented as a point

on the Hotelling line. When the firm adopts customization and offers a range of

products, it is represented as a segment on the line. As such, the product

8
customization is assumed to happen along with a single product attribute, and

consumer preferences for that attribute are viewed as uniformly distributed on a

Hotelling line.2 A similar customization concept is adopted by many other

researchers, for example, Syam and Kumar (2006), Alexandrov (2008), and

Takagoshi and Matsubayashi (2013).

In this paper, we study customization as a part of a firm’s competitive

strategy. Therefore the most relevant body of literature is the one that utilizes a

game-theoretic approach to analysis. There are two different types of competition

such literature considers: the competition between two customizing firms and the

competition between one customizing firm and one offering a standard product

only.

In our paper, we cover both types of competition by endogenizing the firm’s

decision to customize or not. It is a strategic choice for the firm, and this is why the

decision to customize or not is separate from the decision of how much of

customization to offer (which is more of a tactical decision). Mendelson and

Parlakturk (2008) adopt a similar approach and separate these two decisions into

two different stages of the game. They assume the firms are asymmetric with

respect to customization costs and product quality. They show that neither firms

adopt the customization when the asymmetry is small, while one firm adopts the

customization, and the other produces the conventional product when the

2 Hotelling (1929).
9
asymmetry is large. In contrast, we find that in the duopoly, both firms would

choose to customize regardless of how expensive the technology which provides the

ability to customize is (as long as the per-product customization cost is reasonable).

The rest of the relevant papers do not endogenize the decision whether to

offer a customized product or not and as such, they model competition between

either two customizing firms or one customizing and one offering a conventional

product. These papers focus on the tactical decision of how much to customize: the

length of the customization range and its implications for pricing and profits.

For example, Dewan et al. (2003) consider competition between two

symmetric customizing firms located on a circle who chose the optimal length of

customization range. Their cost structure is similar to ours: firms incur the convex

cost when increasing the customization range and the linear per-product cost when

offering each customized product. Dewan et al. (2003) show that the simultaneous

adoption of customization in a duopoly reduces the differentiation between their

standard products but does not intensify price competition. They also investigate

the customization strategy as a market entry deterrent.

Syam and Kumar (2006) develop a duopoly model with two different

consumer segments on a Hotelling line, which differ in their transportation cost.

They find that when the difference in transportation costs between the two

segments is large, firms engage in asymmetric customization, they follow symmetric

customization strategy when the difference is moderate, and offer no customization

when the difference is small.

10
Alptekinoglu and Corbett (2008) focus on two firms following exogenously

determined asymmetric strategies: one can offer a customized product to any

customer on the Hotelling line, whereas the other offers a finite set of conventional

products in the same space. They study conditions under which a firm that sells

conventional products can coexist with one that sells custom products, despite a

potential cost disadvantage. They show that competition lowers the variety of

conventional products offered by the non-customizing firm (as compared to the

monopoly case).

Takagoshi and Matsubayashi (2013) consider the competition of product

customization between two branded firms. The location of each firm’s conventional

product is exogenously given, and each firm chooses the optimal customization

range from its conventional product. They find that a firm is better off extending the

customization range in the direction of the center of the market (the consumers are

uniformly distributed on a Hotelling unit square, where the horizontal dimension

represents product attribute preference, and vertical represents the brand

preference).

While the abovementioned papers have considered competition between

customizing and non-customizing firms, our paper is the first (to the extent of our

knowledge) to go beyond the duopoly setup. Turns out that adding just one more

firm to the competition brings novel insights, such as asymmetric equilibria for

completely symmetric firms and uniform markets. Although Syam and Kumar

(2006) also find that symmetric firms can employ asymmetric strategies in
11
equilibrium, their result is explained by the existence of two different types of

consumers.

When addressing the optimal pricing of customized products, the existing

papers fall into two categories: those that assume a single uniform price for all

customized products (e.g., Alptekinoglu and Corbett (2008), Syam et al. (2005), and

Xia and Rajagopalan (2006)), and those that allow the competing firms to set the

optimal price for each of the customized products it offers (e.g., Mendelson and

Parlaturk (2008), Wind and Rangaswamy (2001), and Dewan et al. 2003)). In our

paper, we analyze both pricing strategies and demonstrate that uniform pricing

might improve firms’ profitability. We also show that when uniform pricing strategy

is employed, the range of customized products offered by a firm is wider than the

range of actually purchased customized products. In contrast, under the

differentiated pricing strategy, each customized product offered by a firm is

purchased by at least one customer.

In Table 1.1, we compare and contrast four key model elements of the most

relevant papers. As can be seen, our paper is the only one going beyond duopoly

setup, and the only one that both has the realistic two-component cost structure and

explicitly allows firms to make the strategic choice to customize or not.

 12
Table 1.1 Key model elements for the related paper on customization.

Market structure Decision whether Pricing of Customization

to customize customized cost
products structure
Symmetric Asymmetric Oligopoly Endogenous Exogenous Differentiated Uniform Linear Quadratic
duopoly duopoly (symm. &
asymm.)
This paper
Dewan et al. (2003)
Syam and Kumar (2006)
Alptekinoglu and Corbett
(2008)
Mendelson and Parlaturk
(2008)
Takagoshi and
Matsubayashi(2013)

1.3. Benchmark model

1.3.1. Firms

We begin by considering a duopoly model with two symmetric firms,

denoted 𝐹1 and 𝐹2 . We adopt a standard Hotelling line model where consumers’

tastes are uniformly distributed along the unit-length line. Usually, in a Hotelling

model, firms offer a single product each, located at the endpoints of the Hotelling

line. In our model, we allow each firm to decide whether to offer such a single

product or to offer a continuous range of products, anchored at the endpoints of the

line.

Figure 1.2 depicts the model setup as follows: Firm 𝐹1 offers the range of

products fitting the tastes of consumers located between 0 and 𝑙1, while Firm 𝐹2

offers the range of products fitting the tastes of consumers located between 1 𝑙2
13
and 1. We refer to these products as “customized products.” Conditional on firm’s

decision to offer a range of customized products (as opposed to a single product),

the length of customization range (𝑙1 and 𝑙2 ), are the firms decision variables. We

limit our attention to the cases where 𝑙1 𝑙2 1, which means that there exist

consumers (specifically, with tastes located between 𝑙1 and 1 𝑙2 , whose ideal

product is not offered by either firm.

In order to be able to offer customized products to customers, firms need to

invest in customization technology. The longer the range of customized products the

firm is able to offer, the more expensive it is to the firm. We assume that firms incur

a convex customization technology cost; specifically, the cost is quadratic in the

length of the range: 𝐹 incurs the cost 𝑎 ∙ 𝑙 2 , where 𝑎 is the customization technology

cost parameter.

Additionally, we assume there is the per-product customization cost denoted

𝑏. The per-product customization cost 𝑏 is incurred only once if and when a specific

customized product is bought by consumers. That is, if no consumers buy a specific

customized product, the firm does not incur cost 𝑏 for this product, but if more than

one customer buys this specific customized product, the cost 𝑏 is only incurred for

this product once.

1.3.2. Timeline

The competition between the two firms evolves in four stages. Figure 1.1

depicts the competition timeline. In the first stage, firms simultaneously decide
14
whether to offer a single product or a range of customized products. This decision is

similar to the firms’ first-stage decision to mass customize or not in Mendelson and

Parlakturk (2008a). The higher level strategic decision, to offer customized products

or not in our case, precedes the tactical decision of exactly how wide the range of

customized products should be.

In the second stage, the firm(s) who decided to offer a range of products

choose(s) the length of the range. After observing customization decisions, the firms

make pricing decisions in stage three. Finally, consumers make purchase decisions

in stage four.

Figure 1.1 The timeline of the game.

Let 𝑝 𝑦 denote the price of a customized product 𝑦 offered by firm 𝑗 and

fitting the customer’s taste located at point 𝑦. Let 𝐵 𝑦 denote the number of

consumers who bought the customized product 𝑦 from firm 𝑗. Then firm 𝑗’s profit

can be expressed as follows:

1
𝛱 ∫0 𝐵 𝑦 ∗ 𝑝 𝑦 𝑑𝑦 𝑎 ∗ 𝑙 2 𝑏∗𝑆,
15
Where 𝑆 is the number of customized products offered by firm 𝑗 that were

1 I B ( y) 0
I B ( y) 0
purchased by at least one customer: 𝑆 ∫0 j
𝑑𝑦, where j
is an

indicator function which takes the value of 1 if the customized product 𝑦 was bought

B j ( y) 0
at least once ( ), and 0 otherwise.

1.3.3. Customers

As in the standard Hotelling model, we assume that each customer buys at

most one unit of the product from one of the firms. The utility a customer whose

ideal product is located at point 𝑥 derives from purchasing a customized product 𝑦

offered by firm 𝑗 is as follows:

𝑈 𝑥, 𝑦 𝑉 𝑝 𝑦 𝑡 ∗ |𝑥 𝑦|.

Here, 𝑉 is the consumer willingness to pay for her ideal product (i.e., the one

that fits her tastes perfectly, e.g., a customized product 𝑥 if it exists), and 𝑡 is the

disutility per unit difference between consumer’s ideal product 𝑥 and the product 𝑦

that she is considering. We assume that 𝑉 is high enough so that the market is fully

covered, meaning that every consumer buys a product.

1.4. Equilibrium analysis

We solve the model using backward induction, leading to a subgame perfect

equilibrium. Three distinctive subgames stem from firms’ decisions at stage 1

(whether to offer a single product or a range of customized products):

16
(1) Subgame CC: Both firms offer a range of customized products.

(2) Subgame CN: One firm offers a range of customized products, and the

other offers a single product. 3

(3) Subgame NN: Both firms offer a single product.

We analyze each of those subgames separately.

1.4.1. Subgame CC

Dewan et al. (2003) have demonstrated that the optimal pricing scheme for

any customized product 𝑦 is as follows: 𝑝1 𝑦 𝑝1 𝑡|𝑙1 𝑦 | and 𝑝2 𝑦 𝑝2

𝑡|1 𝑙2 𝑦 |, where 𝑝 is the price of the last product in the customization range.

This pricing scheme implies the following:

(1) The customers whose tastes are located between 0 and 𝑙1 will buy
customized products from firm 1; and customers whose tastes are located
between 1 𝑙2 and 1 will buy customized products from firm 2 (see Figure
1.2). Each of those customers will buy the customized product that fits that
person’s taste exactly. This is because a customer with a taste located at
point y is (a) indifferent between buying the customized product y and any
other customized product offered by the same firm and located between
point y and the endpoint of the customization range, and (b) strictly prefers
product y to the products located between point y and the firm’s location.

3 Since the firms are symmetric, it is without loss of generality that we can assume that the

firm offering the range of products is 𝐹1 , and the firm that offers a single product is 𝐹2 .
17
(2) Since there are no customized products fitting the customers’ tastes between
𝑙1 and 1 𝑙2 , these consumers will be choosing between products located
at points 𝑙1 and 1 𝑙2 .

We refer to products located at points 𝑙1 and 1 𝑙2 as “conventional

products” since they are purchased by more than one customer each. Note that all

other customized products are each purchased by a single customer.

Figure 1.2 Illustration of the "both firms customize" scenario (CC) in the
benchmark model. Both firms offer partial customization ranges, meaning
that there are consumers (in the middle of the Hotelling line) who have to
purcha e he con en ional p od c When he fi m c omi a ion ange
co e he Ho elling line comple el e a fi m offe f ll ange
c omi a ion
18

Figure 1.3 Illustration of the "only F_1 customizes" (CN) scenario in the
benchmark model

Solving the game in backward induction fashion, we start at the last stage,

where consumers make their purchase decisions by maximizing their utility. By

equating a customer’s utility from buying a conventional product from 𝐹1 with

buying a conventional product from 𝐹2 , we find the consumer indifferent between

the two. It is the consumer whose tastes are located at

l1 1 l2 p1 p2
x .
2 2t

At the third (and previous) stage, the firms make pricing decisions. Note that

with the optimal pricing scheme described by Dewan et al. (2003), the firms only

pj
need to set the price of their conventional product, . The firms’ profit functions at

this stage are as follows:

19
l1
CC
1 p1 x l1 p1 t (l1 s ) ds a l12 b l1 ,
0
1
CC
2 p2 1 l2 x p2 t ( s 1 l2 ) ds a l22 b l2 .
1 l2
(1)

Solving FOC with respect to prices, we obtain optimal prices as functions of

customization range lengths li as follows:

t
pi (l1 , l2 ) 3 li l3 i .
3 (2)

Continuing in the backward induction fashion, consider the second stage,

when each firm chooses the optimal length of its customization range, li . The firms’

profit functions at this stage are as follows:

(10li 2 2li (3 l3 i ) (3 l3 i ) 2
i (l1 , l2 ) t li b li a .
18

Solving for the equilibrium customization range lengths, we obtain them to

be:

1 𝑡
1/2, 𝑖𝑓 𝑎 5𝑡 6𝑏 and 𝑏 full customization range)
6 3
∗ 1 𝑡
𝑙i 0, 𝑖𝑓 𝑎 5𝑡 6𝑏 and 𝑏 effectively no customization)
6 3
𝑡 3𝑏
, o/w partial customization range)
6𝑎 3𝑡
20
Figure 1.4 illustrates those three regions in (a.b) cost parameter space.

Substituting those into optimal prices (Equation (1)) and profit functions (Equation

(2)), gives us the equilibrium profits and prices are shown in the proof of

Proposition 1 in Appendix A.

Figure 1.4 Optimal customization ranges in subgame CC (t=1)

1.4.2. Subgame CN

In this subgame 𝐹1 is the only firm offering the range of customized products,

while 𝐹2 offers a single (conventional) product. The customized products’ pricing

scheme described above still applies. Figure 1.3 illustrates this subgame: customers

with tastes located between 0 and l1 are purchasing customized products (perfectly

fitting their tastes) from 𝐹1 , customers with tastes located between l1 and x are

purchasing the conventional product from 𝐹1 (located at l1 ) and customers with

tastes located between x and 1 are purchasing the conventional product (located at
21
the “1” endpoint of Hotelling line) from 𝐹2 . In this subgame, the expression for 𝐹1 ’s

profit as a function of its prices and customization range length is the same as in

CN
subgame CC (see Equation (1)), while 𝐹2 ’s profit is simply 2 p2 1 x .

The derivation of optimal prices and customization range l1 are similar to

subgame CC, and the equilibrium profits, prices, and customization range are

summarized shown in the proof of Proposition 1 in the Appendix A.

1.4.3. Subgame NN

This subgame is the standard Hotelling model where firms (and the products

they offer) are located at the endpoints of the line. The optimal prices and profits for

this subgame are listed as shown in the proof of Proposition 1.

1.4.4. Equilibrium customization strategies

Following the backward induction, it is finally the time to focus on the first

stage of the game, where firms decide whether or not to offer customized products.

Proposition 1 describes the customization strategies firms choose in equilibrium.

Proposition 1.

(1) When two firms compete in a single market, the unique subgame perfect

equilibrium is either NN (when 𝑏 ) or CC (otherwise).

3

(2) The firms earn lower profits in outcome CC than in NN. Therefore

equilibrium CC ep e en a p i one dilemma

Part (1) of Proposition 1 (illustrated in

22
Figure 1.5) reveals that only symmetric equilibria exist when two symmetric

firms compete.

Figure 1.5 Equilibria in the benchmark (duopoly) model (t=1)

Note that, regardless of how high the customization technology cost a is, CC

is always the unique equilibrium as long as 𝑏 : in the bottom left region in

3

Figure 1.5, when the technology cost a is relatively small, both firms offer

the full range of customized products( i.e., every customer purchases a customized

CC
product ( l1 l2CC ½ )). Otherwise, the length of the range of the customized

products is strictly lower than ½ - i.e., the firms offer customization in a partial

range. The greater the technology cost a, the smaller is the range of customized

CC
products ( li is decreasing in a), but it is always non-zero as long as per-product

customization cost is reasonable (𝑏 3

).
23
Part (2) of Proposition 1 states that equilibrium outcome CC is a prisoner’s

dilemma, as the profit in outcome CC is always lower than the profit in outcome NN.

Since dual customization is detrimental to each firm’s profit, an increase in the cost

of customization benefits them, as it implies a decrease in customization ranges;

indeed, firms’ profits rise as customization cost parameters, a and b, increase.

Note that (a) the price of conventional products offered by 𝐹1 and 𝐹2 is the

same in both the CC and NN outcomes: it is equal to t; and (b) the range of

CC
customization, li , is increasing in t, the taste differentiation parameter.

Competition between the firms lessens with higher t. Therefore each firm can afford

to customize a longer range of products.

In the next section, we extend competitive structure by considering the

competition among three firms and focus on the unique additional insights which

the oligopoly setup allows us to observe.

1.4.4.1. Competitive customization in a three-firm environment

Now consider the environment where three firms are competing in the

marketplace. We focus on two scenarios:

(1) All three firms compete with each other, and therefore are completely
symmetric; the competition between each pair of firms occurs on a Hotelling
24
line of unit length,4 (i.e., the three firms compete on three lines/markets).
Figure 1.6 (iii) illustrates the corresponding market structure.

(2) One of the firms (say, 𝐹1 ) competes with each of the other two, but
these other two (𝐹2 and 𝐹3 ) do not directly compete with each other. In this
scenario, 𝐹2 and 𝐹3 are symmetric, but 𝐹1 is different. This market structure is
illustrated in Figure 1.6 (ii): Here, three firms compete on two lines/markets
(for comparison, the market structure of the benchmark model is depicted in
Figure 1.6 (i)).

First, we analyze the case of completely symmetric firms.

Figure 1.6 Several firms/markets configurations are analyzed in the paper

1.4.4.2. Three symmetric firms are competing in three markets

The market where 𝐹1 and 𝐹2 compete is denoted as 𝑚1 , the market where 𝐹2 and 𝐹3 compete is
denoted 𝑚2 , and the last one (𝐹3 vs 𝐹1 ) is 𝑚3 . We denote the length of customization range by

4 We focus on firms’ choices of customization strategy in equilibrium in different competitive

environments (two firms, three firms, symmetric/asymmetric), rather than on how the profits are
affected by an additional market participant. Therefore we do not normalize the total market size to
be 1, so compared to the benchmark model the market size is bigger here. Keeping the total market
size the same across all the various competitive market structures is a straightforward modification
of the model, and one can easily see that profits decrease as more firms compete in the market.
25
firm i in market j as l ji . As in the benchmark model, the conventional product offered by each

firm is located at the endpoint of its customization range. The price that firm i charges for the
conventional product in market j is denoted as p ji . The taste of a customer who is indifferent

between buying from the two firms competing in market j is denoted as x j .

