parallel trade & coca cola - national university of singapore

This research was financed by research grant A/C No. APF37 from the Hong Kong PolytechnicUniversity. The helpful assistance of various people (especially the executives of Coca-Cola (China) andits bottlers, who prefer to remain anonymous) in facilitating the field survey is deeply appreciated. Weare grateful for the constructive comments and suggestions on earlier drafts of the article by the editorof Economic Geography, Dr. Henry W.-c. Yeung, and three anonymous reviewers. Our deep appreci-ation also goes to Professor Mick Dunford at the University of Sussex; Alan Li, Professor Ira Horowitz,Drs. Y. C. Chan, P. L. Lam, Xinpeng Xu, and Mark William at the Hong Kong Polytechnic University;and Drs. Guangdian Liu and Anthony Wan (experienced business practitioners) for their valuablecomments on the article. Finally, we thank Hazel Lintott at the University of Sussex for preparing themap, Karen Gu for her professional editorial assistance, and Kan Chen for his research assistance inthe collection of some pricing data. Any errors are, of course, ours.

89

Regional Monopoly and Interregional andIntraregional Competition: The Parallel Trade in

Coca-Cola Between Shanghai and Hangzhou in China

Godfrey YeungDepartment of Geography, University of Sussex,

Falmer, Brighton N1 9SN, United [email protected]

Vincent MokSchool of Accounting and Finance,

The Hong Kong Polytechnic University, Hong [email protected]

Abstract: This article uses a “principal-agent-subagent” analytical framework anddata that were collected from field surveys in China to (1) investigate the nature andcauses of the parallel trade in Coca-Cola between Shanghai and Hangzhou and (2)assess the geographic and theoretical implications for the regional monopolies thathave been artificially created by Coca-Cola in China. The parallel trade in Coca-Cola is sustained by its intraregional rivalry with Pepsi-Cola in Shanghai, where Coca-Cola (China) (the principal) seeks to maximize its share of the Shanghai soft-drinksmarket. This goal effectively supersedes the market-division strategy of Coca-Cola(China), since the gap in wholesale prices between the Shanghai and Hangzhoumarkets is higher than the transaction costs of engaging in parallel trade. Theexclusive distributor of Coca-Cola in the Shanghai market (the subagent) makesopportunistic use of a situation in which it does not have to bear the financialconsequences of the major residual claimants (the principal and other agents) andhas an incentive to enter the nondesignated Coca-Cola market of Hangzhou bycrossing the geographic boundary between the two regional monopolies devisedby Coca-Cola. The existence of parallel trade in Coca-Cola promotes interregionalcompetition between the Shanghai and Hangzhou bottlers (the agents). Thisarticle enhances an understanding of the economic geography of spatial equilibrium,disequilibrium, and quasi-equilibrium of a transnational corporation’s distributionsystem and its artificially created market boundary in China.

Key words: regional monopoly, interregional competition, intraregional competi-tion, parallel trade, Coca-Cola, China.

#2626—ECONOMIC GEOGRAPHY—VOL. 82 NO. 1—82104-Yeung

Economic Geography 82(1): 89–109, 2006.© 2006 Clark University. http://www.clarku.edu/econgeography

90 ECONOMIC GEOGRAPHY JANUARY 2006

It is common practice for manufacturersof frequently purchased branded goods,particularly of those with a short shelf lifethat demands local warehousing, to grant aregional monopoly to an authorized localdistributor. The consequence of such a prac-tice is a distribution network that often givesthe illusion of involving separate geographicsubmarkets for the product, each of whichhouses a monopoly distributor of the manu-facturer’s brand. This is an illusion becausethe manufacturer has little control over theultimate disposition of its product once itleaves its hands, notwithstanding anyseemingly inviolable contractual arrange-ments that it may have put in place. Thus,the manufacturer’s authorized distributorsin different geographic submarketsfrequently find themselves in competitionwith unauthorized imports of the same brandfrom other regions. This is the parallel-trading issue that may create the notion thata franchised distribution network invariablyresults in artificially bounded geographicsubmarkets that operate in isolation fromeach other, ignoring the reality of spatialcompetition among those submarkets andits broader implications.1 This articleexplores this issue and its implications withspecific respect to the distribution ofCoca-Cola in the economically importantneighboring submarkets of Shanghai andHangzhou in China.

