Manufacturing and Distribution Strategies, Distribution Channels, and Transaction Costs: The Case of Parallel Imports in Automobiles
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Manufacturing and Distribution Strategies, Distribution Channels,
and Transaction Costs: The Case of Parallel Imports in Automobiles*
Godfrey Yeung* and Vincent Mok**
We apply transaction cost economics to examine the roles of transnational
corporations’ (TNCs) manufacturing and marketing strategies and how
constraints on official distribution channels, the asset specificity and
bounded rational behavior of franchise dealers and parallel traders could
contribute to the sustainability of parallel imports in automobiles. TNCs’
manufacturing and distribution strategies partly contribute to the existence of
regional differences in the pricing and availability of specific models and
specifications of vehicles. These necessary conditions allow opportunistic
parallel traders to engage in arbitrage. In addition, the asset specificity of
franchise dealers, the bounded rationality, and the opportunism of dealers
and arbitrageurs, contribute to the existence and sustainability of parallel
imports. Franchise dealers are unable to respond to the market demand as
they are “locked-in” with specific manufacturers (due to the non-deployable
nature of their assets) and have to implement the official distribution
strategies of manufacturers by stocking certain models and specifications of
vehicles at pre-determined volumes every year. Instead of letting their capital
be tied-up in stocks, rationally bounded and profit-oriented dealers are
willing to risk the possible sanctions of manufacturers to offload their surplus
stocks to opportunistic parallel traders directly or indirectly.
Keywords: Parallel imports, manufacturing and distribution strategies, distribution channels,
transaction costs, and automobiles
Introduction
The parallel distribution of genuine brand name products by unauthorized distributors is a well-
known phenomenon in the globalized world. For instance, it is estimated that 38 percent of
iPhones designated for the United States (US) and European markets in 2007 were resold in other
markets where the phone has yet to be launched officially by Apple (International Herald Tribune,
18 February 2008). Parallel imports exist when an unauthorized distributor procures genuine
brand name products from an authorized distributor and then resells them to customers in a
second market without the permission of the owner of their intellectual property rights (copyright,
patent, or trademark) for that market. In other words, parallel traders engage in “parallel
importation” or “parallel distribution channels” and compete directly with the product‟s authorized
distribution channels in the second market (Duhan and Sheffet, 1988:76; Weigand, 1991:53; Yang,
Ahmadi, and Monroe, 1998:433).1
*PhD, Department of Geography, National University of Singapore, Singapore 117570, Email: geoykyg@nus.edu.sg
**PhD, School of Accounting and Finance, Hong Kong Polytechnic University, Hong Kong, Email:
afvmok@polyu.edu.hk
*
The authors would like to express their gratitude to the anonymous traders and people who facilitated and participated in their
surveys. The Hong Kong Polytechnic University financed the authors‟ field surveys between 2006 and 2009 (Research Project
Reference: GYG24).
1
Some authors, such as Li and Maskus (2006:443) and Maskus (2000:1269), have not made explicit distinctions between parallel
imports and gray-market imports. Duhan and Sheffet (1988:76), Michael (1998:26-27), and Weigand (1989:20; 1991:53-55),
however, have argued that the “gray market” is a broader term, which includes parallel imports and “re-imports” (products
intended for foreign markets that are diverted back into home markets by unauthorized distributors). The re-importation of
genuine products, in which the products may not physically leave the country of production, are gray imports rather than “true”
parallel imports, as these imports compete with the products from authorized distribution channels rather than other authorized
imports in home markets. See Michael (1998:26-27) and Weigand (1991:53-55) for further explanation of the various distribution
channels in a gray market.
1Given that parallel imports in automobiles account for a significant market share at 15-20 percent
in the Hong Kong Special Administrative Region (hereinafter called Hong Kong) and Singapore,
and 15-17 percent in the US and the United Kingdom (UK), global automobile giants and their
franchise dealers are certainly aware of the existence of parallel imports (Bucklin, 1990; The Strait
Times, 18 May 2007).2 Why do parallel imports persist when manufacturers have several tools at
their disposal, including the imposition of fines upon recalcitrant dealers, to end this practice?
There are limited previous studies on parallel imports in automobiles despite the automobile
industry‟s importance in an economy. For an illustration, the automobile industry accounts for 6.2
percent of manufacturing employment (over 850,000 people), and 11 and 13 percent of all
manufactured exports and imports, respectively, in the UK (Daily Telegraph, 5 December 2008).