As in the benchmark model, the game evolves in four stages. In stage 1, the firms
simultaneously decide whether or not they want to offer customized products. A firm who
decides to customize will then customize (i.e. choose the optimal customization range lengths in
stage 2) in both markets it is present in. For example, if 𝐹1 (l ca ed a he 0 end f he H elling
line representing the market 𝑚1 , and a he 1 end f 𝑚3 ) decides to customize, then its profit is
as follows:

l11 1
C
1 p11 x1 l11 p11 t (l11 s ) ds p31 (1 l31 ) x31 p31 t s (1 l31 ) ds
0 1 l31
2
a l11 l31 b l11 l31

Notice that if 𝐹1 decided to customize, its combined customization range is l11 l31
because it competes in two markets, 𝑚1 and 𝑚3 . And if 𝐹1 decides not to customize, then its
profit is simply

N
1 p11 x1 p31 1 x31 .

Due to the complete symmetry between the firms, there are only 4 distinctive subgames here:

(1) Subgame CCC: All three firms offer a range of customized products.

(2) Subgame CCN: 𝐹1 and 𝐹2 offer a range of customized products and 𝐹3 offers a
single product.

(3) Subgame CNN: 𝐹1 offers a range of customized products, while and 𝐹2 and 𝐹3
offer a single product each.

(4) Subgame NNN: All three firms offer a single product.

The derivation of the optimal pricing and optimal customization strategies in each subgame is
similar to that in the benchmark model so that we will relegate it to the Appendix A (proof of
Proposition 2). The next proposition presents the central result of our paper.
26
Proposition 2.

When three a-priori symmetric firms compete in three markets, then there

exists a unique5 equilibrium:

(1) If 𝑏 , then none of the firms offers customized products in equilibrium

3

17
(NNN is the equilibrium); if 𝑏 then all three firms customize in
57

equilibrium (CCC is the equilibrium);

17
(2) When per-product customization cost b is medium 𝑏 and
57 3

1
the technology cost a is large enough 𝑎 5𝑡 6𝑏 , then not only the
12

symmetric outcome CCC but also the asymmetric outcomes where only one or

two firms customize (CNN and CCN) can be the equilibrium (which specific

outcome is the equilibrium is determined by the exact values of a and b).

Figure 1.7 illustrates Proposition 2. This proposition demonstrates that like

in the benchmark model, once the customization technology is out there, at least one

of the firms will choose to customize in equilibrium as long as the per-products

customization cost, b, is below 3. The key difference with the benchmark model,

though, is the fact that there exist asymmetric equilibria here, for a-priori symmetric

5 When we refer to “Only one firm customizes” as a “unique equilibrium”, it means that

outcomes where more or less firms customize are not equilibrium for the same parameter set.
However, since all three firms are symmetric, there are three possible outcomes where only one firm
customizes and each of them is equilibrium outcome for this parameter set.
27
firms. For these equilibria to exist, however, there must be a per-product

customization cost, and it has to be above a certain threshold.

Figure 1.7 Equilibria outcomes in case of three symmetric firms competing in

three markets (t=1)

1
Notice, that once a> 12 5𝑡 6𝑏 , then for small enough b all the firms

customize in equilibrium (CCC), but as b increases, one of the firms will stop

customizing – i.e., the equilibrium outcome will become CCN. Further increase in b

will lead to another firm opting out for offering a single conventional product to its

customers: i.e., CNN will become the equilibrium. Finally, when b is sufficiently large

(𝑏 ), none of the firms would offer customized products (NNN).

3

Proposition 2 is central to our paper because it demonstrates how crucial the

inclusion of the realistic cost structure is: incorporating both customization

technology and per-product customization cost is what allows us to observe this

28
novel result where a-priori symmetric firms employ asymmetric strategies in

equilibrium. The model without either of the cost components cannot explain the

rich set of strategies we observe in the real world – where some firms offer

customized products, and others in the same industry do not.

Let us take a closer look at the impact of per-product customization cost, b,

and provide the intuition for a gradual transition from all to none firms customizing

in equilibrium. As b increases, firms customize less and less (this statement is

formally proven in Lemma 2 below) as it becomes more expensive, and as a result,

profits of any customizing firm in any outcome except CNN increase in b (see Figure

1.8). Which is an interesting phenomenon in itself – it highlights once again that

competitive customization is detrimental for firms’ profits, and that’s why the

increase in customization cost is good for them as it calls for a smaller scope of

customization. Or one can look at it from another angle: as production technologies

evolve and customization becomes cheaper and cheaper for firms to implement on

the per-product basis (aka b is decreasing), the range of customized products that

firms offer grows, but the profits decrease!

This effect of per-product customization cost on firm’s profit also explains

firms’ incentive to stop customizing as b increases: note that each firm’s profit in the

case where all of them customize (CCC) is increasing in b at a lower rate as

compared to the profit of a single non-customizing firm, e.g. 𝐹3 in outcome CCN.

Therefore as b increases past a certain threshold, one of the firms will stop

customizing in equilibrium. Figure 1.8 schematically illustrates this observation.

29

Figure 1.8 F3's profits in subgames CCC and CCN (a=0.8, t=1)

But why does the rate of increase in b differ in those two outcomes? 𝐹3 does

not customize in outcome CCN, so b has no direct bearing on 𝐹3 ’s profit. The only

way b affects 𝐹3 ’s profit in CCN is through a competitor’s choice of customization

range. Lemma 2 will show that customization ranges become smaller with larger b,

which for non-customizing firm 𝐹3 means that the location of the indifferent

consumer’s taste moves further away from it, resulting in larger demand. Which is

why 𝐹3 ’s profit in CCN increases in b it benefits from its competitors offering fewer

customized products. Even though the same positive effect is present in CCC case

(the larger the b, the less the competitors customize), there is also the direct

negative effect of overall higher customization cost since 𝐹3 does customize itself in

CCC. Which is what explains the slower overall increase in 𝐹3 ’s profits in CCC case as

compared to the CCN case.

30
The same logic applies to the transition from CCN to CNN equilibrium: the

profit of a customizing firm in case CCN (e.g. 𝐹2 ) is increasing in b at a slower rate

than the profit of the same firm in the case where there is only one other firm

customizing (case CNN). Therefore with further increase in b, one of the two

customizing firms will stop customizing, resulting in a transition from CCN to CNN

equilibrium.

Lemma 1.

(1) Firms always make a lower profit when all three are customizing as compared to

the profit when all three do not customize.

(2) The sole customizing firm, 𝐹1 in CNN, makes the highest profit, higher than

any firms in NNN. And this profit is decreasing in b.

The result in part (1) is parallel to the “prisoner’s dilemma” result in the

benchmark model. The result in part (2) essentially says that the only case when

customization is good for a customizing firm (as in, the firm’s profit is higher than in

NNN case, which is higher than profits in CCN or CCC) is when the firm is the sole

customizing firm, e.g. 𝐹1 in CNN outcome. And this is the only scenario where a

firm’s profit is actually decreasing in b. See Figure 1.9 below. The explanation for

why in outcome CNN – and only in this outcome – the profit of a customizing firm is

decreasing in b stems from the same “it is good for me because it is bad for my

competitor” intuition laid out above. In the CNN case, this positive effect of an

increase in per-product customization cost is not there because neither competitor

31
customizes. Only the negative impact through higher overall customization cost is

present. That is why𝐹1 ’s profit in CNN is decreasing in b.

Figure 1.9 𝑭𝟏 's profits in all subgames (a=0.8, t=1)

Lemma 2.

(1) The product customization ranges 𝑙i in each subgame are decreasing in

both customization cost parameters, a and b.

(2) As the per-product customization cost b increases and one of the three firms

op c omi ing in e ilib i m he emaining o fi m c omi a ion

ranges increase, or rather, the equilibrium customization range is non-

monotonic in b.
32
Figure 1.10 illustrates part 2 of Lemma 3. Part 1 of Lemma 3 is important for

understanding the intuition behind the main result of the paper presented in

Proposition 2 above.

Figure 1.10 𝑭𝟏 's customization range lengths in subgames CCC and CCN (a=0.8,
t=1)

1.4.4.3. Three asymmetric firms competing in two markets

In this section, we consider the model where three firms compete in two

markets: 𝐹1 and 𝐹2 compete in market 𝑚1 , while 𝐹1 and 𝐹3 compete in market 𝑚3 .

The corresponding market structure is depicted in Figure 1.3(iii). The stages of the

game are the same as in the main model.

Since 𝐹2 and 𝐹3 each competes with one firm only (𝐹1 ), while 𝐹1 competes

with two firms (𝐹2 and 𝐹3 ), the three firms are not completely symmetric. Therefore,

we no longer can say that subgames CNN, NCN, and NNC are all the same, or that
33
CCN is the same subgame as CNC or NCC. When three firms compete in two markets,

it does matter which firm offers customized products in each of the subgames.

Specifically, in this market configuration, there are 6 distinctive subgames: CCC,

NCC, CCN (same as CNC), CNN, NCN (same as NNC), and NNN.

As above, we solve the model in a backward induction fashion. Table A2

presents the optimal prices and customization ranges for each of the subgames. The

following proposition outlines the equilibria, and

Figure 1.11 illustrates it.

Proposition 3. Equilibria

(1) If 𝑏 , then none of the firms offers customized products in equilibrium; if

3

𝑏 𝑓 𝑎 6, then all three firms customize in equilibrium;

5 −233280 +193716 −53431 +4895

(2) If 𝑎 and 𝑏 , then 𝐹1
18 3 −259200 +222444 −63371 +5995 3

customizes in equilibrium, while 𝐹2 and 𝐹3 do not.

Proposition 3 shows that the symmetric market structure is also necessary

for symmetric firms to engage in asymmetric strategies. Indeed, in any equilibrium,

𝐹2 and 𝐹3 (who are symmetric) employ the same strategies, but 𝐹1 (which is

different) may be the only single customizing firm in equilibrium. The subgames

where only one of the symmetric firms (𝐹2 or 𝐹3 ) offers a range of customized

6 where 𝑓 𝑎
33592320 −83685312 +84861360 −44752184 +12930456 −1941324 +118459
111974400 −282128832 +289878480 −155208696 +45628968 −6984120 +435237
34
products is no longer an equilibrium (and neither is the outcome where both 𝐹2 and

𝐹3 customize while 𝐹1 does not). In the previous section, we pointed out that having

the per-product customization cost b is one necessary element to observe a-priori

symmetric firms to employ the asymmetric strategies in equilibrium. Here, we are

pointing out that the market structure is also important for the existence of these

results: all three firms must be completely symmetric for asymmetric equilibrium

strategies to be observed. When the firms are only partially symmetric (two are

symmetric, and one is different), then the symmetric firms only follow symmetric

strategies in equilibrium.

Figure 1.11 Equilibria outcomes in case of three firms competing in two

markets (t=1)
35
1.5. Model Extensions

In this section, we consider two different model extensions. In one, we

increase the number of firms to four to demonstrate that our main result still holds:

the a-priory symmetric firms can choose asymmetric strategies in equilibrium in the

presence of per-product customization cost 𝑏 and the completely symmetric market

structure. In the second extension, we consider the case where the retailer charges

the same price for any customized product (the so-called “uniform pricing strategy”)

and analyze the implications of this pricing mechanism for firms’ choice of

customization strategy, customization range, and firms profits.

1.5.1. Four symmetric firms

In this section, we consider four completely symmetric firms competing in

six Hotelling line markets so that each pair of firms compete with each other on a

Hotelling line, similar to the main model. This market structure is depicted in Figure

1.3(iv).

The model analysis and derivation of the equilibrium customization and

pricing strategies are analogous to the main model, and the results of the analysis

are presented in Table A3 in the Appendix A.

Proposition 4.

When four a-priori symmetric firms compete in six markets, then there exists a

unique equilibrium:
36

(1) If 𝑏 , then none of the firms offers customized products in equilibrium; if

3

25 1
𝑏 and 𝑎 25𝑡 30𝑏 then all four firms customize in equilibrium;
87 87

25
(2) When per-product customization cost b is medium: 87 𝑏 and
3

5
the technology cost a is large enough (𝑎 then not only the symmetric
18

outcome CCCC but also the asymmetric outcomes where only one or two or

three firms customize (CNNN, CCNN, and CCCN) can be the equilibrium.

Figure 1.12 illustrates Proposition 4. One can see that, just like in the main

model, as the per-product customization cost b increases (given large enough

technology cost a), fewer and fewer firms offer the customized product in

equilibrium. This proposition demonstrates that our main result (Proposition 2) is

independent of the number of competing firms. In fact, one can show that it will hold

for any number of symmetric firms as long as the market structure is a simplex.

Further, notice that with more firms, a lower per-product customization cost

b prompts one of the firms to stop customizing in equilibrium. Indeed, with 3 firms,

as long as b <𝑓 𝑎 7, all the firms were offering customized products, and this

25
threshold becomes with four firms.8
87

7 Derived in the proof of Proposition 2.

8 Derived in the proof of Proposition 4.
37

Figure 1.12 Equilibrium outcomes for the case of four symmetric firms
competing in six markets (t=1)

1.5.2. Uniform pricing for customized products

In many industries, all customized products are priced the same. For

example, a customized version of Nike Air VaporMax 2019 costs $220 regardless of

the exact customization chosen by the customer, while the conventional (non-

customized) Nike Air Vapormax 2019 is sold for $190.

In this section, we modify the benchmark model (two firms competing on a

Hotelling line) by using a single (uniform) price for all customized products. That is,

the price of a customized product sold by firm j, 𝑝 𝑦 , no longer depends on the

location 𝑦 of the customized product. Denote this uniform price as 𝑝 .

38
The tastes of the consumer who is indifferent between buying a customized

or conventional product from firm j are now located at 𝑦 . Notice that 𝑦1 𝑙1 and

1 𝑙2 𝑦2 , which means that, in contrast to the benchmark model, not every

customized product offered by the firms is purchased. Instead, customers with

tastes located between 𝑦 and the endpoint of 𝐹 ′s customization range prefers to

purchase the conventional product.

Figure 1.13 Illustration of the "both firms customize" scenario (CC) in the
model with uniform pricing

Figure 1.13 illustrates the demands for conventional and customized

products in the subgame CC. In this subgame, the firms’ profits can be written as:

CC
1 p1 x y1 p1c y1 a l12 b l1 ,
CC
2 p2 y2 x p2c 1 y2 a l22 b l2 .

The derivation of optimal prices and customization range length is done in a

backward induction fashion, similarly to the benchmark model. Proof of Lemma 3 in

39
the Appendix A shows the optimal pricing and customization ranges all three

distinct subgames: CC, CN, and NN. Notice that, whenever a firm offers a range of

customized product, there are always products in this range that are not being

purchased by any consumers: 𝑦1 𝑙1 and 𝑦2 1 𝑙2 .

The following lemma outlines the equilibrium customization strategies in

this extended model.

Lemma 3.

When two firms compete in a single market and use a uniform pricing strategy

for their customized products, the subgame perfect equilibrium is either NN (when 𝑏

3
) or CC (when 𝑏 𝑔 𝑎 9).
18 −

Notice that, as in the benchmark model, the asymmetric outcome CN is never

the equilibrium.

Further, let us take a closer look at the equilibrium outcome CC.

Proposition 5.

The set of parameters where CC is an equilibrium consists of three different regions:

9 Where 𝑔 𝑎
3 21−372 −5832 −24624 −34992 + 5+48 +108 245+2200 +12024 +54432 +104976
49+1038 +5004 +5832
40
(1) Both firms offer full customization ranges (𝑙 1/2), and there are some

1 1
consumers who purchase customized products (that is, 0 𝑦1 𝑎𝑛𝑑 2
2

𝑦2 1);

(2) Both firms offer partial customization ranges (𝑙 1/2) and there are some

consumers who purchase the customized products (that is, 𝑦1 0 𝑎𝑛𝑑 𝑦2

1);

(3) Both firms offer partial customization ranges (𝑙 1/2), but consumers only

purchase conventional products (that is, 𝑦1 0 and 𝑦2 1).

Figure 1.14 illustrates this Proposition.

Figure 1.14 Different customization scenarios in the equilibrium CC, the model
with uniform pricing (t=1)
41
The immediate effect of uniform pricing is that not all customized products

are purchased by consumers. In fact, the region (3) presents the extreme case:

where none of the customized products are purchased by consumers. Yet, the firms

still incur the customization cost 𝑎 ∗ 𝑙 and offer a range of customized products,

essentially pushing the conventional products the customers do buy towards the

middle of the Hoteling line they compete on.

Further, note that uniform pricing strategy leads to smaller customization

range in equilibrium: 𝑙 𝑙 . With uniform pricing of customized products, firms

cannot extract as much surplus from consumers as with the differentiated pricing.

Therefore, the range of customized products is smaller.

Interestingly though, the uniform pricing may improve firms’ profitability.

Figure 1.15 illustrates the comparison of profits in uniform vs. differentiated pricing

cases. One can see that differentiated pricing only benefits the firms when costs are

low enough such that it is optimal to offer full customization under differentiated

pricing (lower left region); Alternatively, differentiated pricing (with partial

customization) is beneficial when costs are high enough, and nobody buys the

customized product under uniform pricing (upper right region) even though the

customizes products are offered.

Otherwise, uniform pricing improves the retailer’s profits as compared to

differentiate pricing. Recall that the customization is detrimental to firms profits (as

discussed in the benchmark model), and with uniform pricing, the customization

ranges are shorter. This is why uniform pricing can lead to higher profits in the set
42
of parameters where firms would offer partial customization (and some consumers

will buy customized products) under either pricing policy.

Figure 1.15 Uniform vs. differentiated pricing: profit comparison

1.6. Conclusion

In this paper, we study customization and pricing strategies in a competitive

setting using a game-theoretic approach. Competing firms choose whether to offer a

single conventional product or a range of customized products with the

conventional one located at the endpoint of the customization range. We assume

that firms incur larger customization cost for larger customization ranges to reflect

the cost of customization technology and information gathering; and that they also

incur the per-product customization cost at the time of production for each

customized product purchased by customers. Through our equilibrium analysis we

43
obtain a number of insights regarding the effect of competitive market structure,

customization cost structure, and the pricing strategy on firms’ decision to

customize or not and the length of customization ranges.

First, we employ a simple duopoly setup in the benchmark model to isolate

the effect of the customization cost structure. We demonstrate that the per-product

customization cost (one piece of the cost structure) is what determines whether

firms choose to offer customized products in equilibrium or not. If the per-product

customization cost is low enough, firms will offer a range of customized products

regardless of how expensive the customization technology is (which is the second

piece of the customization cost structure). As one would guess, the range of

customized products offered by each customizing firm is decreasing with the cost of

customization technology, but the surprising finding is that firms always choose to

offer some customized products, given a reasonable per-product customization cost.