Although China is the world’s largestproducer of carbonated drinks, accountingfor more than half (about 16 billion unitcases) the global market in 2003 (Liu 2004),only three studies on the operations of Coca-Cola in China have been carried out. On thebasis of a case study of the Coca-Colabottling plant in Tianjin, Nolan (1995)conducted the first in-depth analysis of themicroeconomic impact of a single Coca-Colaplant in China. He found that the Coca-Colabusiness system, in general, has had a posi-tive impact on the development of labor,

capital, and product markets in China.Nolan’s findings are in line with the conclu-sion reached in the meticulous input-outputmodel that was constructed by a team ofeconomists from Peking University,Tsinghua University, and the University ofSouth Carolina (PU-TU-USC 2000). On thebasis of the theoretical framework of inter-nalization theory, Mok, Dai, and Yeung(2002) investigated Coca-Cola’s choice ofmode of entry into China. They discoveredthat Coca-Cola had adjusted its initial choice-of-entry mode from franchises and equityjoint ventures (EJVs; see G. Yeung 2001for a definition of this concept) to a hybridof EJVs and franchises as part of its marketexpansion strategy and to consolidating thecontrol of distribution channels for the soft-drinks market in China.

The existence of parallel imports of Coca-Cola is well known to the general public, andit is estimated that parallel imports fromother European Union countries account forup to 20 percent of the Coca-Cola marketin the United Kingdom (Rose and Beck1999). Few scholars have analyzed thesephenomena, mainly because the existenceof parallel imports involves proprietary infor-mation that is well guarded by Coca-Cola.Despite the significance of parallel imports,none of the aforementioned studies was ableto give a satisfactory answer to the ques-tion of where and why parallel importsexist or to detail the geographic implicationsof such activities. Specific questionsremain as to why a parallel trade in Coca-Cola exists in China and how such a paralleltrade between Shanghai and Hangzhou issustained, rather than being a periodicphenomenon, as with parallel imports inother countries.

This article discusses the nature andcauses of the parallel trade in Coca-Colabetween two regional monopolized marketsin China (Shanghai and Hangzhou) andassesses the geographic and theoreticalimplications of this trade for regional monop-olies in China. In doing so, it provides ananalysis of the intricate relationship of theregional monopolies and interregional andintraregional competition, all of which are


1 For extensive discussions of the impact ofspatial competition on market definition, see, forexample, Horowitz (1981) and Stigler andSherwin (1985).

VOL. 82 NO. 1 PARALLEL TRADE IN COCA-COLA IN CHINA 91

vital elements of economic geography. Itconsequently contributes to the under-standing of the geographic implications, inthe form of spatial equilibrium, disequilib-rium, and quasi-equilibrium, of one transna-tional corporation’s (TNC) distributionsystem and its artificially created marketboundaries in China. Our study differs fromconventional studies in two ways. First, incontrast to conventional studies on parallelimports, which have focused on the graydistribution of genuine brand-name prod-ucts across national boundaries by unau-thorized importers (Malueg and Schwartz1994; Barfield and Groombridge 1998;Maskus 2000; Maskus and Chen 2004),this article focuses on the trading of Coca-Cola outside the designated territory of theShanghai bottler (but still within China).Second, in contrast to analyses from theperspective of interregional and intraregionalcompetition—MacKinnon and Phelps(2001a, 2001b), on regional governance andforeign direct investment in the UnitedKingdom, and Sparke, Sidaway, Bunnell,and Grundy-Warr (2004), on geographies ofpower in the Indonesia-Malaysia-Singaporegrowth triangle—this article disentangles thecomplex relationships between a regionalmonopoly and interregional and intrare-gional competition through a proposed“principal-agent-subagent” (PAS) analyticalframework.

The case of Coca-Cola is especiallyintriguing because of the company’s statusas one of the world’s leading TNCs and itsexpanding presence in China’s large andrapidly growing economy. Thus, althoughwe focus on a single pair of geographicregions in China, the omnipresence of thecompany and its products throughout theworld renders our results and the novelmethodology that we introduce to reachthem applicable in both other countries andother contexts. Moreover, this articlecontributes to the literature of economicgeography by providing valuable insights intohow intraregional rivalry between Coca-Colaand Pepsi-Cola in China created a spatialdisequilibrium in the form of parallel tradeand how the subsequent interregional

competition between Shanghai andHangzhou bottlers led to a breakdown of theregional monopolized market boundariesthat were established through Coca-Cola’smarket-division strategy. Apart from disen-tangling the interfirm network embedded inCoca-Cola and its bottlers and distributors,our findings could have profound implica-tions for corporate and public policy withregard to the demarcation and regulation ofmonopolized market boundaries on both themacrogeographic (international) and micro-geographic (local) scales. From the perspec-tive of efficiency, for instance, should TNCsor the state allow parallel trade (imports)?

