Global pricing is a challenge for consumer products companies—cross-border arbitrage is partly to blame

Setting prices for global markets is inherently challenging, with a wide range of both controllable and uncontrollable factors influencing pricing decisions. Drivers such as ongoing globalization, development of the Global Travel Retail (GTR) channel, and increased access and price visibility brought about by digital platforms have all contributed to making global price setting even more complex, and have created more favorable conditions for cross-border arbitrage—transactions influenced by price spreads between geographies. This can result in substantial value leakage and may even motivate grey and black-market activities. Indeed, cross-border arbitrage is a significant issue for consumer product (CP) companies in luxury accessories, fragrances, spirits, consumer electronics, tobacco and other sectors.

However, what are the key factors driving cross-border arbitrage? What challenges does cross-border arbitrage present? What is the real scale of the cross-border arbitrage issue? In what manner can companies set global prices to optimize value while mitigating the impact of cross-border arbitrage?

The cross-border arbitrage challenge

Have you ever seen your preferred perfume bottle being sold for a substantially lower price in a foreign country as opposed to your home country? That is an example of cross-border arbitrage. Since cross border arbitrage is not a novel business issue, why should companies be concerned with it at this time?

Cross-border arbitrage has become more prevalent in today’s interconnected world due to a few key drivers:

1. Globalization, which has made the world smaller. It has not only facilitated the availability of similar products in countries around the world but has also increased travel mobility, thereby granting access to products even away from home.
2. Accelerated growth of the GTR channel as it continues to modernize, enhance the shopping experience and expand its product selection.
3. Digitization, which has led to the breakdown of price information asymmetry. Pricing information is now transparent, and remote access to products sold in (and shipped from) foreign locations has been made possible.
4. Regulatory differences, including tariffs, which determine the cost of conducting business in each market and determine the feasibility of cross-border arbitrage.
5. Exchange-rate fluctuations, which create imbalances in global pricing schemes, particularly when currencies experience abrupt movements that result in price disparities.

Although cross-border arbitrage can help a company gain access to unserved markets where no sales and distribution infrastructure exists, it drives multiple challenges including:

1. Attrition along the value chain, with route-to-market partners across countries and channels
2. Margin dilution, with reduced sales and market share in the higher priced market, as customers buy more volumes from the lower priced markets
3. Undermining the exclusivity of luxury brands by increasing supply to unintended levels
4. Misalignment of a company’s pricing strategy – for companies that have differentiated pricing based on value, customer segmentation, and willingness to pay
5. Grey-market activity, which may develop into fertile ground for illicit trade in stolen and counterfeit goods
6. Avoidable operational and legal risks

Cross-border arbitrage is more prominent for high-intrinsic-value items (such as luxury spirits, cosmetics, fragrances, fashion accessories, consumer electronics, tobacco etc.), where retail price discrepancies are more accentuated, and where the route-to-market depends on third-party partnerships (with less direct control by brand owners/manufacturers).

Additionally, the magnitude of risk increases when the route-to-market depends on third-party partnerships (with less direct control by brand owners/manufacturers).

What the COVID-19 pandemic revealed about cross-border arbitrage risk

Research into alcohol consumption behavior during the COVID-19 pandemic reveals the significance of cross-border arbitrage within the European alcohol market. At the onset of the pandemic, traditionally high cross-border inflow countries experienced a surge in domestic sales. It is noteworthy that this increase in domestic sales could not be attributed to a general increase in demand, given that alcohol consumption per capita generally declined across the continent. Instead, this can be ascribed to the restrictions that prevented consumers from taking advantage of pricing differentials between countries through cross-border arbitrage.

The extent of cross-border arbitrage was revealed during this period of lockdown: the surge in sales observed during travel restrictions indicates that a considerable volume of alcohol purchases typically entails cross-border transactions. The imposition of travel restrictions essentially forced domestic demand to return, thus revealing the otherwise obscured magnitude of cross-border arbitrage sales. For example, Norway, Sweden, and Finland saw significant increases in domestic alcohol sales during the pandemic (23%, 14%, and 5%, respectively), consistent with the high level of cross-border inflows that existed prior to the pandemic. Meanwhile Latvia and Luxembourg, countries that generally have a net outflow of cross-border purchasing, saw large decreases in domestic alcohol sales (-14% and –18%, respectively).*

The pandemic-related travel restrictions served as an unintended natural experiment, presenting a distinct opportunity for research to evaluate the magnitude of cross-border arbitrage on product categories extending beyond alcoholic beverages. Studies have found that potential revenue loss attributed to cross-border arbitrage is very high. In the context of the grocery sector, this phenomenon engenders a potential commercial risk exceeding €25-30 billion for suppliers in the European market alone. This underscores the widespread economic implications of cross-border arbitrage that have been revealed by the pandemic circumstances.

How can CP companies address cross-border arbitrage risk?

Companies can employ various strategies to mitigate the impact of cross-border arbitrage risk. These strategies include:

• Instituting a hybrid pricing policy
  • Analyze each product category across countries to decide whether to follow a strictly global pricing approach or local pricing approach informed by global price guidance
• Pricing separately for travel retail vs. traditional retail
  • Price duty free products differently compared to products sold via traditional retail
  • Use pricing corridors to harmonize prices across travel channels (airports, cruises, etc.) based on highest volume generating locations
• Developing robust pricing policies and trade agreements
  • Design policies and agreements to minimize arbitrage risk, articulating volume limits on number of purchases (per SKU, across SKU types, etc.) for each customer
• Pulling levers other than Pricing to manage risk
  • Utilize sales and distribution strategies (e.g., exclusive distribution agreements) and product strategies (e.g., parallel markets (i.e., official and unofficial markets) tracking via packaging and labeling, limiting the product assortment for travel retail) to aid pricing tactics
• Tracking adherence to minimum advertised prices (MAPs) / policies / trade agreements
  • Actively monitor distribution channels and identify instances of cross-border arbitrage
  • When such activities are discovered, take enforcement actions against distributors engaging in unauthorized selling

*Data for Luxembourg only included sales of spirits, not beer and wine.