In contrast to the existing literature which has largely focused on the regional price differentiation
as the necessary condition for parallel imports, this paper aims to investigate the roles of
transnational corporations‟ (TNCs) manufacturing and marketing strategies in the parallel imports
of passenger vehicles. We also examine how constraints on official distribution channels, the
asset specificity and bounded rational behavior of franchise dealers and parallel traders could
contribute to the sustainability of parallel imports in automobiles. Passenger vehicles include cars,
sport utility vehicles, multi-purpose vehicles, and mini-vans. In addition to the primary and
secondary evidence collected in Hong Kong and Singapore, two regions which have the most
liberal laws regulating the existence of parallel imports in automobiles, we shall use examples of
other major automobile markets in North America and Europe for illustration in this paper.
Regional price differentiation is commonly used by economists to explain the existence of parallel
imports (Ahmadi and Yang, 2000; Dutta, Bergen and John, 1994; Gallini and Hollis, 1999; Hur and
Riyanto, 2006; Malueg and Schwartz, 1994; Maskus, 2000; Maskus and Chen, 2004; Richardson,
2002). Arbitrage can occur when the differences in prices between different markets, including
differences due to volume discounts and market “presence” policies implemented by
manufacturers and substantial fluctuations in exchange rates, are greater than the transaction
costs when engaging in parallel imports of the same product, or when efforts are made to offset
supply shortages in regions below the prevailing market price (Cavusgil and Sikora, 1988:75-77).
This also explains why most, if not all, literature on parallel imports focuses on homogeneous
products such as pharmaceuticals (see Ganslandt and Maskus, 2004; Kanavos and Costa-Font,
2005; Szymanski and Valletti, 2005). This simplistic assumption is certainly not applicable for
heterogeneous products like automobiles.
To cover the high costs of product development and the setting up of production facilities to cater
to local demands, many global automobile giants‟ manufacturing strategy is to assemble vehicles
at scale economies and offload them to their franchise dealers. To keep agency problems with
their franchise dealers in check, manufacturers implement the market-division strategy and the
associated penalty system. TNCs‟ manufacturing and distribution strategies partly contribute to the
existence of regional differences in the pricing and availability of specific models and specifications
of vehicles. These necessary conditions allow opportunistic parallel traders to engage in arbitrage.
In addition, the asset specificity of franchise dealers, bounded rationality, and the opportunism of
dealers and arbitrageurs all contribute to the existence and sustainability of parallel imports.
Franchise dealers are unable to respond to the market demand as they are “locked-in” with
specific manufacturers (due to the non-deployable nature of their assets) and have to implement
the official distribution strategies of manufacturers by stocking certain models and specifications of
vehicles at pre-determined volumes every year. Instead of letting their capital be tied-up in stocks,
rationally bounded and profit-oriented dealers are willing to risk the sanctions of manufacturers to
offload their surplus stocks to opportunistic parallel traders directly or indirectly.
2
It has been established that there are approximately 200 parallel importers in Singapore (The Strait Times, 18 May 2007). The
market share of parallel imported vehicles in the UK is a rough estimate based on 400,000 “gray” Japanese import cars and 2.3
million new cars registered in the UK in 2006 (Auto Industry News, 30 October 2006a-b).
2Parallel imports in automobiles involve proprietary information that is well guarded by
manufacturers, their franchise dealers, and parallel importers alike. In addition, data on parallel
trade are notoriously difficult to come by because trade statistics do not distinguish between
authorized and unauthorized intermediaries. In-depth interviews with the players involved in
parallel imports could be a reliable way to collect the valuable information necessary to examine
this current study‟s research objectives. Through personal networks, we conducted three rounds
of field surveys in Hong Kong with franchise dealers and parallel importers in March 2006,
December 2008, and January 2009 to ascertain how parallel imports could be sustained, and the
potential policy implications of the market-division and other distributing policies on TNCs,
franchise dealers, and parallel traders. All 10 interviewees have decade(s) of work experience as
parallel importers and franchise dealers in Hong Kong. One of them is the founder of the most
established parallel importer in Asia. The interviews were conducted in a semi-structured manner
to facilitate conversational flow, with each interview lasting for at least an hour.
The paper is organized as follows. In the next section, we review the mechanisms and debates on
parallel imports. We then examine how the interaction between the manufacturing and distribution
strategies of automobile manufacturers and price factors facilitate the existence of parallel imports.
A detailed diagnosis of agency costs and their impacts on the sustainability of unofficial distribution
networks in automobiles then follows. The concluding section points out the theoretical and policy
implications of the research.