To collect firsthand information on theparallel trade in Coca-Cola, we conductedsix rounds of field surveys in China and HongKong between June 2002 and December2004 (see Table 1). A number of interviewswith veteran executives and owners of allof the market agents were undertaken atdifferent periods. These agents includedCoca-Cola (China), which is the regionalheadquarters of Coca-Cola; the bottler inShanghai, whose products are involved inthe parallel trade; the bottler in Hangzhou,whose monopolized market is affected bythe parallel trade; and major wholesalers andretailers in Shanghai and Hangzhou, whichoperate independently of the Coca-Colasystem, selling either authorized or unau-thorized Coca-Cola or both. All the inter-views were conducted in a semistructuredmanner to facilitate the flow of conversation,and each interview lasted for at least an hour.The interview questions focused on empir-ical evidence related to the two centralresearch issues of this study: the causes ofparallel trade between the two regionalmonopolized markets of Shanghai andHangzhou and the geographic implicationsof parallel trade for regional monopoly andinterregional and intraregional competition.

Before we discuss the phenomenon ofparallel imports and the market-divisionstrategy of Coca-Cola, we review the rele-vant literature in economic geography andpresent the analytical framework of thisarticle. We then analyze the effects ofparallel trade and the market-maximiza-



tion strategy of Coca-Cola on the designatedmarkets in Shanghai and Hangzhou anddiscuss the geographic and theoretical impli-cations. The major findings are highlightedin the conclusions.

Literature Review andAnalytical Framework

Research on parallel imports has oftenbeen undertaken by scholars in businessschools and economics departments (see,e.g., Palia and Keown 1991; Dutta, Bergen,and John 1994; Malueg and Schwartz1994; Barfield and Groombridge 1998;Maskus 2000; and Maskus and Chen 2004).Game theory-based models developed byDutta, Bergen, and John and Maskus andChen are probably the most important theo-retical works on parallel imports.

Although there have been no previouspublished studies on parallel imports inmainstream Anglo-American economicgeography, there have been numerousstudies on TNCs. These latter studies havevaried considerably. Some have adopted theearlier corporate geographic approach toinvestigate the effect of policies and struc-tures of multiproduct, multiplant enterpriseson changes in industrial location and regionaleconomic development (Hayter and Watts1983, 157). More recent work has concen-trated on networks and embeddedness.

O’Neill (2003, 677, 679), however, notedthat the TNC “has slipped from the geog-rapher’s view and grasp,” even though“enlivened corporate research is likely toyield important understandings about spatialeconomies, understandings that are criticallyimportant to contemporary policy-makingat all levels of government and allied agen-cies.”2 Furthermore, O’Neill argued that ineconomic geography, TNCs have been “side-stepped” by studies that are conductedaround, rather than on, the issues ofcontention, notably under the paradigmsof flexible specialization and the customiza-tion of production (Eng 1997; Norcliffe1997; Ó hUallacháin 1997; Jin and Stough1998; Scott 1988a; Storper and Salais 1997),and global production networks and theirembeddedness (Amin 1997; Dicken andThrift 1992; Dicken and Malmberg 2001;Dicken, Kelley, Olds, and Yeung 2001;Dicken 2003; H. W.-c. Yeung 1994, 1997,1998, 2002; Henderson et al. 2002; Coe etal. 2004).

These strands of literature are useful inexplaining the dynamics of industrial loca-tion (and relocation) and provide valuable


Table 1

Basic Background Information for the Field Study

Date

June 2002July 2002

November 2002April 2003

June 2004

December 2004a There are many beverage wholesalers in Shanghai and Hangzhou. The research assistant from the HangzhouUniversity of Commerce guided the authors to visit the owners of some randomly selected wholesalers.