Second, the benchmark model points out that the ability to offer customized

products might actually be detrimental to firms’ profits. Indeed, in the benchmark

duopoly setting, the equilibrium where both firms offer customized products is a

prisoner’s dilemma: both firms would be better off if they did not customize. This

interesting finding is generalized when in the main model (three firms, each

competing with each other on a Hotelling line), we show that all firms earn the

highest profit in the outcome where none of them offers customized products. But

similarly to the duopoly setup, once the customization technology is available to

firms, at least one of them would choose to customize in equilibrium regardless of

44
how expensive this technology is. Therefore, in equilibrium firms don’t end up in the

outcome where none of them customizes (unless the per-product customization

cost is prohibitively high of course) and therefore end up making less money than

they could have if none of them offered the customized product.

The oligopoly set-up of the main model allows us to analyze different market

structures (see Figure 1.6) and study how the market structure might affect firms’

decision to customize or not, customization range lengths, and pricing. Our main

finding is that there exist asymmetric equilibria (where only one or only two firms

choose to customize) for a-priori completely symmetric firms. To the extent of our

knowledge, this finding is new to the literature. It is the inclusion of per-product

customization cost that allows this result to exist. That is, if there is no additional

per-product production cost for customized products, then the unique (and

symmetric) equilibrium is for all three firms to offer a range of customized products.

But once the per-product customization cost is introduced, then as it increases,

fewer and fewer firms choose to customize in equilibrium. In one of the extensions,

we demonstrate that this result holds for four firms competing with each other, and

can be extended to even more competing firms. There is only one other paper, to the

extent of our knowledge, that considers this realistic, two-component cost structure

– Dewan et all (2003) – however they consider a more restrictive market structure

(a duopoly setup) and therefore miss the finding we present here. The richer

oligopoly setting is needed to observe this insight.

45
Furthermore, we also demonstrate that the structure of the oligopolistic

market is also important in the determination of the equilibrium strategies. For

example, the main result of the paper (symmetric firms – asymmetric equilibria)

only holds when each of the firms competes with all other firms, i.e., when ALL the

firms are symmetric. If this is not the case, if for example, in a three firms model,

only one firm competes with both other firms, then the symmetric firms 2 and 3

always employ symmetric strategies in equilibriums: they either both customize or

both don’t customize.

In some real-life cases, we observe firms charging the same price for all

customized products. We demonstrate (in Section 5.2) that this pricing strategy can

either improve or decrease firms profits as compared to differentiated pricing, but

the structure of equilibrium strategies (when to customize and when not, and the

length of chosen customization ranges) is similar to the main model. The interesting

finding pertaining to this pricing strategy is that not all the offered customized

products are purchased by the customers.

In this paper, we developed a stylized model based on the Hotelling

framework, which is analytically tractable. Because of its game-theoretic nature, our

results might not directly translate into the practitioner’s decision-making at the

operational level. However, our results provide rich managerial insights that aid in

decision-making at the strategic level. Further, as it is the case with all models, the

assumptions we adhere to restrict our analysis to some degree. For example, we

assume that competition is one-dimensional. Future researchers might look at the

46
competition on both horizontal and vertical levels, or multiple horizontally

differentiated product attributes that firms can customize the product on. We

speculate that the length of customization range might differ on different attributes,

or the firms might choose to customize one of the product attributes but not the

other to differentiate themselves from competitors.

Some of the existing literature (Dewan et all 2003) contrast and compare

both simultaneous and sequential customization decisions in a duopoly, whereas we

assume that firms only engage in simultaneous decision making in the oligopolistic

setting. It is possible that with sequential decision making, the first mover

advantage could be observed in oligopoly set up as well, which can have different

implication regarding the profitability of customization than what we observe here.

While relaxing some assumptions might produce additional insights, some

assumptions might not matter at all. For example, in our model, we assume that the

firms incur the per-product customization cost, while in reality, some retailers

transfer the customization cost to customers by adding it to the price. We have

considered the latter setup (customer pays price p plus customization cost b), but

found that results are completely identical: the firms offer the same length of

customization ranges and earn the same profits, and the equilibrium prices are just

shifted down by b, so the customer effectively pays the same price. Due to the lack of

any new insights, we did not include this analysis in our paper.
 Chapter 2

The Impact of Gray Markets on

Product Quality and Profitability

Gray markets, the selling of genuine products via unauthorized channels,

have grown in importance for both manufacturers and retailers, and have thus been

studied extensively since the 1980s. Recently, consumers have shown a greater

willingness to patronize unauthorized retailers for different foreign products (e.g.,

electronics, clothes, cosmetics). Increasing consumers' demand for gray market

products has influenced both manufacturing and marketing decisions. This paper

investigates the impact of gray markets on manufacturers' and retailers' profits and

the quality of the offered products. We show that when the manufacturer sells

directly to consumers, gray markets hurt both the price and quality of products as

well as manufacturer profits. However, when the manufacturer sells through a

distribution channel, the quality of the offered products and the manufacturer’s and

retailers’ profits can all increase regardless of the source of the gray market goods.

47
48
Our study further shows, as expected, that gray markets always increase the total

consumer surplus.

2.1. Introduction

Gray markets, also known as markets with parallel imports, are marketplaces

where genuinely branded merchandise is sold through both an authorized channel

by the trademark holder and an unauthorized one. Unauthorized channels are

created by retailers or other commercial entities buying the goods from authorized

distributors in one market (usually for a low price) and importing the goods to a

different market where they can sell them at a higher price.

Products sold via gray markets are easily found in daily shopping, and their

presence may even go unnoticed by most consumers. Bucklin (1993) documents

that, for certain brands of watches and fine products, market shares for gray goods

were as high as 40%. Furthermore, in 2010-11, iPhone 4 and iPad 2 were initially

sold only in the USA and the European Union. Gray marketers bought the devices

and sold them in other countries where Apple had not yet launched them, and

consumers tended to treat them as authorized purchases (Yeung and Mok 2013).

Gray markets significantly impact online shopping as well. Alibaba, China's

most extensive shopping site, has 300 million online shoppers and offers a

significant number of gray market goods. This practice is so prevalent and

successful that it attracted the official authorized brand channels to launch and link

their sites to Alibaba’s TaoBao.com mall (Chu and Chiu 201 ).

49
The prevalence of gray markets poses a significant problem for

manufacturers and retailers since they potentially deprive them of customers and

profits. It has been reported that 7 to 10 billion USD in goods enter the U.S. market

through gray market channels each year (Lansing and Gabriella 1993, Eagle et al.

2003). According to KPMG (2003), the I.T. industry loses approximately 5 billion

USD per year because of gray market activities.

Therefore, members of the authorized channel try to use the government and

the courts to ban the practice of gray markets. Global companies that manufacture

and sell products ranging from electronics to large industrial machines have taken

efforts to curb the spread of gray markets. Nikon, for example, includes on its official

product website a section intended to educate their consumers on how to identify

and avoid gray market products (Nikon 2018). Similarly, Canon warns, “Customers

in the U.S. may find that Gray Market products do not meet their expectations

because they were not intended by Canon for sale in the U.S.” (Canon 201 ). From

the consumer perspective, the main differences between officially licensed Nikon

and Canon products and those sold on the gray market are product warranties and

ease of getting customer services.

However, gray markets tend to lower prices and benefit the consumers and

thus are not necessarily deemed illegal. Indeed, no specific laws prohibit this

practice in the U.S. Lawsuits involving gray markets have been litigated for years,

and most of the court decisions favor their existence.

50
For instance, the U.S. Supreme Court in 1998, ruled in favor of Quality Kong

Distribution of Long Island in a case involving diverted hair products (Bandler and

Burke 2009). The giant retailer, Costco, more recently bought Omega watches from

distributors outside the U.S. at lower prices than they could have gotten if they had

bought them directly from the authorized channel. The U.S. Supreme Court validated

the practice in their decision on Omega S.A. v. Costco Wholesale Corp. (Northrup

2015) 10. Given the significant role played by gray markets, prior literature devoted

considerable effort to understanding their impact on costs, prices, and profits.

Researchers indeed have identified some cases where gray markets do not

necessarily hurt manufacturers but rather increase their profitability by allowing

them to better segment the customer base (see, for example, Ahmadi and Yang

(2000) and Ahmadi et al. (2015)). Nonetheless, the quality of the offered products in

the presence of gray markets, which significantly affects the perception of gray

markets by consumers, has yet to be studied.

Focusing on the offered product quality allows us to better understand the

existence and operations of gray markets. We argue that when the manufacturer

determines the product quality, it should optimally deliberate the impact of gray

markets on consumer demand. This consideration is more likely to lead to a

10Duhan and Sheffet (1988) discuss in detail the existence and legal status of the gray
markets in the U.S.
51
different augmented product quality compared to the one offered in the absence of

gray markets.

Specifically, we examine how manufacturers’ (and retailers’) profits are

affected by prices and the offered product quality. We note that even though gray

market goods are not counterfeit, but rather authentic products having the same

traits as those purchased from authorized channels, consumers often regard these

products as inferior. This is generally because gray market goods lack warranty

coverage and usually do not include most after-sales services. Their packaging and

instruction manuals are written in the “wrong” language (i.e., different languages

than the country where the goods are bought and which could appear less user-

friendly and unreliable).

We recruit 118 participants whose ages are between 25 and 45 to complete a

gray market product survey. We find that only 3% of consumers will not consider

buying cosmetics from a gray marketer, while 6-7% will not consider buying

electronics. Despite this, over 90% of the consumers that were willing to purchase

via the gray market require some amount of price discount (averaging about 20-

30%), which indicates that the goods are viewed as slightly inferior11.

Taking into account the perception of gram market good as being of a lower

quality, we consider a model of a manufacturer selling a single product to two

11 The full details of the survey are in online Appendix C.

52
markets differing in their sizes and distributions of consumer valuations. We show

that when the manufacturer sells the product directly in the two different markets,

the existence of a gray marketer decreases both the manufacturer’s profit and the

optimal augmented product quality. Furthermore, when the manufacturer sets

prices in such a way that gray markets are no longer viable, their gains decline even

more. This is in line with common intuition and the main reason why manufacturers

fight gray markets.

Surprisingly, we show that when the manufacturer sells the product

indirectly, through retailers in at least one market, the results may change and even

reverse. When the gray marketer is forced to purchase the goods at prevailing

market prices, there exist equilibria where all retail participants are better off in the

presence of gray markets. In these cases, the quality of the offered good also

increases. Thus, gray markets may be beneficial for both the manufacturer and

retailers.

How can this be the case? First, gray marketers increase demand and profit

for the retailer in the lower-priced market (where the gray marketer purchases the

good). Second, the manufacturer can set a higher wholesale price for the better

quality product and get increased sales in both markets (due to the existence of the

gray marketer as a comparison). In several cases, the higher price more than

compensates for the additional cost of the higher quality. Third, despite vigorous

competition and depressed margins, the retailer in the higher price market can be

more profitable due to the bigger demand when the quality of the offered product is
53
much higher. We show that these results hold when the gray marketer can buy the

goods directly from the manufacturer or when one of the retailers decides to engage

in gray market activities. The above results hold even when the manufacturer sells

directly in the lower priced market and through a retailer only in the higher-priced

one. Finally, we explore models with quality dependent marginal cost and find that

the results and the main insight that gray markets may help all participants when

the manufacturer sells through retailers still hold. We further analytically examine a

model considering consumer heterogeneity, including the correlation between

willingness to pay for the original good and the valuation of the gray market one and

find that the manufacturer and two retailers may still be more profitable in the

presence of the gray market.

The rest of this paper is organized as follows. Section 2.2 presents a

literature review regarding the analytical and empirical studies on the topic of gray

markets. Section 2.3 presents and analyzes the models where the manufacturer sells

the product directly. Section 2.4 investigates models with channel structure, Section

2.5 presents models with quality dependent marginal cost, and Section 2.6

concludes and presents opportunities for future research.

2.2. Literature Review

Gray markets have been widely investigated by marketing, economics, and

operation management researchers. Theoretical models were built to explicitly

54
demonstrate how unauthorized distribution channels may lead to arbitrage and

price discrimination (Myers 1999, Richardson 2002, Ganslandt and Maskus 2004).

Most gray market studies have researched how the manufacturer's profits

are affected by gray markets, and they have also characterized the optimal prices in

the distribution channel within the presence of gray marketers. Previous research is

inconclusive with regards to whether the manufacturer’s profit will increase or

decrease in the presence of gray markets. When there is a wide price gap between

two different markets, Ahmadi and Yang (2000) provide theoretical support for the

assertion that a firm can use pricing strategies to increase sales and profit even

when facing gray market activity. They find that the global quantities of the product

increase with the gray market, and the profit may rise depending on the size of each

market. In contrast, Chen (200 ) shows that the manufacturer’s profit does not

always increase when the gray market is introduced to the channel. Chen examines

the effect of gray markets on both the manufacturer and retailer and finds that the

change in service level provided by the authorized retailer will further decrease the

manufacturer’s profit. Ahmadi et al. (201 ) demonstrate that gray markets can

impact the manufacturer's profits if it faces uncertain demand and shows that gray

markets may drive the manufacturer to reduce the price gap between the two

markets. They show that when the product is fashionable, the manufacturer should

ignore the existence of a gray market, but when the product is a commodity, the

manufacturer should attempt to prevent the gray market.

55
Similarly, Iravani et al. (2016) incorporate sales effort and price

differentiation in the presence of a gray market. They find that gray markets compel

the manufacturer to reduce the price gap between markets and invest more in their

sales efforts. They also show that, when a retailer’s effort cost is sufficiently low

relative to the manufacturer’s cost, the decision to delegate the sales effort to the

retailer benefits both the manufacturer and the retailer.

Xiao et al. (2011) study the effect of gray markets on the manufacturer’s

profit when selling through different channel structures and find that

manufacturers can be better off with both gray markets and intermediaries.

Although this research is most closely associated with our research, we shed light on

endogenous product quality with different channel structures, whereas Xiao et al.

(2011) do not. Matsui (2014) studies the influence of gray trade when consumers

are segmented by their tastes and shows that multinational firms will not provide

information services in the presence of the gray market, which leads to lower

consumer welfare than when the gray market is prohibited. Recently, Shao et al.

(2016) examine the incentives of the manufacturer and its authorized retailer to

engage with or endure the gray market. Although they differentiate between local

gray markets and bootlegging, both the manufacturer and retailer are worse off in

the presence of either type of gray market. They show that even though the

existence of a gray market is not profitable for the firms, the retailer will still sell to

a gray marketer due to incentive misalignment in the distribution channel.

56
Several papers explicitly model gray markets across countries. Autrey, Bova,

and Soberman (2015) explain why gray markets can lead to lower profits globally

for manufacturers and specifically show that emerging market firms may make

more money with gray markets while the developed market firm’s profit decreases

when the two manufacturers compete. Their two main results are that the gray

market can incentivize firms to invest in emerging markets in order to build demand

and that the firm's investment can create a positive externality by limiting their

rival’s share in the emerging marketplace. The study conducted by Matsushima and

Matsumura (2010) similarly investigates the competition between domestic and

foreign markets and finds that the gray market can help both the domestic

intellectual property right holder and a foreign imitator by providing a price

commitment mechanism as well as softening price competition.

In some instances, unsold or excess inventories are considered as a part of

the analytical modeling of the gray market (Raff and Schmitt 2007, Dasu et al. 2012,

and Hu et al. 2013), showing similar results and pointing to cases where retailers

and manufacturers may price to prevent the gray market from occurring, to their

mutual benefit. Autrey, Bova, and Soberman (2014) find that, contrary to

conventional thinking, decentralization provides manufacturers with a structural

advantage in the presence of the gray market. Su and Mukhopadhyay (2012)

analyze the effect of quantity discount (Q.D.) schedules made between

manufacturers and the dominant retailer to try to eliminate the role of gray

markets. They find that the manufacturer can incentivize the dominant retailer to

exclude the gray market using two different contracts: a dynamic Q.D. contract that
57
helps lead the dominant retailer to coordinate the channel and a revenue-sharing

contract that can prevent gray markets. Li and Maskus (2006) use a two-market

model to show that the manufacturers are discouraged from investing in R&D in the

presence of gray markets.

A few empirical and behavioral studies examine the effects of gray markets

and their deterrence on manufacturers and retailers (Maskus 2000, Ganslandt and

Maskus 2004, Huang et al. 2000). Specifically, Antia et al. (2006) investigate

whether and how to deter and prevent the gray market. They find that enforcement

may deter gray marketers, but only if the penalties for the gray market are severe

and the detection of violations is quickly made.

Overall, an overlooked aspect in most of the literature is the issue of gray

markets being impacted by the quality of products offered to consumers. This study

aims to address this issue by allowing manufacturers to determine their quality

level in various channel structures optimally. Thus, we investigate not only the

impact of gray markets on the offerings of the quality of goods in equilibrium but

also their indirect effects on pricing and profitability via the changes in quality.

2.3. Model and Analysis

This section aims to shed light on the role that endogenous product quality

plays in the profitability of a manufacturer whose goods may be affected by gray

market distributors. To answer this question, we characterize the equilibrium

prices, profits, and optimal product quality for a manufacturer selling directly or
58
through authorized dealers, and we investigate the impact that gray market

distributors exert on these outcomes.

Specifically, we begin with two separate geographic markets (countries). We

assume that a single manufacturer operates in both markets and has the power to

price discriminate between the two geographic areas. Further, to maximize profit,

the manufacturer may endogenously and at a cost, determine the quality of the

offered products. Consumers in both markets require at most one unit of the

product. However, consumers in one market (Market 1) are assumed to be willing to

pay more on average for quality than their counterparts in the other market (Market

2).

For example, Nikon, a firm that takes grey markets into account,

differentiates between multiple global markets by offering different prices for the

same product. The Nikon D500 camera is sold for a 7.5% price premium in Taiwan

versus Thailand and a 10% price premium in Taiwan versus the Philippines12

A gray marketer may operate by buying the good in the market with lower

prevailing prices, shipping it to the market with higher prices, and selling it there at

a likely profit. Although potentially identical in appearance, consumers view the

goods offered by the gray marketer as inferior to the one provided by the original

12 Prices were verified on the official websites in 11/2018

59
manufacturer due to lack of warranty coverage, after-sales services, or even the

existence of instruction manuals in a foreign language.