Parallel imports: their mechanisms and debates
Before we review the theoretical debates on parallel imports, it is essential to have an overview of
the relevant regulations of parallel imports.
According to the doctrine of national exhaustion, the right (trademark protections) of an intellectual
property‟s owner to control distribution ends only upon the first sale within a country; therefore, the
owner of such a right is allowed to exclude parallel imports from other countries.3 Countries with
national exhaustion are segmented markets, as original manufacturers have complete authority to
distribute goods and services directly or indirectly through authorized dealers. This is not the case
with international exhaustion, where the right of the owner of the intellectual property to control
distribution is exhausted upon the first sale anywhere; thus, parallel imports are allowed. 4 As there
is no specific regulation on parallel imports under The Agreement on Trade-Related Aspects of
Intellectual Property Rights (TRIPs) of the World Trade Organization (WTO), the specific
regulation of parallel imports is up to the discretion of each member country (Hoekman and
Mavroidis, 2003:15). In the case of regional exhaustion, where the right of the owner of the
intellectual property to control distribution ends upon the original sale within a group of countries ,
such as the European Union (EU) (but not the first sale outside the region; hence, parallel imports
outside the region are not allowed), parallel trade in the region is allowed (Maskus 2000; Maskus
and Chen, 2004:551).
Regional price differentiation and its potential limitations
There are two major strands of research on parallel imports. The first strand focuses on the
theoretical discussions of parallel imports, such as the works of Barfield and Groombridge (1998),
3
Three specific theories in trademark laws are used to explain the legality of the gray market. Under the theory of universality
(trade identity), a trademark is an indication of a product‟s origin; thus, gray marketing is allowed. Under the theory of exhaustion,
a trademark owner surrenders all rights after a product‟s first sale so there is no illegality in gray marketing activities. Under the
theory of territoriality, a trademark is effective only in the registered country, so the gray marketing of this trademarked product
could be legal in non-registered countries (Clarke III and Owens, 2000:274; Duhan and Sheffet, 1988:78).
4
There is no trademark infringement if the parallel traded goods are not “materially different” from authentic goods authorized for
sale in the country. In May 1988, the US Supreme Court upheld the legality of gray market imports under Section 526 of the
Tariff Act of 1930 (after the K-Mart vs. Cartier case). This specific law allows the importation of trademarked products as long as
the trademarks are owned by the same entity, or the foreign trademark is applied under the authorization of the US owner
(Cavusgil and Sikora, 1988:83-84. See also Clarke III and Owens, 2000:277-278; Duhan and Sheffet, 1988; NERA, 1999; Palia
and Keown, 1991:48; Palmeter, 1988).
3Gallini and Hollis (1999), Hur and Riyanto (2006), Li and Maskus (2006), Malueg and Schwartz
(1994), and Maskus (2000), and so on. Game theory-based models, developed by Ahmadi and
Yang (2000), Dutta, Bergen, and John (1994), Maskus and Chen (2004), Richardson (2002), and
Yang, Ahmadi, and Monroe (1998), are the most important theoretical works on parallel imports.
Dutta, Bergen, and John (1994:91) concluded that the optimal enforcement policy for
manufacturers is to tolerate some level of parallel imports as this reduces the transaction costs of
self-enforcing contracts with distributors. Ahmadi and Yang (2000) further argued that some
manufacturers knowingly use parallel imports to increase their global market share in volume. 5
Other literature focuses on the impacts of parallel imports upon TNCs and their authorized dealers.
The literature highlights a number of negative effects of parallel imports. TNCs‟ authorized dealers
could end up competing with parallel traders, which may erode that brand‟s prestige. Moreover,
parallel imports may strain the relationship between manufacturers and authorized dealers, partly
because of the erosion of market share and profit margins, and partly because of the disruption of
marketing strategies (Cavusgil and Sikora, 1988:76; Cespedes, Corey and Rangan, 1988:75-77;
Palia and Keown, 1991). Another thread of argument proclaimed that the existence of parallel
imports actually facilitates the penetration of the market by manufacturers because parallel imports
help improve a brand‟s price competitiveness (Maskulka and Gulas, 1987; Michael, 1998;
Weigand, 1989, 1991). Similar arguments are also outlined by Bucklin (1990, 1993). Bucklin
(1993:401) argued that parallel imports could increase manufacturers‟ market share and profits so
the state should not prohibit the occurrence of parallel imports.