Interviewees

Management executives from Coca-ColaEight major wholesalers and three retailers

in the Shanghai and Hangzhou marketsa

Management executives from Coca-ColaFive major wholesalers in the Hangzhou

marketa

Six major wholesalers and two retailers in theHangzhou marketa

Management executives from Coca-Cola

Interviews Conducted By

The second authorThe second author, accompanied by a research

assistant from Hangzhou University ofCommerce

The second author The first author, accompanied by a research

assistant from Hangzhou University ofCommerce

A research assistant from Hangzhou Universityof Commerce

Both authors

2 There are, however, some notable exceptions,such as Maskell (2001) and Taylor and Asheim(2001). See also H. W.-c. Yeung and Lin (2003,111–15) for an excellent review of the major theo-ries in mainstream economic geography.


insights into the linkages of TNCs (especiallytheir backward linkages and their determi-nants and forms) and their geographic impli-cations, yet they are not particularly relevantto the analysis of the geographic distributionof products through unauthorized channels,the impact of parallel imports on the marketboundaries of regional monopolies, andthe geography of supply systems.Contemporary Anglo-American economicand industrial geographies are unable toprovide an analytical framework to analyzethese important geographic phenomena.

The application of transaction-costeconomics by economic geographers can,however, yield insights into the selection ofan analytical framework for this study. Ó hUallacháin and Wasserman (1999, 39)applied the transaction-cost theory of thefirm to analyze the organizational, techno-logical and territorial strategies of Brazil-based tier-one suppliers of chassis, engines,and bodies for automobiles. They arguedthat tier-one suppliers in an automobileproduction chain are vertically integrated tointernalize the production of parts and theassembly of subsystems to exploit economiesof scale, to ensure quality, and to protectproprietary knowledge from opportunisticsubcontractors. Scott (1988b, 1988c, 1992)incorporated transaction-cost economics intothe reconceptualization of neoclassical loca-tion theory and the delineation of flexibleproduction agglomerations. He high-lighted the need for firms to internalizecertain production processes that couldotherwise be efficiently externalized becauseof imperfect and asymmetrical information.By internalizing these processes, firms areable to mitigate the transaction costs that areassociated with interfirm linkages in a decen-tralized production system. Apart from thequality of labor, Brannstrom (2000) madethe case that supervision costs, asymmetricalinformation, and risk also contribute to thecreation of coffee groves in São Paulo, Brazil.

Nonetheless, Phelps (1992) argued thatScott’s (1988b, 1988c) transaction-costanalysis of vertical integration and disinte-gration applies largely to a market that isclose to perfect competition. Pietrykowski

(1995) also contended that the transaction-cost theory of industrial production proposedby Scott (1988b, 1988c) is unable to explainthe location decisions of Ford MotorCompany in Michigan in the mid-twentiethcentury. H. W.-c. Yeung (1996, 1997) alsopointed out that conventional transaction-cost analysis tends to overlook social andcultural factors, such as the role of guanxi(personal relationships), which is embeddedin the development of Hong Kong-basedTNCs.

Although the foregoing studies were noton parallel imports, they demonstrate thepotential explanatory power and draw-backs of transaction-cost economics. In lightof the strengths and weaknesses of existinganalytical frameworks, in this article, we usethe framework of agency theory and trans-action-cost economics for our analysis.

Agency theory is a theory of the firmthat explores the contractual relationshipbetween a property rights owner (the prin-cipal) and its employees (managers andworkers: the agents) (Jensen and Meckling1976). Transaction-cost economics analyzesthe contractual issues of a transaction thatarise out of the existence of the boundedrationality and opportunism (the oppor-tunistic or self-interested behavior) of agentsand asset specificity, which is the uniquecharacter of a durable asset that may notbe redeployed to alternative uses (see Figure1) (Williamson 1975, 1979, 1985). Accordingto behavioral economics, the rational choiceof a decision maker is subject to cognitivelimits, since human beings never haveperfect information and have only a limitedknowledge and ability to forecast the future,which means that irrational decisions maybe made because of bounded rationality(Simon 1957, 1982).

Fama and Jensen (1983a, 302) argued thatan organization (firm) is the nexus of writtenand unwritten contracts between the ownersof property rights and the factors of produc-tion. These contracts specify the rights andobligations, appraisal criteria, and payoff(remuneration) functions of each agent inthe organization, in terms of either fixedpayoffs or incentive payoffs that are tied to



specific performance benchmarks. Fama andJensen (1983a, 303) further divided the deci-sion processes of the agents in an organiza-tion into two major categories: decisionmanagement and decision control. Decisionmanagement involves the initiation ofdecisions (the generation of proposals forthe use of resources and the structuring ofcontracts) and the implementation of deci-sions (the execution of ratified decisions),and decision control involves the ratificationof decisions (the choice of which decisioninitiatives to implement) and the monitoringof decisions (the measurement of the perfor-mance of decision agents and the imple-mentation of rewards).