Specifically, we assume that facing a good of quality13 𝑞 sold at price 𝑝,

consumers with a willingness to pay 𝑡 to possess the standard simple utility function

(Tirole 1988) of

𝑈 𝑡𝑞 𝑝, (2.1)
where we normalize the no-buy option to have zero utility.

In our model, quality is defined, from the view of the consumer not only by

the core value assigned to the product itself, but also the actual product and the

augmented product, which include a brand name, design, packaging, warranty, and

after-sale service. Consumers can enjoy product bundles that are offered by the

original manufacturer; however, buying gray market goods mostly prevents them

from receiving the full, augmented product benefits. So, Taiwanese consumers

purchasing Nikon cameras that were meant to be sold in Thailand (through an

unauthorized channel) may not enjoy the after-sales service or warranties offered

by Nikon in the local market.

Each consumer knows his or her willingness to pay, but the seller only knows

the overall distribution in the population. We assume a uniform distribution of

willingness to pay over the set 0, 𝜃1 and 0, 𝜃2 in Market 1 and 2, respectively. As

13 The quality index q is a summary score of all more-is-better attributes of the product.
60
mentioned before, the average willingness to pay for quality in Market 1 is higher

than in Market 2; thus, 𝜃1 𝜃2 0. Given these assumptions, a consumer with a

willingness to pay 𝜃 will be indifferent between buying the good at price pi

and not buying it at all. Therefore, the demand 𝐷 from each market can be written

as:

𝐷1
−
𝑁1 and 𝐷2
−
𝑁2 , (2.2)

where 𝜃 and Ni is the size of market i.

Note that, although consumers in Market 1 have a higher average willingness

to pay for product quality, it is not necessary for Market 1 to have a larger market

size, 𝑁1 . As a matter of fact, the interesting situation that will be explored in this

paper assumes that 𝑁1 𝑁2 . As a specific example, consider that in Taiwan,

consumers typically have a higher willingness to pay for augmented product quality

than their counterparts in Thailand or the Philippines, while the total market size in

Taiwan is clearly much smaller.

We further assume that, in order to achieve the ability to produce a good

with augmented quality q, the manufacturer needs to invest a convex (quadratic)

fixed cost of 𝑐𝑞 2 . This cost captures not only research and development expenses

but also the creation of an after-market service structure. The profit for the

manufacturer is thus given by:

𝛱 𝑝1 𝐷1 𝑝2 𝐷2 𝑐𝑞 2 . (2.3)
61
The manufacturer maximizes profits by optimally choosing the quality of the

product and the prices in each market. These optimal values are given below:

𝛱∗
+
, 𝑞∗
+
, 𝑝∗
+
𝜃 , 𝜃∗ , 𝐷∗ . (2.4)
64 8 16 2 2

Next, we consider the possibility of a gray market distributor that buys the

good at the prevailing lower prices in one market (without loss of generality we

assume it is Market 2) and sells it at a price 𝑝 𝑝2 in the other market. As

mentioned before, consumers view the quality 𝑞 , of the gray market good as

inferior to the one offered through the authorized channel. Specifically, we assume

that the consumer discounts the gray market good by a fixed percentage of the

original quality. Thus, 𝑞 𝑓𝑞, where 0 𝑓 1 represents the proportional

reduction in quality.

In our survey, the average price discount consumers demanded in order to

purchase the gray market good was about 25-30% for electronics and 15-20% for

clothing and cosmetics. Clearly, this implies perceived lower quality and explains

why the price of the gray market good needs to be lower than the authorized one

(𝑝1 𝑝 ).

Thus, consumers in Market 1 can buy from both the manufacturer and the

gray marketer. On the other hand, consumers in Market 2 are limited to buy

authorized products only from the manufacturer. An example of the above situation

considers Nikon cameras in Taiwan. Taiwanese consumers are willing to pay, on

average, a higher price for cameras than their counterparts in the Philippines. Thus,

retailers sell Nikon cameras for a lower price in the Philippines.

62
Entrepreneurial gray market companies may purchase the cameras in the

Philippines and import them back to Taiwan, and sell them for a lower price than

that of the officially licensed retailers. Nevertheless, Taiwanese consumers view

these international cameras as being of a somewhat lower quality because they may

include unmatched accessories, no local product warranty, or lower customer

service.

Consider a Market 1 consumer with the willingness to pay of 𝜃 that is

exactly indifferent between buying the authorized product and buying the gray

market product than 0 𝜃1 𝜃 𝜃1 14, where 𝜃 1 is in the presence of the gray

market. Thus, the manufacturer’s authorized demand with the existence of the gray

market is given by

𝐷1
−
𝑁1 and 𝐷2
−
𝑁2 . (2.5)

The demand for gray market goods is:

𝐷
−
𝑁1 . (2.6)

The total demand in Market 2 is 𝐷2 ∗ 𝐷2 𝐷 . Note that the manufacturer

loses sales in Market 1 and gains sales in Market 2 due to the transfer of goods

between the two markets by the gray marketer.

14 We present a situation where some Market 1 consumers will end up buying from the

manufacturer, some will buy from the gray marketers and some will not buy at all. Clearly our
analysis considers cases where prices are such that all Market 1 consumers buy from the
manufacturer, or all of them buy from the gray marketer.
63
We further assume that the gray marketer can buy in one market the exact

amount of product that can be sold in the other market15.

Hence, the gray marketer’s profit is given by

𝛱 𝑝 𝑝2 𝐷 . (2.7)

We now depict the parameters of the market model in Figure 2.1 and define a

list of variables for the model in Table 2.1 as follows:

Figure 2.1 The parameters of the market model

15 In order to concentrate on the direct impact of gray markets, we assume that the gray marketer

does not incur any costs to transport the goods from one market to the other. All the results presented here
hold in the presence of small per unit transportation costs and are available from the authors.
64
Table 2.1 The variables in the model (𝒊 𝟏, 𝟐)

𝑁 Size of market 𝑖

𝜃 Consumer's highest willingness to pay for quality in the market 𝑖

𝜃 The willingness to pay for a consumer that is indifferent between buying the product at the

offered price in the market 𝑖 and not buying it at all

𝜃 The willingness to pay for a consumer that is indifferent between buying the authorized

product and the gray market product at their respective prices

𝐷 ,𝐷 Authorized demand in the market i with and without gray markets

𝐷 Gray market demand

𝛱 Manufacturer profit

𝛱 Gray marketer profit

𝑞 Quality of the authorized product

𝑞 Perceived quality of the gray market product

𝑝 Product price in the market 𝑖

𝑓 The quality reduction ratio between the gray market product and authorized one

𝑐 Marginal cost of quality

2.3.1. Gray Market

To model the interaction between the gray marketer and the manufacturer,

we use a Stackelberg leader-follower model (Ahmadi and Yang 2000) in which the

manufacturer is the leader, and the gray marketer is the follower. The manufacturer

first determines the product quality and prices for both markets. Then, the gray
65
marketer observes the decision of the manufacturer and decides on the quantity to

transfer between the markets and the price of the gray market product.

The total profit maximization problem for the manufacturer is given by

𝛱
−
𝑁1 𝑝1
−
𝑁2 𝑝2
−
𝑁1 𝑝2 𝑐𝑞 2 , (2.8)

Subject to 𝜃 1 𝑞 𝑝 0, 𝜃 2 𝑞 𝑝2 0, 𝜃 𝑞 𝑝1 𝜃𝑞 𝑝 , and 𝑞

𝑓𝑞.

Note that the gray marketer is forced to buy the good at the prevailing price

in Market 2, thus increasing the profit of the manufacturer in that market. However,

the presence of the gray market good reduces the quantity sold by the manufacturer

in Market 1.

The profit function of the gray marketer is thus.

𝛱
−
𝑁1 𝑝 𝑝2 . (2.9)

Proposition 1. When the perceived quality of the gray market good is close

enough to the original one 𝑓 , there exists a unique subgame perfect

equilibrium in which a gray market operates, and both the manufacturer and the

gray marketer are profitable. Furthermore, the offered product quality and the

manufacturer's profits are always lower16 in the presence of gray markets.

16 It is straight forward though tedious to show that Proposition 1 holds even when we

assume that products of higher quality incur not only additional fixed costs but higher marginal cost
of production as well.
66
Proof: All proofs are relegated to online Appendix B.

The equilibrium condition of 𝑓 is necessary to provide enough of a

potential profit to the gray marketer so that it chooses to operate. If the gray market

good is considered too inferior, it will not garner enough of a demand to justify its

importation to Market 1. Thus, from this point on, we will assume that the condition

𝑓 holds and will not repeat it for each proposition. It is interesting to note that

even with gray markets, the manufacturer still sells the same number of products in

each market 𝐷1∗ 𝐷1 ∗ and 𝐷2∗ 𝐷2 ∗ 𝐷∗ .

2 2

Moreover, the equilibrium price in Market 1 is lower in the presence of a

gray market, while the equilibrium price in Market 2 is higher. However, the

decrease in price in Market 1 is greater than the increase in price in Market 2, and

the manufacturer's overall profit drops in the presence of gray markets. These

results are similar to those found in Chen (2009), Xiao et al. (2011), Ahmadi et al.

(2015), and Su and Mukhopadhyay (2012), but are different from the one found in

Ahmadi and Yang (2000), who show that under a different demand structure and

fixed original product quality, the manufacturer is sometimes able to use the gray

market product to price discriminate within Market 1.

As can be seen from the expression provided in Appendix B, the optimal

quality offered is increasing in f. Specifically, the higher the perceived quality of the

gray market goods, the higher the original quality offered by the manufacturer. This

is due to the heightened competition provided by the gray market good in Market 1.
67
However, even at the extreme when the gray market good is perceived to be

completely identical to the original one, the quality of the offered product is still

lower relative to the product offered with no gray markets. Notice also that the

profit of the manufacturer is decreasing in f due to the realized quality distortion.

Thus, we understand that Nikon will be worse off in the presence of the gray

markets, which can attest to why they have devoted an entire webpage informing

consumers about the disadvantages of buying from gray markets.

We have shown that gray markets impact the manufacturer negatively;

however, their impact on consumers is not clear. We then define the total consumer

surpluses without and with the gray market as follows:

𝐶𝑆 ∗ ∫ 𝑡 ∗ 𝑞∗ 𝑝1∗ 𝑑t ∫ 𝑡 ∗ 𝑞∗ 𝑝2∗ 𝑑t and (2.10)

∗
𝐶𝑆 𝑡 ∗ 𝑞∗ 𝑝1∗ 𝑑t 𝑡 ∗ 𝑞∗ 𝑝∗ 𝑑𝑡 𝑡 ∗ 𝑞∗ 𝑝2∗ 𝑑t

.
Lemma 1 below shows that consumer surplus is indeed higher when gray

markets can operate.

Lemma 1. Consumer surplus is higher under gray markets and is increasing

in 𝑓, the quality reduction ratio.

2.4. Distributing via Retailers

In the business world, manufacturers rarely sell their products directly to

consumers. Preferably they utilize retailers in each market and sell through a
68
distribution channel. In this section, we study the surprising impact of retailers and

gray markets on the manufacturer’s profit and the quality of the offered good.

We extend the previous Stackelberg leader-follower model by allowing the

manufacturer to first offer the product at per unit wholesale prices 𝑤1, 𝑤2 to two

retailers, one in each market. The two retailers then determine market prices 𝑝 1

and 𝑝 2, respectively.

In the absence of gray markets, the profit of each retailer is given by (i=1,2)

𝛱
−
𝑁 𝑝 𝑤 , (2.11)

where 𝜃 represents the willingness to pay of a consumer in the

market i that is indifferent between buying the good and not buying it.

The manufacturer determines the product quality to maximize the profit

expression given below:

− −
𝛱 𝑁1 𝑤1 𝑁2 𝑤2 𝑐𝑞 2 . (2.12)

Using backward induction, we get the following subgame perfect equilibrium

quantities:

+ + +
𝛱∗ , 𝛱∗ , 𝑞∗ , 𝑤∗
256 256 16

+
, (2.13)
32

3 + 3
𝑝∗ , 𝜃∗ , 𝐷∗ .
64 4 4
69
As expected, when compared to a market without retailers, the quality of the

offered good is lower (halved), and the manufacturer's profit is reduced to one

quarter. Total channel profit is also reduced due to the double marginalization

problem.

We introduce a gray marketer into the channel environment in this model.

The gray marketer observes the offered product quality and then prices and buys a

certain quantity of the authorized product from Retailer 2, transfers it to Market 1,

and sells it at a price 𝑝 , competing with Retailer 1. As before, the perceived quality

of the gray market product is lower than the quality of the original product, thus

forcing the following relationship between the prices: 𝑝 1 𝑝 𝑝 2 0.

In the presence of a gray marketer, the profit expressions are given below:

− − −
𝛱 𝑁1 𝑤1 𝑁2 𝑤2 𝑁1 𝑤2 𝑐𝑞 2 ,

−
𝛱 𝑁1 𝑝 𝑝 2 ,
(2.14)

− − −
𝛱 1 𝑁1 𝑝 1 𝑤1 , 𝛱 2 𝑁2 𝑁1 𝑝 2

𝑤2 .

Proposition 2. There exists a unique subgame perfect equilibrium in which a

gray market operates, and the manufacturer, the two retailers, and the gray

marketer are profitable. (a) The offered product quality and the manufacturer's

profit can be either lower or higher in the presence of gray markets. (b) The

manufacturer’s profit is higher if and only if the offered product quality is higher.
70
With the knowledge of the existence of gray markets, Nikon should consider

introducing a higher quality camera than it would introduce if there were no gray

markets. Utilizing the market expansion and segmentation opportunities offered by

the gray marketer to increase its profit.

Note that, a higher quality allows the manufacturer to set higher wholesale

prices and get higher sales in both markets (due to the existence of the gray

marketer) far exceeding the cost of the higher quality. Figure 2.2 below depicts the

parameter space for which both quality and the manufacturer profit increase.

Figure 2.2 The set of parameters for which quality and profits increase in the
presence of gray markets (without loss of generality we assume 𝑵𝟏 𝟏, 𝜽𝟏
𝟏)
71
There are two beneficial effects of the gray market for the manufacturer: the

first is the introduction of a second product allowing the manufacturer to price

discriminate in Market 1; the second benefit is that the gray market reduces the

power of the monopolistic retailer in Market 1, leaving the manufacturer with a

higher profit. However, if the original quality is fixed, the two positive effects are not

sufficient to compensate for the fact that the manufacturer sells fewer products at a

high wholesale price and suffers the more significant impact of double

marginalization. When the offered product quality is endogenous, the manufacturer

chooses a much higher level of quality in the presence of gray markets. The

manufacturer benefits by allowing for a much higher wholesale price that more than

compensates for the additional cost of the higher quality and double

marginalization.

Our model shows that the gray marketer always helps Retailer 2 by

increasing demand in Market 2. As a matter of fact, the set of parameters for which

Retailer 2 is better off is much larger than the set of parameters for which the

manufacturer enjoys a larger profit. Thus, Retailer 2 can be better off in the

presence of gray markets even when the product quality is lower due to its

monopoly power in Market 2. At the same time, the gray marketer provides great

competition to the retailer in Market 1. Can the existence of gray markets actually

benefit all participants? The following proposition answers that question in the

affirmative:
72
Proposition 3. When the gray marketer buys the good from Retailer 2, there

exists a set of market parameters for which the manufacturer and both retailers are

better off.

The parameter space where all participants have higher profits is shown in

Figure 2.3 below:

Figure 2.3 The set of parameters for which the manufacturer and both
retailers are better off

The proof of Proposition 3 shows that both the wholesale and market

prices in Market 1 increase. Retailer 1's margin decreases, as the increase in the

wholesale price is more significant than the increase in the market price. However,
73
the demand for Retailer 1’s product increases. Thus, the profit of Retailer 1 could be

either higher or lower in the presence of the gray market. For a given 𝜃2 and 𝑁2 , we

show that Retailer 1’s profit starts above the no gray market profit and decreases in

𝑓, eventually leading to a lower profit for high values of 𝑓. The difference between

the shapes depicted in Figure 2.2 and Figure 2.3 demonstrates that, for larger values

of 𝑓, the manufacturer is better off with the gray market, while Retailer 1 is not. As

shown in Proposition 2, the manufacturer is better off only when the quality of the

offered product is higher. Thus, for the depicted parameter region, the product

delivered is of much higher quality, and Retailer 1 sells enough of the product to

gain higher profit. In the following proposition, we turn to consumer surplus and

show that regardless of the impact on the profitability of the manufacturer and

retailers, gray markets are always beneficial to consumers.

Proposition 4. Total consumer surplus always increases in the presence of

distribution channels and gray markets.

Consumer surplus in Market 1 is always increasing due to the added

competition from the gray marketer. The consumer surplus in Market 2 can go

either way, but the total is always positive. Furthermore, one can check that, as in

Lemma 1, consumer surplus increases in the quality ratio parameter f.

We have shown above that gray markets are never beneficial to a

manufacturer that sells directly while they can be profitable and quality enhancing

when the manufacturer sells through retailers. Below we show that selling via

retailers in both markets is not necessary for gray markets to increase the
74
manufacturer's profit. In fact, as long as the manufacturer uses a retailer in one of

the markets, the manufacturer’s profit could increase in equilibrium.17

Proposition 5. When the manufacturer sells directly in either market but sells

through a retailer in the other, gray markets may lead to higher manufacturer

profits and product quality. In fact, the manufacturer’s profit increases if and only if

the optimal quality increases.

Furthermore, when the retailer is in Market 1, the set of parameters for

which the manufacturer’s profits increase is much larger.

Note that, when the manufacturer sells through a retailer in Market 1 only,

the gray market allows the manufacturer to segment consumers in Market 1 and

mitigates the monopoly power of Retailer 1. When the manufacturer only sells

through a retailer in Market 2, the gray market only helps mitigate double

marginalization in the low-end market. Thus, it is not surprising that, when the

retailer is only in the high-end market, the set of parameters for which the

manufacturer's profit increase is much more substantial.

In many cases, Retailer 2 may wish to buy extra goods in Market 2, selling

them in Market 1 and becoming a de facto gray marketer. Retailer 2 is the

authorized retailer in Market 2 and acts as a gray marketer in Market 1. In our

17 It is straightforward to show that a quality optimizing manufacturer would make the

highest profit when selling directly in both markets, a lower profit when selling through one retailer,
and the lowest profit when selling through two retailers.
75
example, the retailer in Thailand selling Nikon camera can export them to Taiwan,

serving as a gray marketer in that country. The manufacturer and Retailer 1’s profit

functions will not change compared to the profits with no gray market. However,

Retailer 2’s profit function is affected. The equilibrium and the relevant parameter

set for which it is valid are presented and depicted in the Appendix B. The

proposition below answers this question as well as demonstrate the impact on

Retailer 1.