The existing literature largely uses regional price differentiation to explain the existence of parallel
imports. This prevailing thought assumes homogenous products and geographical variation in the
price elasticity of demand, and results in consumer surplus appropriation. Parallel traders can
profit from arbitrage when the differences in price between different markets, including differences
due to substantial fluctuations in exchange rates, are greater than the costs engaged in the
parallel imports of the same product. 6 Regional price differentiation could also exist when an
authorized distributor sells excessive stock to parallel marketers outside their designated territories
to become eligible for a volume-discount pricing scheme or to meet sales quotas that are assigned
by the manufacturer (Cavusgil and Sikora, 1988:75-77; Cespedes, Corey and Rangan, 1988:75-
77; Maskulka and Gulas, 1987). This also explains why most literature on parallel imports is
focused on homogeneous products, especially pharmaceuticals.
While the aforementioned literature provides valuable insights into the mechanism of parallel
imports in general, it nonetheless failed to explain the existence of parallel imports in
heterogeneous products satisfactorily, as the analytical framework of regional price
differentiation may not be capable of explaining the impact of factors other than the recommended
retail price (RRP) that contribute to the existence of parallel imports. Consumers‟ demand is a
function of RRP and non-RRP factors, including the specifications and availability of certain
models of products. The behavior of customers is thus monetarized and could be partially
reflected in the price elasticity of different regional markets. This is especially the case of
automobiles, as car purchasing could be an emotional decision for customers (Sandqvist, 1997).
Transaction cost economics and agency costs
Transaction cost economics (North 1990; Williamson 1979, 1989) could yield insights into the
causes of parallel imports in automobiles. Transaction cost economics analyzes the contractual
issues of a transaction that arise out of the existence of bounded rationality, the opportunism
(the opportunistic or self-interested behavior) of agents, and asset specificity, the unique
5
However, the profitability of manufacturers may not increase as profitability depends on the sizes and profit margins of the
market segment of parallel imports. Knox and Richardson (2002:137) argued that parallel imports are welfare enhancing for free-
trading countries.
6
Another conventional explanation for parallel imports is based on the free-rider theory. It examines the issue from three
perspectives: the availability of trademarked products in markets, the profit incentives attributed to price differences, and the low
legal barriers to ship products from one place to another (Duhan and Sheffet, 1988).
4character of a durable asset that may not be redeployed to alternative uses (Williamson 1979,
1989).
Fama and Jensen (1983:302) argued that a firm is the nexus of written and unwritten contracts
between property rights owners and the factors of production. These contracts specify the rights
and obligations, appraisal criteria, and payoff (remuneration) functions of each agent in the
organization, either in terms of fixed payoffs or incentive payoffs that are tied to specific
performance benchmarks. Agency problems often arise because the preparation and enforcement
of contracts involve agency costs, the costs of protection against opportunistic behavior of agents
under the conditions of informational asymmetries and incompleteness (Jensen and Meckling,
1976:308-310). The imperfect enforceability of contractual agreements is a natural consequence
of the opportunistic behavior of agents and the bounded rationality of decision makers (Williamson,
1989). Apart from involving the enforceability of contractual agreement, the high transaction costs
associated with certain economic activities (which could represent as much as 35-40 percent of
the costs of activities; see North, 1990) explain the existence of parallel trade, that is, parallel
imports will not exist if the enforcement of contracts carries no cost.
Agency problems obviously existed in the manufacturer-franchise dealer relationship as their
agendas may not be always in harmony. The following sections examine how the interactions
between manufacturers‟ manufacturing and distribution strategies, the asset specificity, bounded
rationality, and opportunism of authorized dealers and parallel traders contribute to the
sustainability of parallel imports.
Integrated manufacturing and distribution strategies of global
automobile giants
This section examines how global automobile giants attempt to integrate official manufacturing
and distribution strategies, which could consequently contribute to the existence of parallel imports
in their products.
Modular system manufacturing and product localization
The global automobile industry is facing two major challenges: overcapacity and product
localization. The industry has been suffering from an excessive production capacity of 40 percent
as car factories are built according to marketing predictions, with a lead in investment decisions of
one to two decades. To keep per unit production costs down and to cover the high costs of
product development, automobile assemblers are under intense pressure to maximize economies
of scale with their existing production lines, and this result in the production of cars close to
manufacturing capacities. Manufacturers are desperate to shift as much stock as possible to keep
their plants operating as closing them down is politically and economically costly. The mass
production in forms of Fordism is intrinsically incompatible with a market where the customers are
demanding less than homogeneous vehicles in terms of specifications.