When an organization is the nexus ofcontracts, agency problems often arisebecause the preparation and enforcementof contracts involves agency costs (see Figure1). These costs include the costs of struc-turing, monitoring, and bonding a set of

contracts among agents with conflictinginterests (the interests of the firm versus self-interest) and the value of output that is lostwhen the costs of the full enforcement ofcontracts exceed the benefits (Jensen andMeckling 1976). According to Williamson(1989), agency problems are part of humannature because employees are prone toopportunism under a mixture of stewardshipand agentship. In the context of the theoryof incentives, employees can be motivatedby their own commitment to be loyal stew-ards of the organization, on the one hand,and by the promise of rewards (throughremunerations) or the threat of bearing thefinancial consequences of their decisionmaking, on the other hand. Therefore, theimperfect enforceability of contractualagreements is a natural consequence of theopportunistic behavior of agents and thebounded rationality of decision makers(Williamson 1989). Apart from involving the


Figure 1. The “Principal-Agent” (PA) analytical framework.


enforceability of contractual agreements, thehigh transactions costs that are associatedwith some economic activities (representingas much as 35 percent to 40 percent of thecosts; see North 1990) suggest that trans-action-cost theory is an appealing approachto explaining the existence of paralleltrade, for example, that it will not exist if theenforcement of contracts carries no cost.

Parallel Imports andDistribution Strategies of Coca-Cola

Parallel imports (gray marketing) existwhen an unauthorized distributor obtainsgenuine brand-name products and thenresells them to others (wholesalers, retailers,or consumers) without the permission of theowner of the intellectual property rights(copyright, patent, or trademark). It is esti-mated that in the United Kingdom alone,the parallel trade accounted for up to 20percent of all medicine sales in 2004 (Jack2005). From the perspective of the manu-facturers or authorized distributors, it isdesirable to eliminate parallel imports toprotect market share. From the perspectiveof consumers, parallel trade is desirable toachieve the lower prices and increasedchoice that come with the availability ofparallel imported commodities.3

According to the doctrine of nationalexhaustion, the right of the owner of theintellectual property to control distributionends only upon the first sale within a country,and therefore the owner of such a right isallowed to exclude parallel imports fromother countries. Countries with nationalexhaustion are segmented markets, since theoriginal manufacturers have completeauthority to distribute goods and servicesdirectly or indirectly through authorized

dealers. This is not the case with interna-tional exhaustion, where the right of theowner of the intellectual property right tocontrol distribution ends upon the first saleanywhere, and therefore parallel imports areallowed. In the case of regional exhaustion,where the right of the owner of the intel-lectual property right to control distributionends upon the original sale within a groupof countries (but not the first sale outsidethe region; hence, parallel imports outsidethe region are not allowed), parallel trade inthe region is allowed (Maskus 2000; Maskusand Chen 2004). Arbitrage can occur whenthe differences in price between differentmarkets (including differences that are dueto substantial fluctuations in exchange rates)are greater than the transaction costs thatare involved in engaging in parallel importsor when efforts are made to offset supplyshortages in regions at below the prevailingmarket price (Cavusgil and Sikora 1988).

For a product with a short life cycle orone that requires sale economies, sales teamsare under constant pressure to sell off exces-sive stocks to distributors (including paralleltraders) before the cost of the product iswritten off on the company ’s balancesheet. This price reduction by manufacturersand the subsequent fire sale by parallelimporters further erode the price of theproduct and may lead to a vicious circle inwhich the accumulation of excessive stockprompts price discounts by the manufac-turers, which entails further fire sales byparallel importers. A gray market for aproduct can also exist when an authorizeddistributor sells excessive stock to graymarketers outside the designated territoriesto become eligible for a volume-discountpricing scheme or to meet sales quotas thatare assigned by the manufacturer. A manu-facturer’s authorized distributors may endup competing with parallel traders, whichmay erode that brand’s prestige. Moreover,parallel imports may strain the relationshipbetween manufacturers and authorizeddealers, partly because of the erosion ofmarket share and profit margins and partlybecause of the disruption of marketingstrategies. It can be argued, however, that