Proposition 6. When Retailer 2 is the gray marketer, the manufacturer’s profit

increases if and only if the quality increases. However, Retailer 1 is always worse off.

When Retailer 2 acts as the gray marketer, as before, the manufacturer can

set a higher wholesale price and get higher sales in both markets, only when the

product quality is higher. However, Retailer 1’s margin is depressed (the increase in

wholesale price is higher than the market price, and the increase in quality is

insufficient to compensate for it). So, if Nikon improves product quality, Nikon gains

more profit in the presence of the gray markets, even when the authorized retailer

in Thailand plays the role as the gray marketer18. This result complements

proposition 4 of Xiao et al. (2011), who show that in such cases, when the quality is

fixed, the manufacturer always suffers from the presence of the gray market.

18 Clearly when the retailer in Market 1 (Taiwan) acts as a gray marketer importing the good

from Market 2 there exists a set of parameters for which all retailers and the manufacturer are better
off.
76
One can think of environments in which a gray marketer can buy the good

directly from the manufacturer in Market 2 at a wholesale price level, and therefore,

does not have to resort to buying it from Retailer 2. Proposition 7 below

summarizes the impact on the profits and quality in this situation.

Proposition 7. When the gray marketer can buy the product directly from the

manufacturer, Retailer 1 is always worse off. Retailer 2 and the manufacturer are

better off, if and only if the offered product quality increases.

The intuition for the above proposition is as follows: for the manufacturer

and Retailer 1, having an independent gray marketer buying directly from the

manufacturer or having Retailer 2 acting as a gray marketer are entirely identical.

Therefore, an increase in product quality is necessary for the manufacturer to be

better off, but insufficient for Retailer 1 to be better off. The margins for Retailer 2

are slightly higher when the gray marketer buys from the manufacturer directly.

Therefore, Retailer 2 is better off when it sells (almost) as many units as before or

more, which occurs only when the offered quality is higher.

Note that, the gray marketer is always better off buying from the

manufacturer at a lower wholesale price than from Retailer 2 at the prevailing

market price as it can charge a lower price in Market 1 and still enjoy higher

margins.

In reality, most manufacturers object to the existence of gray markets and try

to fight them via legal channels. Since most manufacturers do not sell directly to

consumers in all markets, our paper shows that gray markets can improve
77
profitability for all participants. Specifically, manufacturers that sell through

retailers need not necessarily view gray markets automatically as hindering their

profits. In some cases, manufacturers should not oppose gray markets as they lead

to overall improved profits.

2.5. Model Extensions

In this section, we have two extensions of the main model: the marginal cost

of production is quality-dependent, and the customer heterogeneity evaluation of

the gray market is good.

In response to a gray marketer, the manufacturer may consider changing

(improving) the quality of the core product and not just the augmented one,

resulting in an increase in the marginal cost of production (e.g., a higher resolution

camera may be offered and probably costs more to produce). In this section, we

extend our previous analysis to allow for a model with the quality dependent

marginal cost when the manufacturer sells directly to the market (Section 3.1). We

capture the quality-dependent marginal cost with parameter 𝑏 ∈ 0,1 leading to the

following manufacturer profit:

− − −
𝛱 𝑁1 𝑝1 𝑏 𝑁2 𝑝2 𝑏 𝑁1 𝑝2 𝑏 𝑐𝑞 2 ,

Proposition 8. When the marginal cost of production is quality dependent,

and the perceived quality of the gray market good is close enough to the original one

𝑓 , there exists a unique subgame perfect equilibrium in which a gray market

78
operates, and both the manufacturer and the gray marketer are profitable.

Furthermore, the offered product quality and the manufacturer's profits are always

lower in the presence of the gray market.

We find that quality-dependent marginal cost renders the model where the

manufacturer sells through retailers analytically intractable. Nevertheless, we were

able to provide a numerical solution and show that the results are similar in nature

to the results in the previous sections. For example, when the manufacturer sells

through two retailers, there still exists a set of parameters for which all participants

in the channel are better off in the presence of the gray market. This set obviously

depends on the marginal cost and shrinks as the coefficient, b, of marginal cost

increases.

Below we present a numerical example of the combinations of 𝑓 (the

percentage discount in gray market valuation) and θ2 (the upper valuation for

quality in Market 2) for which all participants are better off in the presence of the

gray market. The blue area is the set of parameters 𝜃1 𝑁1 1 for the original case

without marginal cost of quality. And the orange (𝑏 .1) and green (𝑏 .3) areas

show how it shrinks when the marginal cost of quality increases.

79

𝑁2 1.5 𝑁2 2

Figure 2.4 The parameter set for which models with the quality dependent
marginal cost when the manufacturer sells directly to the market

Furthermore, when added quality carries an extra marginal cost, some may

think that gray markets may cause manufacturers to lower quality in equilibrium to

achieve cost savings. However, our results still show that, in cases where all

participants are better off, equilibrium quality increases rather than decreases.

We also extend our previous analysis to allow for heterogeneous consumers in

Market 1. In many cases, consumers treat gray market goods as completely

equivalent to the authorized ones; they possess the same inherent quality but are

offered at a lower price. For example, a consumer who physically lives in the United

States, but purchases a gray market designer handbag from a European retailer at a

lower price may evaluate the handbags as having the exact same high quality. Thus,

we add consumer heterogeneity to our analysis in the following way.

80
We assume that a fraction 𝛼 ∈ 0,1 of consumers in Market 1 consider the

quality of the gray market product to be equivalent to the authorized product (q

q), while a fraction 1 𝛼 of the consumers find the gray market product to be

inferior in quality 𝑞 𝑓 𝑞 . Note that consumers that value the gray market good

as equivalent to the original offering will buy the gray market good, as its price will

be lower than the original authorized product. Figure 2.5 below depicts the model

setup.

Figure 2.5 The parameter set for which the market model exhibits consumer
heterogeneity

In this scenario, the manufacturer sells directly in both markets, and the gray

marketer aims to sell to both segments of consumers in Market 1. The manufacturer

and gray marketer, therefore, optimize the following profit functions:

81
− −
ΠM 1 α N1 p1 1 α N1 p2
(2.15)
− −
α N1 p2 N2 p2 cq2 ,

Subject to θl1 q p 0, θl1 q p 0, θl2 q p2 0, θc q p1

θc q p ,

also, q fq.

Π 1 α
−
α
−
N1 p p2 . (2.16)

We find that the equilibrium for the above model with heterogeneous

consumers is consistent with the result in Proposition 1, so there exists a unique

subgame perfect equilibrium where both the manufacturer and the gray marketer

are profitable in the presence of the gray market. We also observe that the

manufacturer makes an even lower profit, and the product quality decreases with

the gray market. We summarize the results in Proposition 9.

Proposition 9. Where there are heterogeneous consumers in Market 1, the

product quality and the manufacturer's profits are always lower in the presence of

gray markets, regardless of the value of 𝛼.

In this scenario, the gray marketer buys from Retailer 2 in Market 2 and sells

the product in Market 1 to both types of consumers. In the presence of the gray

marketer, the profit of the manufacturer, gray marketer, and both retailers are given

by:
82
− −
ΠM 1 α N1 w1 1 α N1 w2

− −
α N1 w2 N2 w2 cq2 ,

− −
Π 1 α α N1 p P 2 ., (2.17)

−
Π 1 1 α N1 p 1 w1 ,

− − −
Π 2 N2 α N1 1 α N1 p 2 w2 .

The next proposition characterizes how the manufacturer and the two

retailers' profit changes in the presence of a gray market when we take consumer

heterogeneity into account in the model:

Proposition 10. When the gray marketer buys the good from Retailer 2 with

consumer heterogeneity in Market 1, there exists a set of parameters for which the

manufacturer and both retailers are better off.

We find that the size of the set of parameters for which all participants are

better off shrinks as α increases. Note that as α increases, the gray marketer sells

more units, leading to higher profits for himself and Retailer 2. At the same time,

Retailer 1 sells fewer units and, therefore, makes less money, while the

manufacturer sees lower profits due to selling more units at a lower wholesale

price. We also find that Proposition 10 holds (with slightly lower profits) when one

allows for positive correlations between willingness to pay and valuation of the gray

market goods.
83
2.6. Discussion and Conclusion

As gray markets—the selling of genuine goods through an unauthorized

channel—become more prevalent, their potential impact on manufacturers,

retailers, and consumers requires further study. Several recent analytical papers

have examined the impact of gray markets on prices and profits of both

manufacturers and retailers, reaching different, parameter-specific conclusions.

To our knowledge, this paper is the first to analyze the effects of gray

markets, not only on market prices but also on the endogenously determined quality

of the offered product. When manufacturers take the existence of gray markets into

account in the process of designing ways to augment the quality of offered products,

we can determine their profitability and the profitability of other channel members

in addition to the welfare of consumers.

We consider a manufacturer selling its product in two markets that differ in

size and in the distribution of consumers’ willingness to pay for the product. We

show that, when the manufacturer sells directly to consumers in the two separate

markets, both augmented product quality and the manufacturer’s profits decline in

the presence of gray markets (though consumer surplus increases). When selling

through a distribution channel, we show that the augmented quality of the offered

goods can increase, resulting in a higher profit for the manufacturer. The above

results hold even when the channel structure is such that the manufacturer sells

directly in one market and through a retailer in the other.

84
Contrary to common belief, our results indicate that gray markets may

encourage the manufacturer to innovate and increase the augmented quality of the

offered products so that wholesale prices and profits can increase as well. In other

words, manufacturers should not rush to demand that governments and courts shut

down gray markets. When selling through retailers, a better approach may be to

improve the augmented quality of the product, charge higher wholesale prices, and

improve profitability by utilizing the gray market to better segment consumers in

Market 1 and mitigate the monopoly power of Retailer 1. It is interesting that we can

find a set of parameters for which not only the manufacturer is better off in the

presence of gray markets, but the retailers are better off as well. So, gray markets

may benefit all channel participants.

The manufacturer clearly prefers that the gray marketer buys the goods

directly from it in Market 2. However, even if the gray marketer legally has to buy

the goods from Retailer 2, the manufacturer and both retailers can benefit due to the

higher augmented quality and prices.

In this paper, we consider the gray market impact on the augmented quality

of the offered product. Thus, the change in quality for the Nikon camera example is

mainly due to changes in warranty and customer service and not the improvement

in the lens or any digital enhancements. These quality changes do not directly

increase the marginal cost of production; thus, their costs can be viewed more as

fixed costs. However, if the existence of grey markets may lead the manufacturer to

improve the core product, our model needs to be altered to include the marginal
85
cost of production that is increasing in the offered quality (e.g., Nikon may offer a

higher resolution camera that will come at a higher marginal cost).

We analyze and numerically solve a model with the quality-dependent

marginal cost of production as well as fixed costs, and find that the results are

qualitatively the same. The manufacturer that sells directly can never be better off in

the presence of gray markets and, as long as the marginal production cost of quality

is not too high, there exists a set of parameters for which all participants are better

off in the presence of a channel structure and gray markets. Furthermore, the

manufacturer and the two retailers are all better off only when the offered product

quality is higher.

We assume that the gray marketer does not incur any costs to transport the

goods from one market to another. Clearly, all the results presented here hold in the

presence of small per-unit transportation costs. We further assume that all goods

that were bought by the gray marketer in Market 2 arrive in Market 1 in perfect

condition and that the entire inventory is sold. If this assumption does not hold, one

can introduce a new parameter to represent the proportion of the goods that spoil

or that the gray marketer cannot sell. As long as the gray marketer still finds it

profitable to operate, all of the previous results hold with the appropriate

modifications.

We extend our baseline model to account for consumer heterogeneity. We

find that when the gray marketer buys the good from Retailer 2 with consumer

heterogeneity in Market 1, there exists a set of parameters for which the

86
manufacturer and both retailers are better off. We also consider the model with

quality dependent marginal cost and find that when selling directly, the

manufacturer is never better off in the presence of the gray market; thus

Proposition 1 still holds. When selling through retailers and the marginal cost is low

enough, all participants can still be better off.

In our analysis, we consider an environment with a single manufacturer and

a single retailer in each market. It would be interesting to model the impact of gray

markets on multiple manufacturers and several retailers in each market. Moreover,

we assume that there is a single product with a single quality offered in the market.

It is natural to research the profitability of allowing for several different products

with different qualities to be offered in each market. Another possible extension is

to allow the manufacturer to limit the supply of the goods to each market. We leave

these for future exploration.

87

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93

Appendix A
Proof of Proposition 1.

(1) Subgame CC). Both firms customize. We start by optimizing each firms’

profit in the equation 1 , using first-order condition methods

∂π1 𝑙1 , 𝑙2 2p1 p2 t 1 l1 l2
0
∂p1 2t

∂π1 𝑙1 , 𝑙2 p1 2p2 t 1 l1 l2
0
∂p2 2t

t
pi (l1 , l2 ) 3 li l3 i .
We obtain the solution as 3

Next, substitute these price expressions back into profit function:

(10li 2 2li (3 l3 i ) (3 l3 i ) 2
i (l1 , l2 ) t li b li a .
18

Then, take the derivative of new profits with respect of ranges of

customization lengths:

, 1
𝑏 2 𝑎 l1 20 l1 2 3 l2 𝑡 0
l 18

, 1
𝑏 2 𝑎 l2 6 2 l1 20 l2 𝑡 0
l 18

The solution is as follows:

94

1 , if a 1 t
(5 6b) and b (full range customization)
2 6 3
1 t
liCC* 0, if a (5 6b) and b (effectively no customization)
6 3
t 3b
, o/w (partial customization range).
6a 3t

∗
𝜋i

1 1
5𝑡 2𝑎 4𝑏 , 𝑖𝑓 𝑎 5𝑡 6𝑏 and 𝑏 full customization range)
8 6 3
1
, 𝑖𝑓 𝑎 5𝑡 6𝑏 and 𝑏 effectively no customization)
2 6 3
9 +2 9 −5
, o/w partial customizationrange)
36 −18

∗ ∗
𝑝1 𝑡, 𝑝2 𝑡

1
Feasibility conditions for full customization in CC: 𝑎 5 6𝑏 and 0 𝑏
6

Feasibility conditions for partial customization in CC: 0 𝑏 and 𝑎

3

1 5 1
5𝑡 6𝑏 or 𝑏 and 0 𝑎 5𝑡 6𝑏
6 3 6 6

(Subgame CN). Only one firm customizes.

When only one firm customizes, we set l2 0 and start by optimizing each

firms’ profit in the equation 1 , using first-order condition methods as follows:

,0 −2p +p +l ,0 p p −p + −1+l
0, 0
p 2 p 2 2
95

Then the solution is p1 3 l1 , p2 𝑡 1

3 3

Next, substitute these price expressions back into profit function: π1 𝑙1 , 0

1 1
𝑏 l1 𝑎 l12 9 6 l1 10 l12 𝑡, π2 𝑙1 , 0 𝑙1 3 2
𝑡
18 18

,0 1
and the FOC with respect of l1 becomes: 𝑏 2𝑎l1 6
l 18

20l1 𝑡 0

The profts and prices of the subgame are:

∗
𝜋1

−36 −60 +11 +132 +26 −61 1

, 𝑖𝑓 𝑎 𝑏 3𝑡 and 𝑏 full customization range)
16 9 −5 6 3
1
, 𝑖𝑓 𝑎 𝑏 3𝑡 and 𝑏 effectively no customization)
2 6 3
9 +2 9 −5
, o/w partial customizationrange)
36 −18

3 6 − −3 1
, 𝑖𝑓 𝑎 𝑏 3𝑡 and 𝑏 full customization range)
4 9 −5 6 3
∗ 1
li 0, 𝑖𝑓 𝑎 𝑏 3𝑡 and 𝑏 effectively no customization)
6 3
3 −3
, o/w partial customizationrange)
2 9 −5

18a 3b 11t 2 t
∗
Π2CN ,
8 9a 5t 2
∗ 3𝑡 6𝑎 𝑏 3𝑡 ∗ 𝑡 3𝑏 𝑡
p1CN , pCN
2 𝑡 𝐴2
2 9𝑎 5𝑡 2 9𝑎 5𝑡
96

Feasibility conditions for full customization in CN: 0 𝑏 and 0 𝑎

3

1
𝑏 3𝑡
6

Feasibility conditions for partial customization in CN: 𝑏

3

2 1 1 2 8 1
and 9𝑏 8𝑡 𝑎 3𝑏 11𝑡 or 𝑏 and 9𝑏 8𝑡 𝑎
3 9 18 3 9 9

−3 +2 +3
6

In addition, we solve for the corner solutions for the CN and CC subgames,

the outcome equilibrium is:

3 8 1
Π1CNc 6a 10b 15t , Π2CNc , Π2CCc 2a 4b 5t 𝐴3
50 25 8

(Subgame NN). Neither firm customizes.

This is a standard Hotelling line. We obtain prices and profits as follows:

∗ ∗
p1 𝑝2 𝑡

∗ ∗ 𝑡
π1 𝜋2
2

(Subgame perfect equilibrium).

CC is the unique subgame perfect equilibrium because

97

∗ ∗
when b<t/3 and both firms do partial customization, Π1CC Π1CN

9 +2 9 −5 9b +18a −6b −9 36 −3 −19 3 −

0.
36 −18 36a−20 36 9 −5 2 −

∗ ∗
We find that Π1CC Π1CN holds under the interaction of feasibility conditions

of CC and CN. Thus, CC is the unique subgame perfect equilibrium.

∗
Note that, when b t/3, Π1CC both full customization
∗ 1 1
Π1CC one full and one partial customization 5𝑡 2𝑎 4𝑏 8𝑎 8𝑏
8 8

6 −3 + −3 +
13𝑡 >0;
9 −5 9 −5

∗
Moreover, Π1CC both full customization

∗ 1 9 +2 9 −5
Π1CC both partial customization 5𝑡 2𝑎 4𝑏 0;
8 36 −18

∗ ∗
We find that both Π1CC full customization Π1CC partial customization
∗ ∗
and Π1CC full customization Π1CC partial customization hold under the

interaction of feasibility conditions of CC and CN. “For b t/3” and the (write the

range where they do full customization) profit comparison also demonstrates that

CC with both firms offering full range customization is the unique equilibrium as

well. Thus, CC is the unique subgame perfect equilibrium.

