When Gray Markets Meet “Made in China”: The Impacts of Global Markets and Value-Added Tax Refund

Motivated by the trend that a gray market such as overseas shopping is thriving on E-commerce platforms, this paper investigates the impacts of the gray market on global supply chain management. We consider a multinational firm (MNF) that outsources product manufacturing to a contract manufacturer (CM) in China and sells products in both the China market and overseas market. Owing to the price gap between the two markets, gray firms may purchase products in the low-price market and compete with the MNF in the high-price market. We build MNF-led Stackelberg game models under the two cases where the wholesale price between the CM and MNF is exogenously given or endogenously set by the CM. We also consider the impacts of China’s partial value-added tax (VAT) refund policy and consumers’ valuation discount for gray products. Our analysis shows that the gray market emerges if the two markets are highly asymmetric in size. Moreover, the gray market is more likely to emerge with lower values of valuation discount, substitutability, and VAT loss. We find that both the MNF and CM may be better off with the emergence of the gray market. When the gray market does not emerge but poses a threat, the MNF strategically adjusts her global pricing strategy to prevent the gray market. In this case, the threat of the gray market always hurts the MNF and CM under exogenous wholesale price, but may improve the MNF’s profit under endogenous wholesale price, since the CM is motivated to lower wholesale price to restore demand.