3 This generalization does not always holdbecause some manufacturers need the graymarket to clear excessive stock, and someconsumers complain about the lack of after-salesservice that is associated with gray market prod-ucts (Cespedes, Corey, and Rangan 1988).


the existence of parallel imports actuallyfacilitates the penetration of the market bymanufacturers because parallel imports helpto maintain a brand’s price competitive-ness (Maskulka and Gulas 1987; Cavusgiland Sikora 1988; Cespedes, Corey, andRangan 1988).4

Manufacturers can control the graymarket by disenfranchising offending distrib-utors or by setting a one-price-for-allpolicy for all distributors. Disenfranchise-ment is costly for manufacturers becauseof the expenses that are incurred in moni-toring the incidents of offense, and a one-price-for-all policy eliminates the opportu-nities for price discrimination (Cespedes,Corey, and Rangan 1988; Cavusgil andSikora 1988; Palia and Keown 1991).

Coca-Cola divides the world into differentregional markets, each of which is monopo-lized by a corresponding exclusively fran-chised or EJV bottler. Coca-Cola implementsa market-division strategy by including “terri-torial sales provisions” in the exclusivecontract that is signed by each independentlyoperating bottler. These provisions forbidany bottler’s sales team from selling Coca-Cola outside the designated market where itwas bottled, thus in effect forbidding theinterregional competition of Coca-Cola.5 IfCoca-Cola products are found for sale outsidetheir designated territories, such as the saleof U.S. Coca-Cola in Japan, then Coca-Cola imposes a fine on the bottler that isresponsible for the parallel import. Thefine is equivalent to the wholesale price ofCoca-Cola and is payable to the bottler thatis affected by the parallel imports. In the fore-going example, the U.S. bottler would haveto pay a fine for its parallel export of Coca-

Cola to the Japanese bottler to compensatefor its financial losses. The actual quantity ofCoca-Cola that is involved in the paralleltrade is verified by an independent intellec-tual property consultant who is employed byCoca-Cola (Field survey June 2002). In otherwords, Coca-Cola creates a number of defacto regional monopolies for its products allover the world through its market-divisionstrategy and its associated penalty system. Inspite of the strict distribution rules that areimposed by Coca-Cola, the parallel importof its products still exists because there is asignificant difference in the price of Coca-Cola in different markets to allow arbitragersto earn profits. For instance, at 67 cents fora 12-ounce can from a vending machine inJapan, the parallel-imported U.S. productis 40 percent cheaper than the Japaneseproduct, even when the extra transporta-tion costs are included (Hays 2000).

Given China’s population of 1.3 billion,which accounts for 21 percent of the world’spopulation, and its average annual real rateof growth in its gross domestic product ofabout 9 percent since 1979, the countryhas long been viewed as an important marketby Coca-Cola. Faced with keen competitionfrom its close competitor, Pepsi-Cola, andan unfamiliar and highly volatile local marketenvironment, Coca-Cola has used differentmodes of market entry, from franchises andEJVs to a hybrid of EJVs and franchises, topenetrate the Chinese carbonated-drinksmarket (Mok, Dai, and Yeung 2002).

Coca-Cola implements a market-divisionstrategy in China, which means that it dividesthe Chinese market into different regions,where each regional bottler is vested withmonopoly rights to sell Coca-Cola in itsown territory. In 1993, Coca-Cola signedterritorial arrangements with the Hong Kong-based Swire Pacific Group and the Malaysia-based Kerry Beverages Group and assumedan equity stake of 12.5 percent in eachcompany. Swire Pacific is responsible for theproduction and distribution of Coca-Colaproducts in southern China and in selectedinterior provinces, and Kerry Beverages isresponsible for the northern and interiorparts of China. At present, Swire Pacific is


4 In May 1988, the U.S. Supreme Court upheldthe legality of gray-market imports (Cavusgil andSikora 1988, 83–84; see also Duhan and Sheffet1988; Palmeter 1988; National EconomicResearch Associates 1999).

