Black Market Price Differentiation

I’ve been reading Stealth of Nations by Robert Neuwirth. He makes the interesting point that the black market—the less-than-totally-legitimate sale of legal goods—acts as a useful mechanism for price differentiation, and that legitimate companies can benefit from participating in it.

Ideally, anyone selling anything would like to be able to charge each customer the most they’re willing to pay. Bargaining with each individual isn’t feasible, but companies have come up with rough ways to figure out who will pay what. The most visible example is media—books, movies, video games—which are initially sold at full price, but often gradually marked down over time. The richest people and/or those who want something the most will buy it right away and pay full price. The poor and indifferent will wait until it’s 20% off, 50% off, or remaindered for a couple bucks. You see this with media in particular because there are a lot of up-front costs but low marginal costs. Writing, editing, and marketing a book is expensive; printing an extra copy is pretty negligible. Even more so for music or movies. The Avengers cost a quarter billion or whatever to make, but pressing a disc is maybe a dollar.

You also see this in the supermarket with name-brand and generic/store-brand products. They’re often made by the same company. The store brand is a way for the manufacturer to capture purchases that would have gone to lower-cost competitors.

So say you’re a Taiwanese electronics manufacturer and you sell a Blu-Ray player for $100 in Brazil. Most people in Brazil can’t afford that, so you won’t sell many. But a lot of that price is reseller markup, licensing fees for the underlying technology, taxes and import tariffs, etc. Say the actual cost to make one is $20. If you can dodge all those extra costs—the cost of legitimacy—and sell it on the black market at $25, you’re still turning a profit. That’s a lower margin, but it’s probably a much bigger market.

The important point here is that items sold at markdown aren’t lost revenue. Those customers weren’t going to buy at full price. The sale would not have happened, and the vendor would have made zero dollars off them. By dropping the price, the vendor converted non-customers to customers, and made some dollars.

The big hitch in all of this is that you don’t want to make it too easy for your premium customers to pay less than they’re willing to. Stores won’t admit who makes their generic products; they need the customers to think those might be lower quality. If everyone knew they were the same, they’d never buy the name-brand product.

With the bootlegged Blu-Ray player, the company wants to capture the lower-value customers in the black market, but if it’s too easy to buy there, they won’t make any full-price sales. They want to discourage low-price sales, but not prevent them. This puts them in the awkward position of both supplying and fighting the black market.

What makes this even more interesting is that they’re rarely dealing with a completely illegal market; it’s often shades of gray. Maybe the seller is an unlicensed and highly mobile stall. Maybe it’s a permanent, licensed storefront, but you pay cash and no tax is charged. Maybe the goods are legit, but were smuggled in to the country to avoid import duties. These can all present different price points and different levels of deterrence.

I don’t see any way to make this work for digital distribution, but it’s something to ponder. Bootleg music worked when it cost money and time to copy, and the quality degraded, none of which is true anymore. Some bands are starting to treat their recordings as advertising for their live performances, which they can charge for, but there’s no corollary for movies.

There’s probably something interesting to say about the illicit market for prescription drugs in America, but I don’t know enough about that to comment. Anyone? Any other examples of first-world illicit markets for legal goods?