∗ ∗ 9 +2 9 −5 −9 +
NN is equilibrium when Π1NN Π1CN always
2 36 −18 36 −18

hold when b .
3
98

∗ ∗ ∗ ∗
CN is never the equilibrium because Π1CC Π1CN and Π1NN Π1CN always

hold when b .
3

(2). CC is a prisoner’s dilemma because

∗ ∗ 9 +2 9 −5 9 −
ΔΠ Π2CC Π2NN 𝑡⁄2 0
36 −18 36 −18

The profit of CC is always lower than that of NN under the interaction of

feasibility conditions of CC and NN.

Proof of Proposition 2.

First, in a backward induction fashion similar to the steps outlined in the proof of

Proposition 1, we solve for the optimal prices, customization ranges, and the

resulting profits in each of the subgames CCC, CCN, CNN, and NNN. Those optimal

expressions are given in Table A1.

Optimal prices, customization ranges, profits Applicab

le parameter

set (feasibility

conditions)

Subgame CCC
99

∗ 9 +36 −10
ΠiCCC , 0
36 −9

1
∗ −3 + ∗ 𝑏 and 𝑎
𝑙 ,𝑝 𝑡 3
12 −3
1
5
12

1
6𝑏 or 3

5
𝑏 and 0
6

1
𝑎 5
12

6𝑏

Subgame CCN

Π1CCN
∗
Π2CCN
∗ 181−684 +54 −171
, 0
180−684
1
𝑏 and 𝑎
3
CCN∗ 38 +3 −11
Π3 ,
4 19 −5 1
, 25 30𝑏
57
CCN∗ ∗ 5 −3 + ∗ −9 +3
l11 lCCN
21 , lCCN
22 ,
57 −15 38 −10 1
∗ ∗ ∗ 3 −3 + or 𝑏
𝑙32 0, 𝑙33 0, 𝑙13 3
2 19 −5
5
and 0 𝑎
6
CCN∗ ∗
p11 pCCN
21 t,
∗ −3 + 1
pCCN
22 𝑡 , 25 30𝑏
38 −10 57
∗ ∗ 38 +3 −11
𝑝32 𝑝33 ,
38 −10
∗ −3 +
𝑝13 𝑡 38 −10

Subgame CNN
100

Π1CNN
∗ 9 +36 −6 −9
, Π2CNN
∗ 0
36 −10
1
2592 +9 +216 −7 −66 +221 𝑏 and 𝑎
, 3
8 18 −5
1
5 5𝑏 or
12
∗ 1 9 −3 9 −3
Π3CNN 𝑡 18 , 1
18 18 −5 4 18 −5 𝑏
3

CNN
l11
∗ 3 −9
, lCNN
∗
0, lCNN
∗
0 1and 0 𝑎
36 −10 21 22
∗ ∗
𝑙32 0, 𝑙33 0, , 1
5 5𝑏
∗ 3 −3 12
𝑙13 ,
2 18 −5

CCN ∗ 3 −12 + +3 ∗ 36 +3 −11

p11 , pCCN
21 ,
2 18 −5 36 −10
∗ ∗
pCCN
22 𝑡, 𝑝32 𝑡,
∗ 36 +3 −11
𝑝33 ,
36 −10

∗ 3 −12 + +3
𝑝13 2 18 −5

Subgame NNN

∗ ∗ ∗
ΠiNNN t,pNNN
i t, lNNN
i 0 𝑎 0 and 𝑏

Table A1 Optimal Outcomes of Three symmetric firms competing in three

markets.
101

∗ ∗
We compare profits in the optimal outcomes: π1 𝜋1

9 +36 −10 38 +3 −11 17

> 0 when b . Thus, we find that CCC is a subgame
36 −9 4 19 −5 57

17 ∗ ∗ ∗
perfect equilibrium when b . Note that 𝜋1 𝜋3 , we otain that π1
57

∗ ∗
𝜋3 𝜋1 .

Similarly, we can show that CCN/NCC, CNN/NNC, and NNN are subgame

equilibriums.

Proof of Lemma 1

∗ ∗ 36a +9b −10 9b −

(1) ΠiCCC ΠiNNN t 0 under the feasible
36a−9 36a−9

conditions of ΠiCCC and ΠiNNN .

∗ ∗ 9b +36a −6b −9 −3b+

(2) Π1CNN Π1NNN t 0 under the feasible
36a−10 36a−10

conditions of Π1CNN and Π1NNN .

Proof of Lemma 2

(1) Firm 1 is the one that customizes in all subgame equilibriums. Thus, we take

derivatives of 𝑙11 with respective to 𝑎 and 𝑏 in each subgame and obtain the

following:
102

∗
l 12 −3 +
0,
a 12 −3
∗
l 57 5−15
0,
a −15+57
∗
l 36 −9 +3
0,
a 36 −10
∗
l 3
0,
b 12 −3
∗
l 15
0,
b −15+57
∗
l 9
0, A8
b 36 −10

The derivative of 𝑙11 concerning a and b are always negative.

(2)Consider the customization range of firm 1, which customizes in each of

the subgames CCC, CCN, and CNN. As the per-product customization cost increases

and moves above 3, the customization range length increases:

5 −3b+ −3b+ a 3b−

l1CCN l1CCC -12a−3 >0
57a−15 3 76a −39a +5

under the feasibility conditions. It is non-monotonic in b, and there is a jump

between the plot l1CCN and l1CCC with the same value b.

Proof of Proposition 3

Similarly to the solution procedure outlines in Propositions 1 and 2, we solve

for the optimal prices and customization range length in each of the distinct

subgames. Table A2 summarizes the optimal outcomes.

103

Optimal prices, customization ranges, profits Applicable

parameter set (feasibility

conditions)

Subgame CCC

∗ 1 5
Π1CCC 46656𝑎4 𝑡 0 𝑎
9 72 −60 +11 12

44𝑎𝑡 2 171𝑏 2 30𝑏𝑡 299𝑡 2 3888𝑎3 3𝑏 2 √

and 𝑏
4√3 3

2𝑏𝑡 21𝑡 2 121𝑡 3 9𝑏 2 10𝑡 2

−216 +222 −55 5
or
∗ ∗ 126 −66 12
216𝑎2 𝑡 75𝑏 2 32𝑏𝑡 235𝑡 2 , Π2CCC π3CCC
√ 11
1 𝑎 and
4√3 36
46656𝑎4 𝑡 7776𝑎3 3𝑏 2 𝑏𝑡
18 72 −60 +11
−216 +222 −55
𝑏
10𝑡 2 121𝑡 3 9𝑏 2 10𝑡 2 108𝑎2 𝑡 249𝑏 2 126 −66

11 5
62𝑏𝑡 439𝑡 2 22𝑎𝑡 2 441𝑏 2 60𝑏𝑡 569𝑡 2 or 𝑎 and
3 18 6

−216 +246 −55

∗ 18 −11 −3 + 𝑏
lCCC
1 , 198 −66
3 72 −60 +11
∗ ∗ 36 −11 −3 +
lCCC
2 lCCC
3 , or 𝑎
5
and 0 𝑏
3 72 −60 +11 3 6
∗ 72 +6 −62 +11
𝑝1 ,
72 −60 +11
3
∗ ∗ 72 +6 −62 +11
𝑝2 𝑝3 ,
72 −60 +11

Subgame NCC
104

∗ 18 +3 −11 ∗ ∗
Π1NCC , Π2NCC πNCC
3 0 𝑏 and 𝑎
4 9 −5 3

9 +18 −6 −9 1
36 −20 5𝑏 5𝑡 or 𝑏
6 3

1
lNCC
∗
0, 𝑡 and 0 𝑎 5𝑏
1 6
∗ ∗ 3 −3 +
lNCC
2 lNCC
3 , 5𝑡
2 9 −5
∗ −3 +
𝑝1 𝑡 ,
2 9 −5
∗ ∗ 3 −6 + +3
𝑝2 𝑝3 ,
2 9 −5

Subgame CCN/CNC

∗ 1 11
Π1CCN 4665600𝑎4 𝑡 0 𝑎 and
36 40 −11 9 −5 40

25920𝑎3 45𝑏 2 304𝑡 2 36𝑎2 𝑡 44910𝑏 2 𝑏

3

5400𝑏𝑡 132191𝑡 2 11𝑎𝑡 2 66519𝑏 2 −1080 +1122 −275

or
675 −330
15606𝑏𝑡 109829𝑡 2 605𝑡 3 171𝑏 2 54𝑏𝑡
11 11
𝑎 and
40 36
181𝑡 2 ,
−1080 +1122 −275
𝑏
∗ 1 675 −330
Π2CCN 129600𝑎 𝑡 3
18 40 −11 9 −5
11 5
or 𝑎 and
3 18 6
720𝑎2 90𝑏 2 27𝑏𝑡 200𝑡 2 11𝑎𝑡 3501𝑏 2
−1080 +1230 −275
540𝑏𝑡 4700𝑡 2 605 9𝑏 2 𝑡 2 10𝑡 4 , 𝑏
999 −330

5
720 +54 −616 −33 +121
or 𝑎 and 0 𝑏
CCN∗ 3 6
Π3 ,
8 40 −11 9 −5

3
105

CCN ∗ 11 −3 + ∗ 5 36 −11 −3 + ∗
l11 , lCCN
21
CNN
, l22 0
120 −33 3 40 −11 9 −5
∗ ∗ 3 18 −11 −3 +
𝑙22 0, 𝑙23 ,
2 40 −11 9 −5
CCN ∗ 360 +27 −308 +55
p11 ,
40 −11 9 −5

∗ 360 −27 −290 +55

pCCN
21 ,
40 −11 9 −5
∗ 18 −11 −3 +
pCCN
22 𝑡 ,
2 40 −11 9 −5
∗ 18 −11 −3 +
𝑝23 𝑡 ,
2 40 −11 9 −5

Subgame CNN

∗ 1
Π1CNN 4665600𝑎4 𝑡 0 𝑏 and 𝑎
36 40 −11 9 −5 3

25920𝑎3 45𝑏 2 304𝑡 2 36𝑎2 𝑡 44910𝑏 2 1

5𝑏 5𝑡 or 𝑏
12 3
5400𝑏𝑡 132191𝑡 2 11𝑎𝑡 2 66519𝑏 2
1
𝑡 and 0 𝑎 5𝑏
2 3 2 12
15606𝑏𝑡 109829𝑡 605𝑡 171𝑏 54𝑏𝑡
5𝑡
181𝑡 2 ,

∗ 1
Π2CNN 129600𝑎3 𝑡
18 40 −11 9 −5

720𝑎2 90𝑏 2 27𝑏𝑡 200𝑡 2 11𝑎𝑡 3501𝑏 2

540𝑏𝑡 4700𝑡 2 605 9𝑏 2 𝑡 2 10𝑡 4 ,

∗ 720 +54 −616 −33 +121

Π3CNN ,
8 40 −11 9 −5
106

CNN ∗ 11 −3 + ∗ 5 36 −11 −3 + ∗
l11 , lCNN
21
CNN
, l22 0
120 −33 3 40 −11 9 −5
∗ ∗ 3 18 −11 −3 +
𝑙22 0, 𝑙23 ,
2 40 −11 9 −5
CCN ∗ 360 +27 −308 +55
p11 ,
40 −11 9 −5

∗ 360 −27 −290 +55

pCCN
21 ,
40 −11 9 −5
∗ 18 −11 −3 +
pCCN
22 𝑡 ,
2 40 −11 9 −5
∗ 18 −11 −3 +
𝑝23 𝑡 ,
2 40 −11 9 −5

Subgame NCN/NNC

1 4 −3 + −3 +
Π1
∗
𝑡 8 , 0 𝑏 and 𝑎
8 9 −5 9 −5 3

1
5𝑏 5𝑡 or 𝑏
9 +18 −6 −9 6 3
NCN∗
Π2 ,
36 −20
1
𝑡 and 0 𝑎 5𝑏
6
∗
Π3NCN , 5𝑡
2

NCN ∗ ∗ 3 −3 + ∗
l11 0, lNCN
21 , lNCN
22 0,
2 9 −5
∗
𝑙23 0,
NCN∗ −3 +
p11 𝑡 ,
2 9 −5
107

∗ 3 −6 + +3
pNCN
21 ,
2 9 −5
∗
pNCN
22 𝑡,
∗
𝑝23 𝑡,

Subgame NNN

ΠiNNN
∗ 3
,pNNN
i
∗
t, lNNN
i
∗
0 𝑎 0 and 𝑏 0
2

Table A2 Optimal Outcomes of Three symmetric firms competing in two

markets

The proof of subgame equilibria is similar to the ones in proposition 2.

Proof of Proposition 4

The proof of each subgame equilibrium is the same the ones in proposition 2. The

subgame outcomes are shown in Table A3:

108

Optimal prices, customization ranges, profits Applicab

le parameter

set (feasibility

conditions)

Subgame CCCC

∗ 9 +54 −10
ΠiCCCC , 0
36 −6

∗ −3 + 𝑏 and 𝑎
lCCCC
i , 3
18 −3
1
6𝑏
∗ 18
pCCCC
i 𝑡,
5𝑡 or 3

5
𝑏 and 0
6

1
𝑎 6𝑏
18

5𝑡

Subgame CCCN
109

∗ ∗ ∗ 261 +1566 −54 −281

Π1CCCN Π2CCCN Π3CCCN , 0
1044 −180

∗ 3 58 +3 −11
Π4CCCN , 𝑏 and𝑎
8 29 −5 3

1
∗ 5 −3 + ∗ 5 −3 +
30𝑏
87
𝑙11 , 𝑙21 ,
87 −15 87 −15
∗ 5 −3 + ∗ 5 −3 +
𝑙22 87 −15
, 𝑙32 87 −15
, 25𝑡 or 3
∗ 5 −3 + ∗ 5 −3 +
𝑙33 , 𝑙43 ,
87 −15 87 −15 5
∗ 5 −3 + ∗ 5 −3 + 𝑏 and 0
𝑙44 14 ,𝑙 , 6
87 −15 87 −15
∗ 3 −3 + ∗
1
𝑙15 , 𝑙35 0, 𝑎 30𝑏
2 29 −5 87
∗ ∗ 3 −3 +
𝑙26 0, 𝑙46 ,
2 29 −5
25𝑡
∗ ∗
𝑝11 𝑡, 𝑝21 t,
∗ ∗
𝑝22 t, 𝑝32 t,
∗ −3 + ∗ 58 +3 −11
𝑝33 𝑡 , 𝑝43 ,
58 −10 58 −10
∗ 58 +3 −11 ∗ −3 +
𝑝44 , 𝑝14 𝑡 ,
58 −10 58 −10
∗ ∗
𝑝15 t, 𝑝35 𝑡,
∗ −3 + ∗ 58 +3 −11
𝑝26 𝑡 , 𝑝46 ,
58 −10 58 −10

Subgame CCNN

Π1CCNN
∗
Π2CCNN
∗ 126 +756 −54 −131
, 0
504 −90

𝑏 and 𝑎
3
∗ 1 4 −3 + −3 +
Π3CCNN 𝑡 6 ,
4 28 −5 28 −5 1
30𝑏
84

∗ 4704 +9 +112 3 −16 −66 +171

Π4CCNN , 25𝑡 or 𝑏
4 28 −5 3

5
6
and 0 𝑎
110

∗ 5 −3 + ∗ 5 −3 + 1
𝑙11 NN , 𝑙21 NN , 84
30𝑏
84 −15 84 −15
NN∗ 3 −3 + NN∗
𝑙22 , 𝑙32 0,
2 28 −5 25𝑡
∗ ∗
𝑙33 NN 0, 𝑙43 NN 0,
∗ ∗ 3 −3 +
𝑙44 NN 0, 𝑙14 NN ,
2 28 −5
∗ 3 −3 + ∗
𝑙15 NN , 𝑙 35 0,
2 28 −5
∗ −9 +3 ∗
𝑙26 , 𝑙46 0,
56 −10
∗ ∗
𝑝11 𝑡, 𝑝21 t,
∗ −3 + ∗ 56 +3 −11
𝑝22 𝑡 , 𝑝32 ,
56 −10 56 −10
∗ ∗
𝑝33 𝑡, 𝑝43 t,
∗ 56 +3 −11 ∗ −3 +
𝑝44 , 𝑝14 𝑡 ,
56 −10 56 −10
∗ −3 + ∗ 56 +3 −11
𝑝15 𝑡 , 𝑝35 ,
56 −10 56 −10
∗ −3 + ∗ 56 +3 −11
𝑝26 𝑡 , 𝑝46 ,
56 −10 56 −10

Subgame CNNN

Π1CNNN
∗ 9 3 −2 +3 6 −
, 0
4 27 −5

𝑏 and 𝑎
3
CNNN∗ CNNN∗ CNNN∗ 1 9 −3 +
Π2 Π3 Π4 𝑡 27
18 27 −5 1
18
5𝑏 5𝑡
9 −3 +
,
4 27 −5
or 𝑏
3

𝑡 and 0 𝑎
1
5𝑏 5𝑡
18
111

∗ 3 −3 + ∗
𝑙11 , 𝑙21 0, ,
2 27 −5
∗ ∗
𝑙22 0, 𝑙32 0,
∗ ∗
𝑙33 0, 𝑙43 0,
∗ ∗ 3 −3 +
𝑙44 0, 𝑙14 ,
2 27 −5
∗ 3 −3 + ∗
𝑙15 , 𝑙35 0,
2 27 −5
∗ ∗
𝑙26 0, 𝑙46 0,
∗ 3 −18 + +3 ∗ 54 +3 −11
𝑝11 , 𝑝21 ,
2 27 −5 54 −10
∗ ∗
𝑝22 t, 𝑝32 t,
∗ ∗
𝑝33 𝑡, 𝑝43 T,
∗ 54 +3 −11 ∗ 3 −18 + +3
𝑝44 , 𝑝14 ,
54 −10 2 27 −5
∗ 3 −18 + +3 ∗ 54 +3 −11
𝑝15 , 𝑝35 ,
2 27 −5 54 −10
∗ ∗
𝑝26 𝑡, 𝑝46 t,

Subgame NNNN

ΠiNNN
∗
t, lNNNN
i
∗
0, pNNNN
i
∗
t 𝑎 0 and 𝑏

Table A3 Optimal Outcomes of Four symmetric firms

Proof of Lemma 3

The proof of Lemma 3 is the same as the proof of Proposition 1. The optimal

solutions are:
112

4 −4 −4 +9
, 𝑖𝑓 b f a full customization range)
16
∗ +2
𝜋 i , 𝑖𝑓 b f a effectively no customization)
4
18 +36 −11
, o/w opartial customizationrange)
72 −18

1
, 𝑖𝑓 𝑏 𝑓 𝑎 full customization range)
2
∗
𝑙 i 0, 𝑖𝑓 𝑏 f a effectively no customization)
2 −3
, o/w opartial customizationrange)
12 −3

∗ ∗
𝑝 1 𝑡, 𝑝 2 𝑡

Moreover, we solve the "corner" case where y1CC = 0 and y2CC = 1, but lCC1 and

2 are positive, and the equilibrium results are:

lCC

∗ 5 +36 −2 + −2 +10 −14 ∗

Π CCc
1 ,Π CCc
2
2 6 +

5 +36 −2 + −2 +10 −14

,
2 6 +

∗ b+2 ∗ b+2
lCCc
1 ,lCCc
2 ;
6a+ 6a+

The profits and prices of the CN subgame are:

∗
𝜋 1

144 +11 3 −2 +11 −24 6 −5 +19 1 2

, 𝑖𝑓 𝑎 18𝑏 23𝑡 and 𝑏 full customization ra
16 −36 +11 36 3
9 +2 −3+l2 1 2
, 𝑖𝑓 𝑎 𝑏 3𝑡 and 𝑏 effectively no customization)
36 12 3
+3 −18 +2
, o/w opartial customizationrange)
2 −36 +11
113

∗
l 1

36𝑎 3𝑏 9𝑡 1 2𝑡
, 𝑖𝑓 𝑎 18𝑏 23𝑡 and 𝑏 full customization range)
72𝑎 22𝑡 36 3
1 2𝑡
0, 𝑖𝑓 𝑎 𝑏 3𝑡 and 𝑏 effectively no customization)
12 3
6𝑡 9𝑏
, o/w opartial customizationrange)
36𝑎 11𝑡

∗ 36 +3 −13
Π2CN ,
2 36 −11
∗ 3 −12 + +3 ∗ 1 5 −9 +6
p1CN , pCN
2 3𝑏 𝑡 6 𝐴18
−36 +11 6 36 −11

The "corner" case where y CN

1 0, the equilibrium results are:

67 b+3 +1458a b +2 +18a −67b −96b +90 54a−7b+9

ΠCNc
1 , ΠCNc
2 ,
18 18a+5 18 18a+5

7b+6
lCNc
1 , y CNc
1 0.
18a+5

∗ ∗
If CC is the subgame equilibrium, π2 𝜋2CNc 0.