5 The 1980 U.S. Interband Competition Actallows Coca-Cola and other soft-drinks compa-nies to grant exclusive franchise rights to bottlersin given locations. This law, however, may not beenforceable outside the United States, since nosuch law exists elsewhere (Hays 2000).


an equity partner in 9 EJVs, and KerryBeverages is an equity partner in another 10EJVs with Coca-Cola in China (PU-TU-USC2000, 20–21). Since its entry into China in1979, Coca-Cola has invested $1.1 billionin building 25 bottlers (34 bottling plants)and in setting up a sales and distributionsystem with 600 service centers and 1.1million distributors that reaches about 80percent of the population in China. Coca-Cola is the number-one brand in the carbon-ated-drinks market in China and accountsfor a 23-percent share of the market.Together with other brands under its distri-bution network, such as Sprite, Fanta, andthe local brand, Smart, Coca-Cola representsmore than 50 percent of the Chinese market,nearly double the share held by Pepsi-Cola.With an increase in sales of 16 percent over2003, China was the second largest marketfor Coca-Cola in Asia in terms of volume in2004, just next to Japan (“China Is the SixthLargest Market for Coca-Cola” 2004). By2008, China is expected to be the third-largest market for Coca-Cola (McGregor2004; Dai 2004; Wang 2004).

Regional Monopoly andInterregional and IntraregionalCompetition

For the sake of simplicity, we do notdiscuss the roles of chain supermarkets, suchas Metro and Carrefour, since they accountfor a relatively small amount of parallel-traded Coca-Cola. The relationship betweenthe three major agents that are involved inthe parallel trade (see Figure 2) is as follows(Field surveys June and November 2002,December 2004).

• Shenmei Food (Shanghai) is Coca-Cola’sauthorized bottler in Shanghai. It wasestablished in the form of an EJV byCoca-Cola (China) in 1986. Coca-Cola(China) became the majority equityowner of this JV (40 percent) after itbought equity shares from its EJV part-ners, the Ministry of Light Industryand the Shanghai Investment and Trust

Company, in 1995. It sets the wholesaleprice of Coca-Cola in the exclusive anddesignated Shanghai market indirectlyby selling Coca-Cola to its exclusivedistributor, Jiashan Co. (a pseudonym).6

• Jiashan is the exclusive distributor of theCoca-Cola that is bottled by Shenmeiin the Shanghai market. It distributesabout 80 percent of the Coca-Cola thatis bottled by Shenmei, and Shenmei sellsthe remaining Coca-Cola to chain super-markets and restaurants directly. It alsosells Coca-Cola in the nondesignatedHangzhou market through parallel trade.

• Zhongcui Food (Hangzhou) is Coca-Cola’s authorized bottler in Hangzhou.It was established by Swire Pacific in theform of an EJV (with China National


Figure 2. Market division and parallel trade inCoca-Cola in Shanghai and Hangzhou, China.

6 Owing to the sensitive nature of the busi-ness dealings between Shenmei and its exclusivedistributor, we call the distributor “Jiashan,” thegeographic name of its location and businessregistration, to protect its anonymity.


Cereals, Oils and Foodstuffs Import andExport Corporation) in 1989. SwirePacific is the majority equity owner (44.6percent) of this JV, which is financiallyindependent from Shenmei, althoughCoca-Cola has an equity holding of12.5 percent in the Swire Pacific bottlingunit. Zhongcui distributes Coca-Coladirectly to wholesalers in the designatedHangzhou market.

Shanghai is a monopoly market withonly one entrant—Jiashan—whereasHangzhou is a duopoly market with twoentrants—the authorized bottler, Zhongcui,and the unauthorized parallel trader, Jiashan.

Interregional Competition in theForm of Parallel Trade

Parallel trade in Coca-Cola exists betweenthe designated Shanghai and Hangzhoumarkets when the gap in the wholesale pricebetween these two markets is higher thanthe transaction costs, including the cost oftransporting the products from Shanghaito Hangzhou and the risk premium of beingpunished by Coca-Cola (China), that areinvolved in engaging in parallel trade. Byapplying agency theory and transaction-costeconomics in the context of parallel trade,one can regard the business relationshipbetween Coca-Cola and its bottlers as thenexus of contracts (or the interfirm network,according to H. W.-c. Yeung 1994, 1997)between the principal and its agents. Agencyproblems arise when a bottler (the agent)that engages in parallel trade does not haveto bear a major share of the financialconsequences of the major residual (profits)claimants (shareholders, owners, or princi-pals that are responsible for net cash flowsand bear the residual risk), which includeCoca-Cola (the principal) and the otherbottlers (agents) (see Figure 1) (Fama andJensen 1983a, 1983b).7 In other words, an

agent’s decision to engage in parallel tradegenerates an external cost to the principaland the other agents. When an effectivecontrol mechanism is not available to theprincipal, the bottler is thus more likely toact against the interests of the residualclaimants. To deal with agency problems andto maintain the distribution system in anorderly manner, Coca-Cola creates a numberof regional monopolies through a market-division strategy that prevents interre-gional competition to maximize the profitsof each designated bottler within its owndesignated market.