5Figure 1: Manufacturing and Distribution Strategies, Distribution
Channels, Transaction Costs, and Parallel Imports in Automobiles
Manufacturers
OFFICIAL manufacturing strategies:
Scale economy OFFICIAL distribution strategies:
Modular systems & product Market-division with franchisees
localization
Integrated manufacturing &
distribution strategies:
Regional price discrimination
Volume discount & market „presence‟
PRICE factors:
AGENCY problems: RRP for homogeneous products:
Asset specificity of dealers regional price differentiation
Bounded rationality & Non-RRP for heterogeneous
Opportunism of dealers & products: specification & model
parallel traders availability
UNOFFICIAL distribution OFFICIAL distribution
channel via channel via
parallel imports authorized dealers
Authorized dealers
Parallel traders
Source: Authors
To fulfill the market demand for heterogenized vehicles in terms of models and specifications ,
global automobile giants are increasingly tailoring their products for local markets through the
application of modular systems in vehicle-assembling technologies (flexible specialization) (Figure
1). Product localization is illustrated by the case for passenger vehicles assembled for the
Japanese Domestic Market (JDM). These JDM models are different from other mass-produced
Japanese vehicles in two main aspects. First, JDM models are specially designed for a domestic
(niche) market where Japanese automobile giants do not expect a mass market overseas. Typical
examples include the first generation of petrol-electric hybrids, such as Toyota Prius and Honda
Insight, which were originally designed for the stop-go traffic of Tokyo before being exported to
target the trendy North American and European “green” markets. Second, JDM models are used
to test consumers‟ responses in the ultra-competitive Japanese markets before their worldwide
launches. Thus, they normally have higher specification levels, such as an Engine Control Unit
(ECU) mapped for high-octane petrol (98 to 100-octane) commonly available in Japan (but which
6may not be the case elsewhere), and luxury, state-of-the-art automated gadgets as standard
equipment (Field survey, March 2006, December 2008).
Manufacturing and “market-division” distribution strategies
To recover their substantial investment in product localization, manufacturers normally implement
certain forms of distribution strategies in various regional markets. The dealers in franchise
networks can price the vehicles (in consultation with manufacturers) according to the local
market‟s price elasticity. Dealers, however, normally have to stock certain models and
specifications of vehicles determined by manufacturers. For instance, Asian dealers are only
allowed to sell vehicles assembled in Asia, and this could lower the investment risks of
manufacturers‟ assembled plants in the region.
In order to deal with agency problems (especially free-rideable services provided by franchise
dealers) and to maintain the distribution system in an orderly manner, automobile manufacturers
normally implement the “market-division” marketing strategy by dividing the world into different
regional markets, with each market monopolized by the corresponding exclusive franchise dealer
(de facto regional monopoly) (see Antia and Frazier, 2001; Bergen, Heide and Dutta, 1998; Dutta,
Bergen and John, 1994). Dealers normally have to sign contracts with manufacturers forbidding
them to re-sell their allocated cars in other countries (Field survey, December 2008).7
Manufacturers also use other means of punishment, such as withholding (a part of) bonuses,
delaying the delivery of newly launched models, cancelling volume discount pricing, and not
supplying certain models (such as right-hand drive models with speedometers in miles/hour), to
regulate the market-division strategy (Field survey, December 2008; see also Antia, Bergen and
Dutta, 2004; Raff and Schmitt, 2005). This prevents inter-regional competition between different
regional monopolies and maximizes the profits of each franchise dealer within its own designated
market.
In spite of all these restrictions, parallel imports in automobiles account for double-digit market
shares in a number of major markets (Antia, Bergen and Dutta, 2004:68; Raff and Schmitt,
2005:2-3). The market-division distribution strategy is fundamentally ineffective because of its
intrinsic contradiction with other official manufacturing systems implemented by manufacturers.
Volume discount and market “presence” strategies
The official manufacturing strategy of automobile giants implies market maximization for
manufacturers as they have to shift as many cars as possible to recover high development costs.
The resultant volume discount pricing and regional price discrimination lead to arbitrage and thus
the existence of parallel imports in automobiles (Figure 1).
