Gray market occurs when a product is diverted from a market to another without the authorisation of the manufacturer. Conventional wisdom believes that (a) the manufacturer should increase product quality as consumer valuation increases, (b) gray market dilutes the manufacturer's incentive to invest in quality, (c) gray products flow from a low-value market to a high-value one, and (d) the manufacturer can decrease product differentiation across regions to curb gray diversion. This paper provides another look by analysing a game-theoretic model wherein one manufacturer sells a product in two markets, a high-value market and a low-value one, each of which contains one single authorised retailer. Using a game-theoretic approach, we find that (a) in the absence of a gray market, the manufacturer may decrease product quality as consumer valuation increases, (b) a unilateral gray market, which diverts products from the low- to the high-value market, can motivate the manufacturer to improve quality, (c) there may exist two gray markets simultaneously: one diverts products from the low- to the high-value market, and the other occurs along the reverse direction, and (d) when quality can be differentiated across markets, the manufacturer might increase quality differentiation in order to manage gray market.
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