∗ ∗ 1
π2 𝜋2CNc 1044 12456𝑎 50544𝑎2 69984𝑎3
18 1+6 5+18

126𝑏 2232𝑎𝑏 34992𝑎2 𝑏 147744𝑎3 𝑏 209952𝑎4 𝑏 49𝑏 2 1038𝑎𝑏 2

5004𝑎2 𝑏 2 5832𝑎3 𝑏 2

The denominator 18 1 6𝑎 2
5 18𝑎 2
is always positive. We need

1044 12456𝑎 50544𝑎2 69984𝑎3 126𝑏 2232𝑎𝑏 34992𝑎2 𝑏

147744𝑎3 𝑏 209952𝑎4 𝑏 49𝑏 2 1038𝑎𝑏 2 5004𝑎2 𝑏 2 5832𝑎3 𝑏 2 >0, solve for

b, then obtain:
114

3 21−372 −5832 −24624 −34992 + 5+48 +108 245+2200 +12024 +54432 +104976
49+1038 +5004 +5832

𝑓 𝑎 .

∗ ∗ +3 −18 +2
NN is equilibrium when Π1NN Π1CN always hold
2 2 −36 +11

3
when 𝑏 .
18 −

∗ ∗ ∗ ∗
CN is never the equilibrium because Π1CC Π1CN and Π1NN Π1CN always

3
hold when 𝑏 and 𝑏 𝑓 𝑎 .
18 −

Thus, When two firms compete in a single market and use uniform pricing

strategy for their customized products, the subgame perfect equilibrium is either

3
NN (when b ) or CC (when b f a).
18a−

Proof of Proposition 5.

Proposition 5 immediately follows from Lemma 3, which outlines the ranges

where the firms offer partial and full customization.

The end.
115

Appendix B
Proof of Proposition 1

We solve for the subgame perfect equilibrium using standard backwards induction

arguments. We start by optimizing the gray marketer’s profit in equation 7 taking

manufacturer prices and product quality as given and then optimize for these in

equation 3 - 6 , the resulting equilibrium values are given below:

𝛱 ∗
,
64

1− −
𝛱∗ ,
32

𝑞 ∗
,
8

−1 − + 2 − 2 + −
𝑝∗ , 𝑝1 ∗ ,
16 16

−2 −
𝑝2 ∗ ,
16

− − + −2 −
𝜃 1∗ , 𝜃 2∗ , 𝜃∗ , 𝐷1 ∗ ,𝐷 ∗ ,
2 2 2 2

1
𝐷2 ∗ ,𝐷 ∗
𝑁1 𝑁2 ,
2 2

1
𝐶𝑆1 ∗ 𝜃12 𝑦 𝑓 4 𝜃12 𝑁22 𝑓 3 𝜃1 𝜃1 2𝜃2 𝑁22 2𝑓 2 𝜃1 3𝜃2 2𝜃1 𝑁22
64

𝑓𝜃2 𝑁2 4𝜃1 𝑁1 2𝜃2 𝑁1 𝜃2 𝑁2 𝜃22 𝑁12 ,

−2 + −2
𝐶𝑆2 ∗ ,
64
116

1
𝐶𝑆 ∗
(𝑦 𝑓 4 𝜃12 𝜃22 𝜃12 𝑁22 𝑓 3 𝜃12 𝑁2 2𝜃22 𝑁1 𝜃12 2𝜃2 𝜃1 4𝜃22 𝑁2
64

𝑓 2 𝜃1 2𝜃1 2𝜃12 3𝜃2 𝜃1 2𝜃22 𝑁22 4𝜃22 𝜃1 𝜃2 𝑁1 𝑁2 𝜃1 𝜃22 𝑁12

𝑓𝜃1 𝜃2 𝜃1 𝜃2 𝑁22 2 2𝜃12 𝜃2 𝜃1 4𝜃22 𝑁1 𝑁2 4𝜃22 𝑁12 𝜃22 𝜃12 4𝜃22 𝑁12 ),

where

𝑦 𝜃1 𝑓 2 𝑁2 2𝜃1 𝑁1 𝜃2 𝑁2 2𝑓𝑁2 𝜃2 𝑁2 𝜃1 𝜃2 𝑁1 𝜃2 𝑁12 ,

𝑧 𝑓 2 𝜃1 𝑁2 2𝑓𝜃1 𝑁2 𝜃2 𝑁1 . (B1)

Conditions for the existence of the equilibrium:

0 𝑓 1, 0 𝜃2 𝑓𝜃1 , 0 𝑁1 𝑁2 , and 0 𝑐 (B2)

Furthermore, we compare the profits with and without the gray market and obtain

the change in equilibrium profits under the two scenarios

∗ ∗
1 𝑦2 2
ΔΠ Π Π 𝜃1 𝑁1 𝜃2 𝑁2 (B3)
64𝑐 𝑧 2

Since we have 0 𝑓 1 and 0 𝜃2 𝑓𝜃1 , we can show that ΔΠ Π Π

0 always holds under these basic assumptions. Thus, the manufacturer's profit

without the gray market is always greater than the profit in the presence of the gray

market.
117

∗
𝑁1 𝑁2 𝜃2 𝑓𝜃1 2
Δ𝑞 𝑞 𝑞∗
8𝑐 𝑓 2 𝑓𝜃1 𝑁2 8𝑐𝜃2 𝑁1 (B4)

Since 8𝑐 𝑓 2 𝜃1 𝑁2 2𝑓𝜃1 𝑁2 𝜃2 𝑁1 0, the change of quality is always negative,

which means the quality will decrease in the presence of the gray market.

We compare the changes in prices and quantities in the presence of the gray market,

by subtracting the parameters with the gray market from the one with the gray

market and obtain

− 3 −4 + 2−3 + −2 −2 +
Δ𝑝1 < 0,
16

− −2 −2 −1 + −2 −2 + +
Δ𝑝2 <0,
16

Δ𝐷1 0, Δ𝐷2 0, and Δ𝐷 0. (B5)

The reason for the above conclusion is because of the change of the prices change in

Market 1, and Market 2 is given as

Δ𝑝12 Δ𝑝1 Δ𝑝2

𝑓𝜃1 𝜃2 𝑓 2 3𝑓 4 𝜃13 𝑁1 𝑁22 𝑓𝜃2 𝜃12 𝑁2 𝑓2 𝑓 2 𝑁2 𝑁1 2 𝑓

2 𝑁12 𝑓 2 𝑓𝑁22 𝜃22 𝜃1 𝑁1 𝑓 1 𝑁2 𝑁1 2 𝑓 2 𝑓𝑁22 𝑁12 (B6)

𝜃23 𝑁12 𝑁2 /16𝑐𝑧 2

Δ𝑝12 is always positive under the equilibrium conditions, which means that the

change of price in Market 1 is always greater than the price change in Market 2.

Moreover, the change of the demand in two markets is zero.

118

Proof of Lemma 1

∗
We obtain the difference of the consumer surpluses between the 𝐶𝑆 ∗ and 𝐶𝑆

∗
Δ𝐶𝑆 𝐶𝑆 𝐶𝑆 ∗

1
𝜃 𝑓𝜃12 𝑁22 𝜃2 𝑓𝜃1 2
64𝑐𝑧 3 1

𝜃12 𝑓 2 𝑓𝜃1 𝑁2 𝜃2 𝑁1 𝑓𝑁2 𝑓 2 𝜃1 2𝜃2

𝜃2 𝑁1 (B7)

2
𝜃22 𝑓𝜃1 𝑓 2 𝑁2 𝑁1 2𝜃2 𝑁1 𝑓 2 𝑁2 2𝜃1 𝑁1

𝜃2 𝑁2 2𝑓𝑁2 𝜃2 𝑁2 𝜃1 𝜃2 𝑁1 𝜃2 𝑁12

𝜃12 𝜃22 𝜃1 𝑁1 𝜃2 𝑁2

Under the two equilibrium conditions, Δ𝐶𝑆 ∗ 0 always holds.

Proof of Proposition 2

The equilibrium is calculated by standard backwards induction arguments to yield

𝛱 ∗
,
64

∗
𝛱

−1 12 −2 −1 + 2 7−5 − −2 11 −12 + 4 2 −3 +
32

−2 −1 −2 − −4 −1 +2
Π ∗
1 ,
16
119

−1 −2 −2 −2 − 2 −1 −
Π ∗
2 ,
16

𝑞 ∗
, 𝑞∗ 𝑓𝑞 ∗ ,
8

8−5 +8 −2 −1 2 −1 − +
𝑤1 ∗ ,
16

− −2
𝑤2 ∗ ,
16

𝑝∗

12 −2 −1 + −1 34−20 + −12 −2 + 8 −11 − −10 +12

16

∗
𝑝 1

24 −2 −1 −2 −1 3 5 −8 +5 −2 + 3 3 −4 + 7 −10
16

2 −2 −1 6 −2 −5 + 7 −10 −3 −2 3 −4
𝑝 ∗
2 ,
16

1
𝜃 ∗1 𝜃1 12 𝑓 2 𝑓 1 2 𝑓 2 𝜃1 2 𝑁2 2 𝑓 1 𝑓𝜃1 𝜃2 𝑁2 34 20𝑓 𝑁1 𝑓
2

12 𝑓 2 𝑁2 𝜃2 2 𝑁1 8𝑓 11 𝑁1 𝑓 10 𝑓 12 𝑁2 ,

1
𝜃 ∗2 𝑓𝜃1 𝜃2 2 𝑓 2 𝑓 1 𝑓𝜃1 𝑁2 6 𝑓 2 𝑁2 5𝑁1 𝜃2 𝑁1 7𝑓 10 𝑁1
2

3 𝑓 2 3𝑓 4 𝑁2 ,

−2 − 12−8 + −2 +12 −2 −1
𝜃∗ ,
2
120

−2 −2 − 4 −1 − +2
𝐷1∗ ,
2

−2 −2 −2 +2 + −2 −
𝐷2∗ ,
2

−2 − 5−2 − −4 +2 −1 2 −5 +2 −2
𝐷∗ ,
2

where 𝑦 ≝ 8𝑓 5 𝜃13 𝑁1 𝑁22 4𝑓 5 𝜃12 𝜃2 𝑁23 32𝑓 4 𝜃13 𝑁1 𝑁22 20𝑓 4 𝜃12 𝜃2 𝑁23

12𝑓 4 𝜃12 𝜃2 𝑁1 𝑁22 40𝑓 3 𝜃13 𝑁1 𝑁22 𝑓 3 𝜃1 𝜃22 𝑁1 𝑁22 32𝑓 3 𝜃12 𝜃2 𝑁23 36𝑓 3 𝜃12 𝜃2 𝑁1 𝑁22

6𝑓 3 𝜃12 𝜃2 𝑁12 𝑁2 16𝑓 2 𝜃13 𝑁1 𝑁22 6𝑓 2 𝜃1 𝜃22 𝑁1 𝑁22 6𝑓 2 𝜃1 𝜃22 𝑁12 𝑁2 16𝑓 2 𝜃12 𝜃2 𝑁23

24𝑓 2 𝜃12 𝜃2 𝑁1 𝑁22 22𝑓 2 𝜃12 𝜃2 𝑁12 𝑁2 𝑓𝜃1 𝜃22 𝑁13 8𝑓𝜃1 𝜃22 𝑁1 𝑁22 12𝑓𝜃1 𝜃22 𝑁12 𝑁2

16𝑓𝜃12 𝜃2 𝑁12 𝑁2 4𝜃1 𝜃22 𝑁13 ,

𝑧 ≝ 𝑓 2 𝜃1 𝑁2 2𝑓𝜃1 𝑁2 𝜃2 𝑁1 8𝑓 3 𝜃1 𝑁2 24𝑓 2 𝜃1 𝑁2 16𝑓𝜃1 𝑁2 (B8)

5𝑓𝜃2 𝑁1 8𝜃2 𝑁1 .

To ensure the equilibrium of proposition 2 (a) holds , we need the condition set A

such that for the optimal product quality, all prices and quantities are positive:

𝑞 ∗
0, 𝑝∗ 𝑤∗ 0, 𝜃1∗ 𝜃∗ 𝜃 ∗1 0, 𝜃2∗ 𝜃 ∗2 0, 𝑝∗ 1 𝑝∗ 𝑝∗ 2 0 (B9)
A ,
Π ∗
0, Π ∗ 0

where 𝑖 1,2.

As an example we offer below, a plot of the parameter space for which the

equilibrium holds where WLOG 𝑁1 1, 𝜃1 1 and we set 𝑐 0.01 for expositional

purposes.
121

Figure A.1 The parameter space for which equilibrium in the presence of the gray

markets exists

The change of the qualities with and without the gray market:

𝛥𝑞 𝑞 ∗
𝑞∗ 𝑁1 8 𝑓 2 𝑓 1 𝑓 3 𝜃13 𝑁22 𝑓 2 𝜃2 𝜃12 𝑁2 𝑓 2 𝑁1 (B10)

24 𝑓 2 𝑓 1 𝑁2 𝑓𝜃22 𝜃1 12 𝑓 2 𝑁2 𝑁1 𝑓 2 11𝑓 8 𝑁22

3𝑁12 8 5𝑓 𝜃23 𝑁1 𝑁2 /16𝑐 𝑓 2 𝑓𝜃1 𝑁2 𝜃2 𝑁1 8 𝑓 2 𝑓

1 𝑓𝜃1 𝑁2 8 5𝑓 𝜃2 𝑁1

Under our basic assumptions, the change of the product quality can either be

positive or negative. Below we show a plot of the equilibrium parameters where the

yellow part represents the positive product quality and the red represents the

negative product quality:

122

Figure A.2 Partition of the equilibrium parameter space based on the change in

quality

The blue dot (𝜃2 0.6, 𝑓 0.8, 𝑁2 2) represents a parameter collection where the

equilibrium holds and quality increases.

To prove (b) the manufacturer profit increases if and only if the offer product

quality is higher in proposition 2, we first obtain the change of the profits with and

without the gray market given the channel structure:

∗ 1
𝛥𝛱 𝛱 𝛱∗ 𝜃1 𝑁1 𝜃2 𝑁2 2
4𝜃12 8 𝑓 2 𝑓 1 2 𝑓 2 𝜃12 𝑁1 𝑁22
256

2 𝑓 1 𝑓𝜃2 𝜃1 𝑁2 8 3𝑓 𝑁12 6 𝑓 2 𝑓𝑁2 𝑁1 2 𝑓 2 2 𝑓𝑁22 𝜃22 𝑁1 𝑓

(B11)
4 𝑁12 6 𝑓 2 𝑓𝑁2 𝑁1 𝑓 4 𝑓 2 𝑓𝑁22 2
/ 𝑓 2 𝑓𝜃1 𝑁2 𝜃2 𝑁1 2
8 𝑓
2
2 𝑓 1 𝑓𝜃1 𝑁2 8 5𝑓 𝜃2 𝑁1

Consider the ratio between the change in profits and the change in quality
123

8 𝑓 2 𝑓 1 𝑓 2 3𝑓 4 𝜃13 𝑁1 𝑁22 𝑓𝜃2 𝜃12 𝑁2 86 25𝑓 𝑓 64 𝑁12

24 𝑓 2 𝑓 1 𝑓𝑁2 𝑁1 16 𝑓 2 2
𝑓 1 𝑓𝑁22 𝜃22 𝜃1 𝑁1 7𝑓 16 𝑁12 12 𝑓
(B12)
2 𝑓𝑁2 𝑁1 3 𝑓 2 𝑓 5𝑓 8 𝑁22

5𝑓 8 𝜃23 𝑁12 𝑁2 ⁄ 16 𝑓 2 𝑓𝜃1 𝑁2 𝜃2 𝑁1 8 𝑓 2 𝑓 1 𝑓𝜃1 𝑁2 8 5𝑓 𝜃2 𝑁1

Under our assumptions and when the two equilibria in equation 𝐴16 and

𝐴17 exist it is straightforward to show that is always positive. Thus, the

manufacturer's profit increases if and only if product quality increases.

Proof of Proposition 3

We define the set B for which gray markets increase the profits of all three entities

as follows:

B {Π ∗
Π∗ , Π ∗
1 Π∗ 1 , Π ∗
2 Π∗ 2 , 𝑐 0, 𝑁2 𝑁1 0, 𝑓 𝜃1∗ (B13)

𝜃2∗ , and 0 𝑓 1}.