To shift as many assembled cars as possible, manufacturers have pre-determined volume
discount (per model) agreements with their franchise dealers worldwide; that is, dealers could
receive bonuses or special discounts by ordering certain units per model per year. Some volume
brand manufacturers also have special volume discount deals with vehicle fleet management
companies (including car rental companies serving private individuals and servic e providers for
company cars) partly to maintain their market “presence” (see below). For example, vehicle fleet
management companies account for almost half of all new car registrations in the UK (SMMT,
2008). Obviously, a mismatch between the demand and supply in a particular model of car in
certain markets could exist. A gray market for a product exists when a franchise dealer sells
excessive stock to parallel traders outside their designated territories in order to become eligible
for a volume-discount pricing scheme or to meet the sales quotas assigned by the manufacturer
(Field survey, December 2008, January 2009; see also Antia, Bergen and Dutta, 2004; Maskulka
and Gulas, 1987). In the UK, one major car supermarket was selling the Nissan Patrol 3.0 Di SE
7
The 1980 Interband Competition Act in the US allows American automobile assemblers to grant exclusive franchise rights to
dealers in given locations. However, this law may not be enforceable outside of the US as no such law exists elsewhere (The New
York Times, 26 January 2000).
7automatic (a top specification model) at £19,999, a massive discount of almost 40 percent over the
RRP (Telegraph Motoring, 17 February 2007).
An oversupply of vehicles due to a “market presence” (a de facto form of market maximization)
distribution strategy employed by some manufacturers could contribute to the opportunities of
arbitrage by parallel importers. It is not uncommon for manufacturers to deliberately oversupply to
certain regional markets in order to keep a presence there. For instance, Mercedes-Benz is known
to systematically ship excessive stocks to Barbados so that their “presence” in the market is
recognized. A number of these unsold cars are subsequently re-exported into the UK.
Regional price discrimination
Regional price discrimination could be a result of price reduction by manufacturers or differentiated
pricing by manufacturers or dealers. For products with short lifecycles or those that require sale
economies, sales teams are under constant pressure to sell off excessive stocks to distributors
(including parallel traders) before the cost of the product is written off in the company balance
sheets. This price reduction by manufacturers and the subsequent fire-sale by parallel importers
further erode the price of the product. These may even lead to a vicious cycle in which the
accumulation of excessive stocks prompts price discounts by the manufacturers, thus entailing
further fire-sales by parallel importers.
Regional price discrimination reflects the price elasticity of demand: dealers charge lower prices in
price elastic markets and vice versa. The RRPs of automobiles are normally lower in Vancouver,
Canada than in the US, and this contributes to the 200,000 parallel imported vehicles into the US
(Automobile News, 4 March 2002:12). Parallel imports in automobiles are still common in the EU
despite the comparable after-tax RRP. For instance, parallel traders “export” more than 25,000
automobiles a year from Belgium to other European countries even though there is no local
automobile assembler (Weigand, 1991; Yang, Ahmadi and Monroe, 1998).
Regional differentiation of vehicle availability
The spatial differentiation of vehicle availability, especially on newly launched models and different
vehicle specifications and models, is the major non-RRP factor that contributes to the parallel
imports in automobiles (Figure 1). Despite all the hype surrounding globalization and the power of
TNCs, bottlenecks in manufacturing and distribution systems are not uncommon. Parallel imports
in automobiles could exist if there is a significant time lag in the launch of certain models or
regional quotas in some markets. This market for parallel imported vehicles is highly dynamic as
the (strong) demand only lasts for as long as the bottleneck in the distribution channel exists. For
instance, customers in Hong Kong could buy the newly launched Toyota models (such as the
Alphard and MkIII Previa MPVs) through parallel importers within 10 days after the first launch of
such models in Japan, even faster than some dealers in Japan could get their stocks. Once the
official dealer in Hong Kong is able to distribute the same model and specification of vehicles, the
price premium demanded by parallel importers disappears. Parallel imports are a means for
customers to overcome the constraints in distribution networks, specifically, the time lag in the
launch of certain models in different markets. Under these circumstances, price inelastic
customers are willing to pay a premium to get their coveted vehicles, especially premium brand
ones, earlier than the general public. This creates the niche market of specialized parallel traders.
Market maximization, profit maximization, and agency costs
After examining the roles of integrated manufacturing and distribution strategies on the existence
of parallel imports, it is crucial to investigate the importance of agency problems on franchise
dealers and parallel importers, and how these issues contribute to the sustainability of parallel
imports.