If we consider the set 𝐴 ∩ 𝐵, it is straightforward to check that the point 𝑁2

2, 𝑁1 1, 𝜃1 1, 𝜃2 0.6, and 𝑓 0.8 is indeed in the intersection set

guaranteeing it is not empty proving the proposition. The plot below depicts the full

set of parameters for which 𝐴 ∩ 𝐵 is not empty 𝑁1 1, 𝜃1 1. The blue dot (𝜃2

0.6, 𝑓 0.8, 𝑁2 2) represents a parameter set for which all three entities make

higher profits in the equilibrium.

124

Figure A.3 The parameter space for which of all three entities are better off in the

presence of the gray market

Note that, Retailer 2 can be better off even when the manufacturer is not. This

occurs only when the quality offered is lower. That is, for a set of parameter there

exists a unique equilibrium for which Retailer 2’s profit increases while the product

quality, Retailer 1 and the manufacturer’s profit all decrease.

125

Figure A.4 The parameter space for which Retailer 2 is better off and the

Manufacturer and Retailer 1 are worse off in the presence of the gray market

The blue dot (𝜃2 0.03, 𝑓 0.3, 𝑁2 2) represents a parameter set for which

Retailer 2’s profits increase in the presence of gray markets while the manufacturer

and Retailer 1’s profits decrease.

Proof of Proposition 4

The proof of Proposition 4 is similar to the proof of Lemma 1.

Proof of Proposition 5

We first solve for the equilibrium where there is no gray market for the mixed

channel structure:
126

+2 +2 +2 +2
𝛱∗ , Π∗ 1 , 𝑞∗ , 𝑤1∗ ,
256 256 16 32

(A14)
3 +2 +2 3
𝑝∗ 1 , 𝑝2∗ , 𝜃 ∗1 , 𝜃 ∗2 , 𝐷1∗ , 𝐷2∗ ,
64 32 4 2 4 2

1
𝐷∗ 𝑁1 2𝑁2 .
4

We need the condition set C to ensure the equilibrium holds:

𝑞∗ 0, 𝑤1∗ 0, 𝜃1∗ 𝜃 ∗1 0, 𝜃2∗ 𝜃 ∗2 0, 𝑝∗ 1 𝑝∗ 2 0

C , (A15)
Π ∗ 0, Π∗ 0

Furthermore, we consider the equilibrium conditions for mixed structure in the

presence of the gray market is as follows:

𝛱 ∗
,
64

−1 −2 3 −2 −
𝛱 ∗
,
128

−1
𝛱 1
∗
, (A16)
64 −2

𝑞 ∗
,
8

2 −1 − −
𝑤1 ∗
,
16 −2 −
127

5−3 + −2 3 −1 −2
𝑝 ∗
, 𝑝∗ 1
32

−2 3 −1 − + 3−2
,
16

−2 −2 − 5−3 + −2 3 −1 −2
𝑝2 ∗
, 𝜃 ∗1 , 𝜃 ∗2
16 4

−2 −2 − 3
, 𝜃∗ ,
2 4

−2 + +4 −3 +2 −2
𝐷1 ∗
, 𝐷2 ∗
,𝐷 ∗
,
4 8−4 4 −2

where

𝑦 𝜃1 𝑓 3 𝜃1 𝑁1 𝑁2 𝑓 3 𝜃2 𝑁22 3𝑓 2 𝜃1 𝑁1 𝑁2 4𝑓 2 𝜃2 𝑁22 2𝑓 2 𝜃2 𝑁1 𝑁2 2𝑓𝜃1 𝑁1 𝑁2

4𝑓𝜃2 𝑁22 4𝑓𝜃2 𝑁1 𝑁2 𝜃2 𝑁12 ,

𝑧 𝑓 2 𝑓 2 𝜃1 𝑁2 2𝑓𝜃1 𝑁2 𝜃2 𝑁1 .

We need the condition set D to make sure that the equilibrium holds in the presence

of the gray market:

∗ ∗ ∗ ∗
𝑞 ∗
0, 𝑝 1 𝑤1 0, 𝜃1∗ 𝜃 ∗ 𝜃 1 0, 𝜃2∗ 𝜃2 0,
D 𝑝∗ 1 𝑝∗ 𝑝2∗ 0, , where
Π ∗
0, Π ∗
0, Π ∗
1 0 (A17)

𝑖 1,2.

The profit change between having a gray market and not having the gray market is

given by:
128

+2 −
𝛥𝛱 𝛱 ∗
𝛱∗ . (A18)
256

Similarly, the quality change is:

−2 + −4 −2 +2 −2
𝛥𝑞 𝑞 ∗
𝑞∗ 16 −2 −2 −
.. (A19)

Without loss of generality, we let N1 1 and θ1 1, then the ratio between the

change in profit and change of quality becomes:

(A20)
−2 −2 − +2 −
16 −2 + −4 −2 +2 −2

One can easily see that the ratio will always be positive under the equilibrium

conditions, which indicates that the manufacturer’s profit increases if and only if the

product quality increases in the presence of the gray market for the mixed channel

structure. Similar proof holds for the case where there is a retailer in Market 2 only.

The red area in Figure A.5 is the set of parameters where the manufacturer makes

more money in the presence of the gray market with a retailer in Market 1 only, and

the yellow area is the case where there is a retailer in Market 2 only :
129

Figure A.5 Plot where the manufacturer makes more money in the presence of the

gray market with only one retailer in each market

Proof of Proposition 6

We assume that Retailer 2 acts as a gray marketer. We first characterize the

equilibrium and the set of parameters for which it holds. We use the same backward

induction process and get the following equilibrium:

𝛱 2∗
,
256

−1
Π 2∗
1 ,
128 −2 (A21)

2∗ 1
Π 2 𝜃1 𝑦 𝑓 6 𝜃12 𝑁22 9𝜃1 𝑁1 𝜃2 𝑁2 𝑓 5 𝜃12 𝑁22 45𝜃1 𝑁1 16𝜃2 𝑁1
256

8𝜃2 𝑁2 4𝑓 4 𝜃1 𝑁2 4𝜃1 𝜃2 𝑁12 3 6𝜃12 7𝜃2 𝜃1 𝜃22 𝑁2 𝑁1 6𝜃1 𝜃2 𝑁22

130

4𝑓 3 𝜃1 𝑁2 𝜃2 13𝜃1 6𝜃2 𝑁12 9𝜃12 36𝜃2 𝜃1 17𝜃22 𝑁2 𝑁1 8𝜃1 𝜃2 𝑁22

4𝑓 2 𝜃2 𝜃1 𝜃2 𝑁13 2 5𝜃12 11𝜃2 𝜃1 2𝜃22 𝑁2 𝑁12 4𝜃1 5𝜃1 8𝜃2 𝑁22 𝑁1 4𝜃12 𝑁23

4𝑓𝜃22 𝑁1 𝜃1 𝑁12 4 5𝜃1 4𝜃2 𝑁2 𝑁1 20𝜃1 𝑁22 64𝜃23 𝑁12 𝑁2

𝑞 2∗
,
16

−2 2 − 2 + −2
𝑤1 2∗ ,
32

−2 −2 −2
𝑤2 2∗ ,
32

3 −9 +6 −6 −2 +10 +4
𝑝 2∗
,
64

3 − 9 + +2 3 + −2 +6
𝑝 2∗
1 ,
32

−2 −3 +2 +3 +4
2 = ,
2∗
𝑝 64

− + +2 −3 + −2
𝐷1 2∗ , 𝐷2 2∗ ,𝐷 2∗
,
4 8−4 4 −2

where

𝑦 2𝑓 3 𝜃1 𝑁1 𝑁2 𝑓 3 𝜃2 𝑁22 6𝑓 2 𝜃1 𝑁1 𝑁2 4𝑓 2 𝜃2 𝑁22 4𝑓 2 𝜃2 𝑁1 𝑁2 4𝑓𝜃1 𝑁1 𝑁2

4𝑓𝜃2 𝑁22 8𝑓𝜃2 𝑁1 𝑁2 4𝜃2 𝑁12 and 𝑧 𝑓 2 𝑓 2 𝜃1 𝑁2 2𝑓𝜃1 𝑁2 2𝜃2 𝑁1 .

To ensure the equilibrium holds, we need the condition set C such that:
131

E {Π 2∗
0, Π 2∗
1 0, Π 2∗
2 0, 𝑞 2∗
0, 𝑝 2∗
1 𝑤1 2∗ 0, 𝑝 2∗
2 𝑤2 2∗ 0, 𝜃1∗ (A22)

𝜃 2∗
𝜃 12∗ 0, 𝜃2∗ 𝜃 22∗ 0, 𝑝 2∗
1 𝑝 2∗
𝑤2 2∗ 0

𝑐 0, 𝑁2 𝑁1 0, 𝑓 𝜃1∗ 𝜃2∗ , and 0 𝑓 1}.

The set E is depicted below:

Figure A.6 The parameter space for which equilibrium exists when the Retailer 2 is a

gray marketer

To further prove Proposition 6, we first obtain the change of the profits and the

product quality with and without the gray market:

− +
𝛥𝛱 2
𝛱 2∗
𝛱∗ , (A23)
256
132

2∗
𝑁1 𝑓 2 𝑓 2 𝜃12 𝑁2 2𝑓𝜃2 𝜃1 𝑁1 2 𝑓 2 𝑁2 2 𝑓 2 𝜃22 𝑁2
𝛥𝑞 2
𝑞 𝑞∗
16𝑐 𝑓 2 𝑓 2 𝑓𝜃1 𝑁2 2𝜃2 𝑁1

The change of the quality can be either positive or negative under our basic

assumptions, since the sign of the expression 𝑁1 2 𝑓 𝑓 2 𝑁2 𝜃1 2 2𝑓 𝑁1

2 2 𝑓 𝑁2 𝜃1 𝜃2 2 2 𝑓 𝑁2 𝜃2 2 can be either positive or negative.

Next, consider the ratio between 𝛥𝛱 2

and 𝛥𝑞:

𝛥𝛱 2
(A24)
2
𝑓 2 𝑓 3𝑓 4 𝜃12 𝑁1 𝑁2 2𝜃2 𝜃1 𝑓 4 𝑁12 2 𝑓 2 𝑓𝑁2 𝑁1
𝛥𝑞

𝑓 2 2 𝑓𝑁22 2 𝑓 2 𝜃22 𝑁1 𝑁2 /16 𝑓 2 𝑓 2 𝑓𝜃1 𝑁2

Under our basic assumptions and the two equilibria conditions in section 4,
2𝜃2 𝑁1
0 holds.

In fact, 0 holds for the entire parameter sets.

Consider the changes of Retailer 1 and Retailer 2’s profits, we obtain:

2 2∗
𝛥𝛱 1 𝛱 1 𝛱∗1

−2 3 −4 + 2 −8 −2 −1 + −2 +2 −2
0,
256 −2 −2 −2
(A25)

2 2∗ 1
𝛥𝛱 2 𝛱 2 𝛱∗2 𝜃2 𝑁2 𝜃1 𝑁1 𝜃2 𝑁2 𝜃1 2 𝑓 2 𝑓 1 𝑓𝜃1 𝑁1 𝑁2
256

𝜃2 4 𝑓 2 𝑓𝑁2 𝑁1 𝑓 2 2 𝑓𝑁22 4𝑁12 9 𝑓 2 2

𝑓 1 𝑓 3 𝜃13 𝑁1 𝑁22 𝑓
133

2 𝑓 2 𝜃2 𝜃12 𝑁2 𝑓 2 3 𝑁22 4 4𝑓 5 𝑓 2 𝑁1 𝑁2 4 4𝑓 5 𝑁12 4𝑓𝜃22 𝜃1 𝑁1 𝑓

1 𝑁12 2 𝑓 2 3𝑓 5 𝑁2 𝑁1 𝑓 2 2
3𝑓 5 𝑁22 16 𝑓 2 2 𝜃23 𝑁12 𝑁2 /

3 3
𝑓 2 𝑓 2 𝑓𝜃1 𝑁2 2𝜃2 𝑁1 0

Clearly, the change of the Retailer 2’s profit is always positive or the retailer would

not act as a gray marketer. However, Retailer 1’s profit is always lower with the

presence of the gray market created by Retailer 2.

Proof of Proposition 7

If the gray marketer can buy from the manufacturer directly, and we find the

optimal equilibrium solutions as:

−1 −3 +2 3 + +2 −2
𝛱 ∗
,𝛱 ∗
256 256

−1 −2 +2 − −4
Π 1
∗
,Π 2
∗
,
128 −2 256

(A26)
𝑞 ∗
,𝑞 ∗
𝑓∗𝑞 , ∗
16

2 − 2 + −2 −2 −2
𝑤1 ∗
,𝑤2 ∗
,𝑝 1
∗
32 −2 −2 32 −2 −2

3 − 9 + +2 3 +𝜽𝟐 −𝟐𝜽𝟐 𝑵𝟏 +𝟔𝜽𝟐 𝑵𝟏

,𝑝 2
∗
𝟑𝟐𝒄𝒛𝟐

−2 3 −2 +3 −4
,𝑝 ∗
64

3 −9 −6 +6 −2 +10 +4
,
64

− + +2 −3 + −2
𝐷1 ∗
, 𝐷2 ∗
,𝐷 ∗
,
4 8−4 4 −2
134

where 𝑦 𝜃1 2𝑓 3 𝜃1 𝑁1 𝑁2 𝑓 3 𝜃2 𝑁22 6𝑓 2 𝜃1 𝑁1 𝑁2 4𝑓 2 𝜃2 𝑁22 4𝑓 2 𝜃2 𝑁1 𝑁2

4𝑓𝜃1 𝑁1 𝑁2 4𝑓𝜃2 𝑁22 8𝑓𝜃2 𝑁1 𝑁2 4𝜃2 𝑁12 , and 𝑧 𝑓 2 𝑓 2 𝜃1 𝑁2 2𝑓𝜃1 𝑁2

2𝜃2 𝑁1 .

Condition set F for the existence of the above equilibrium is given by

F {Π ∗
0, Π ∗
1 0, Π 2
∗
0, 𝑞 ∗
0, 𝑝 1
∗
𝑤1 ∗
0, 𝑝 2
∗
𝑤2 ∗
0, 𝜃1∗ (A27)

𝜃 ∗
𝜃 1∗ 0, 𝜃2∗ 𝜃 2∗ 0, 𝑝 1
∗
𝑝 ∗
𝑤2 ∗
0, 𝑐 0, 𝑁2 𝑁1 0, 𝑓 𝜃1∗

𝜃2∗ , and 0 𝑓 1}.

Consider the profit change of buying from the manufacturer directly and no gray

market (the blue dot is 𝜃2 0.6, 𝑓 0.8, 𝑁2 2 ):

Figure .7. The parameter space for the existence of an equilibrium when the gray

marketer buys from the manufacturer directly

135

∗
𝛥𝛱 𝛱 𝛱∗

− +
,
256

−2 +2 −2 −2 +2 −2
𝛥𝑞 𝑞 ∗
𝑞∗ , (A28)
16 −2 −2 −2

The ratio between the change in profits and the change in profits is:

−2 3 −4 +2 − −4 −2 −2 + −2 −2 −2
, (A29)
16 −2 −2 −2

Under our underlying assumptions, 0 always holds. Thus, we conclude that

the manufacturer’s profits increase if and only if quality increases. Next, consider

the changes in Retailer 1 and Retailer 2 profits:

∗
𝛥𝛱 1 𝛱 1 𝛱∗1

−2 3 −4 + 2 −8 −2 −1 + −2 +2 −2
𝟎,
256 −2 −2 −2

𝛥𝛱 M2 𝛱 2
∗
𝛱∗2 𝜃1 2 𝑓 2 𝑓 1 𝑓𝜃1 𝑁1 𝑁2 𝜃2 4 𝑓 2 𝑓𝑁2 𝑁1
256

2
𝑓 2 2 𝑓𝑁22 4𝑁12 𝑓𝜃1 𝑓 2 𝑁2 2𝑁1 4𝜃2 𝑁1 / 𝑓 2 𝑓 2 𝑓𝜃1 𝑁2 (A30)

3
2𝜃2 𝑁1 𝜃1 𝑁1 𝜃2 𝑁2

The manufacturer’s profit change can be positive or negative compared the profits

between buying from the manufacturer directly and buying from the Retailer 2,
136

which can be found in the following plot (The blue dot is 𝜃2 0.3, 𝑓 0.5, 𝑁2 2 ),

where the yellow part represents the increase and the red represents decrease:

Figure A. The plot of manufacturer’s profit changes between buying from the

manufacturer directly and buying from the Retailer 2

Similarly, we show that the profit difference of the gray marketer when it buys from

the manufacturer, as opposed to retailer 2 is always positive. Thus, we conclude that

the gray marketer’s profit is always higher when buying from the manufacturer

directly.

Proof of Proposition 8

The proof pf proposition 8 uses the exact same process as proposition 1.

137

Proof of Proposition 9

The proof pf proposition 8 uses the exact same process as proposition 1.

Proof of Proposition 10

The proof pf proposition 8 uses the exact same process as proposition 1.

138

Appendix C
Survey19

Many manufacturers set different prices for their products when selling them in

different countries. When identical items are sold for lower prices outside of the US,

retailers can buy them abroad and bring them to the US to sell them to American

consumers. The practice of importing items from one country to another through an

unauthorized channel is legal (with some exceptions) according to the US Supreme

Court.

1. You are interested in buying a high-end camera. You find a model you like at

reputable retailer A, and you find the exact same model at a different

reputable retailer B20. The only difference between the two models is that the

one sold by Retailer B was originally meant to be sold in a market outside the

US, and therefore is priced differently.

a. Do you have any concerns about buying the camera from Retailer B21?

19 Each participant was presented with a computerized survey that included items from one

or two out of three potential product categories. These were cosmetics, clothing and electronics with
average prices of $50, $300 and $800 respectively.
20 We randomized the identity of the retailer offering the gray market good.
21 The participants saw parts a-e sequentially. Each part revealed only after answering the

previous ones.
139

Now assume that retailer A sells the camera at $800

b. What is the maximum price you would pay for the camera sold by Retailer B?

c. What factors led to your decision?

d. If Retailer B sells the camera for $680 and promises the same refund policy as

retailer A will you buy from It.

Yes or No

e. Please explain your decision in part d.

140

The survey was taken by 118 consumers between the ages of 25 and 45 providing

71 responses for products in each of three categories. The average required

discount in order to shop at the gray market retailer was about 20% for Cosmetics

about 18% for Clothing and 25% for electronics.

Below is a graph summarizing the percentage discount required by the participants:

% Discount Required to Buy GM Goods

30

25

20

15

10

0
0-5% 5-10% 10-20% 20-30% 30-40% 40%+ No Buy

Cosmetics Clothing Electronics

141