8Asset specificity of franchise dealers
To deal with agency problems, manufacturers control their franchise dealers through certain
transaction-specific investments. To qualify as franchise dealers, franchisees have to invest in
certain transaction-specific, non-redeployable physical and human assets that are specialized and
unique to the task (Figure 1). It is a mechanism that exchange partners use as a private ordering
mechanism to reduce opportunism. It is common that an automobile manufacturer requires a
franchisee to invest his or her own money in branding the franchise location to fulfill certain pre-
determined standards; for example, the showroom is matched with the brand‟s image, and the
workshop is equipped with specialized diagnostic computers. These transaction-specific
investments make it costly for the franchisee to offer an alternative brand or to switch to a different
brand without significant reinvestment in changing the asset-specific equipment. For example, the
newly appointed dealer for Ferrari in Singapore, Ital Auto (Komoco), is expected to invest US$7
million to establish the new franchise (The Strait Times, 19 July 2009:18). In other words, dealers
are “locked-in” with specific manufacturers although it is illegal for manufacturers to forbid their
dealers in the EU to sell other marquees, according to the EU‟s Block Exemption Regulation that
had been implemented since 2002.
As mentioned earlier, dealers can only sell specific models and specifications of vehicles in pre-
determined quotas assigned by manufacturers when the volume-discount agreements are signed
in each financial year. The determination of quotas is largely based on the product lifecycle of the
manufacturer‟s plants locally (Field survey, December 2008, January 2009). Under this
circumstance, franchise dealers are sure to be less able than parallel traders to respond to the
changes in market demand. This is especially the case for vehicles of “non-mainstream” models
and specifications.
Bounded rationality and opportunism of dealers and traders
The interests of manufacturers and dealers may not always be compatible with one another when
they are pursuing their own agenda. Market maximization is the unavoidable consequence of
assembling vehicles in scale economies by automobile giants, while profit maximization is the
most vital objective of dealers (Figure 1). This interesting manufacturer-dealer relationship could
be demonstrated by the reluctance of dealers to invest in their facilities to cater to the market
demand for niche models and other pro-active market maximization distribution strategies of
manufacturers. After all, franchise dealers earn the majority of their profits through after-sales
services (with an average gross profit margin of 63.7 percent in the UK) rather than relying on the
wafer-thin gross profit margin of 4.6 percent for selling vehicles (AIGT, 2002:3). The lower the
investment on the training of mechanics and stock (including components) keeping, the higher the
profit margins of dealers on the provisions of vehicle maintenance and other after-sales services.
In addition to the niche models, franchise dealers are reluctant or even refuse to stock the “bare-
bone specification” models of vehicles in certain markets due to the asset specificity of providing
full dealer support for such models and the bounded rationality of minimizing the capital tied-up in
stock keeping. These “bare-bone specification” models are normally entry models and vehicle
specifications that may not command a mass market, but look (almost) exactly the same in
physical appearance as the higher-end models. These vehicles are targeted for customers who
are on relatively tight budgets but prefer to purchase European brands (and their associated
prestige) with lower specifications. For instance, the basic 3-series models (318) of BMW are
popular in the UK, but their smaller engines would struggle with the hilly roads in Hong Kong.
These basic models of BMW are only available from parallel traders as they do not fit into the
marketing, pricing (which protracts it as a premium brand), and financing of the franchise dealers
in Hong Kong.
To maximize their market shares in highly competitive markets, it is not unusual for premium brand
manufacturers to pressurize their franchise dealers to implement a number of proactive pricing
and marketing strategies. For instance, dealers of BMW in Japan have reduced their RRPs seven
times in two years until they are almost the same as those in Germany (Weigand 1989). Some
9manufacturers, such as Mercedes-Benz, Peugeot, and Renault, have implemented the “market
area” distribution strategy by taking over the dealerships in selected major cities in Europe. 8 In
addition to compete with their rivals for market share, this strategy could assist manufacturers to
have more direct control over the distribution of its products and lower the agency costs in dealing
with dealers. To compete for market share with their arch rival BMW in Asia effectively, Mercedes-
Benz had even taken back the pricing rights from their franchise dealers in Singapore and Hong
Kong and converted their dealerships to exclusive retailers in 2001 and 2004, respectively (see
Lee and Lim, 2002 for the case in Singapore).
By supplying parts to non-franchised garages directly, some opportunistic franchise dealers not
only can maximize their profits but also fulfill the manufacturers‟ market maximization policy. The
dealers of two German limousines in Hong Kong actually act as “unofficial importers” of parts for
non-franchised workshops, including those operated by parallel traders, and specialized parts
suppliers, with a special volume discount for bulk purchases (Field survey, March 2006, December
2008). There are several interesting features in this strategy.
First, this is part of a very effective market maximization strategy in conjunction with the reduction
of RRP. Potential customers, especially those “marginal” customers who are just about able to
afford such luxury limousines, will not be put off by the high maintenance costs of owning such a
premium brand of vehicles.
Second, by using the unofficial suppliers of genuine parts and a network of non-franchised
garages, franchise dealers could minimize operating costs, in the provision of after-sale warranty
and post-warranty maintenance services, by keeping a smaller team of mechanics and keeping a
significantly less inventory of parts. The cost saving for the two German limousine deal ers could
be relatively substantial due to high land costs and the shortage of well-trained mechanics in Hong
Kong. As there are plenty of service specialists available at other independent garages, dealers
could charge higher prices for their maintenance services in order to protect their profit margin and
the brand premium without worrying about complaints from disgruntled customers.
Third, dealers could earn decent profits by being the “unofficial importers” of the genuine parts for
non-franchised garages at minimal marginal costs and high cash flow. The widespread usage of
genuine parts by independent specialist garages also lowers the chance of complaints from
disgruntled customers who may suffer from embarrassing breakdowns. An example of this would
be mechanical breakdowns that are more likely due to poor fitments rather than fitting poor quality
pattern parts. This cost-effective market maximization strategy employed by dealers will not ruin
the reputation of these two brands as reliable and luxury limousines.
Conclusions and Implications
Instead of heavily attributing the existence of parallel imports in homogenized products to regional
price differentiation as suggested by conventional literature (see Antia et al., 2006; Barfield and
Groombridge, 1998; Bergen, Heide and Dutta, 1998; Cavusgil and Sikora, 1988; Hur and Riyanto,
2006; Li and Maskus, 2006; Malueg and Schwartz, 1994; Maskus, 2000), we argue that the official
manufacturing and distribution strategies of TNCs in the form of regional market quotas, localized
models, and specifications are important non-RRP factors that are monetarized and contribute to
the existence of parallel imports in heterogeneous products.
In the automobile sector, we have argued that the integrated manufacturing and distribution
strategies of manufacturers partly contribute to the existence of regional differences in pricing and
the availability of specific models and specifications of vehicles. These necessary conditions allow
opportunistic parallel traders to engage in arbitrage (due to regional differences in RRP and non-
RRP). In addition, agency problems such as the asset specificity of franchise dealers, the bounded
rationality, and the opportunism of dealers and arbitrageurs all contribute to the existence and
sustainability of parallel imports. Franchise dealers are unable to respond to the market demand
8
Ferrari also took back and internalized its import and distribution rights from authorized dealers in Japan in 2007.
10as they are “locked-in” with specific manufacturers (due to the non-deployable nature of their
assets) and have to implement the official distribution strategies of manufacturers by stocking
certain models and specifications of vehicles at pre-determined volumes every year. Instead of
letting their capital be tied-up in stocks, the recalcitrant profit-oriented dealers with bounded
rationality are willing to risk the sanctions from manufacturers to offload their surplus stocks to
opportunistic parallel traders directly or indirectly. This is especially the case for those stocks
approaching the end of their product lifecycles. Parallel imports compete in price as well as
availability in terms of earlier delivery of newly launched models or supply of certain non-mass
manufactured specifications/models. This could explain why some parallel imported automobiles
could be more expensive than those from authorized channels of distribution. As long as the price
premium (determined by price (in)elasticity of vehicles) can offset the transaction costs, parallel
imports in automobiles between different regional markets can be sustained.
This policy suggestion is consistent with the conjecture that parallel imports may not be
incompatible with the market maximization strategy of TNCs. These findings contradict the
findings of Cavusgil and Sikora (1988:76), Cespedes, Corey, and Rangan (1988:75-77), and Palia
and Keown (1991) but are supported by the theoretical models on parallel imports proposed by
Dutta, Bergen, and John (1994), Bucklin (1993), and Ahmadi and Yang (2000). In addition to
gathering valuable market intelligence in terms of effectiveness in distribution networks , including
the comparative efficiency of each dealer in the network and customers‟ demands at minimal
additional marketing costs (Michael, 1998:28-30), manufacturers could also use parallel imports as
supplemental channels to explore untapped markets that authorized dealers are unable to or find
too costly to access. 9 Manufacturers could maximize the global market share at relatively low
costs, as there are no agreements between manufacturers and parallel imports traders, and
therefore, traders have to use their own resources to develop the market. Parallel imports could
induce new customers who are unwilling to buy the manufacturers‟ products through the high-
priced channel managed by franchise dealers, to buy the said products. Using parallel imports to
penetrate previously untapped markets by TNCs also happens in products other than automobiles.
In addition to provide consumers with more choices, authorized dealers catering to service-
sensitive customers and parallel traders catering to bargain hunters, the state could benefit from
higher amount of sales and profits taxes through higher turnovers in manufacturers and/or
dealers/traders.
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