In this particular case of parallel tradingof Coca-Cola between the designatedmarkets of Shanghai and Hangzhou, anextension of the “principal-agent” (PA)framework that is outlined in Figure 1 isrequired. Although Shenmei and Jiashan areboth agents of Coca-Cola (China), therelationship between them can also beregarded as the nexus of contracts betweenthe principal (Shenmei) and its agent(Jiashan). Thus, this is not a conventional PArelationship, but a more complex PAS rela-tionship among Coca-Cola, Shenmei, andJiashan (see Figure 3). In the proposed PASframework, agency problems arise when theopportunistic decision of Jiashan (thesubagent) to engage in parallel trade bearsnone of the financial consequences of majorresidual claimants, which include Coca-Cola(China) (the principal) and Shenmei andZhongcui (agents). In the case of Shenmei,their gain in market share and the subse-quent increase in production value that isbrought about by allowing Jiashan to engagein parallel trade are partially offset by thefine that is imposed by Coca-Cola (China)for violating the market-division strategy. Inthe case of Zhongcui, the existence ofparallel trade results in a loss in market shareand profits, but Zhongcui gets part of thelost profits back in the form of fines.Locating the parallel trade of Coca-Colawithin a transaction-cost paradigm revealsthat the enforcement of contractual agree-ments by the principal to rein in the oppor-tunistic market behavior of its agents andsubagents involves a high transaction cost,


7 Residual risk is the risk of the differencebetween stochastic inflows of resources andpromised payments to agents (Fama and Jensen1983a).


and any reliance on a self-enforcing agree-ment in the form of market division and theirassociated penalty system appears to be inef-fective.

Regional Monopoly versusIntraregional Rivalry with Pepsi-Cola

It is inconceivable that Shenmei does notknow about the existence of parallel tradein Coca-Cola in Hangzhou, since it has beenfined by Coca-Cola (China) for engaging insuch activities as the sole supplier to theparallel trader, Jiashan. It can be argued thatShenmei is able to manipulate the Coca-Colamarket in both Shanghai and Hangzhou by

adjusting the selling price of Coca-Cola toJiashan. If Shenmei lowers its selling price,then Zhongcui will lose its designated marketshare in Hangzhou to the parallel trader aslong as Jiashan can arbitrage the differencebetween the prices in Shanghai and those inHangzhou. According to the estimate of anexperienced beverage wholesaler inHangzhou, the value of the arbitrage whenJiashan can transport Coca-Cola into theHangzhou market and undercut Zhongcuiis about 7.4 cents (0.6 yuan) per case per 100kilometers (about 62 miles) (each case has12 1.25-liter, or about 42-ounce, bottles ofCoca-Cola or an equivalent quantity) (Fieldsurvey April 2003).


Figure 3. The “Principal-Agent-Subagent” (PAS) analytical framework of parallel trade in Coca-Cola in Shanghai and Hangzhou, China.


The crux of the issue is why Shenmei islowering its selling price and thuscontributing to the existence of the paralleltrade and whether it is lowering the pricedeliberately or has another agenda. Toanswer these two vital questions, one hasto understand the marketing strategy ofCoca-Cola (China).

Coca-Cola (China) aims to dominate theChinese cola market and especially to defeatPepsi-Cola, its major competitor. Pepsi-Colahas two key strongholds in China: Chengduand Shanghai. Since its Shanghai marketaccounts for about 40 percent of all thePepsi-Cola that is sold in China, Shanghai isthe natural battleground between Pepsi-Colaand Coca-Cola. A management executivefrom Coca-Cola told us:

It is Pepsi’s pricing policy to undercut Coca-Cola by always charging a lower price thanCoca-Cola in China.|.|.|. Therefore, theShanghai bottler [Shenmei] has no choice butto simply follow the orders of the Division[Coca-Cola (China)] to try to match the priceof Pepsi by charging the lowest possibleprice for Coke, even though it is earning nextto nothing in profit. In fact, the price ofShanghai’s Coke is already the lowest in China.It is the aim of Coca-Cola (China) to conqueras much market share as possible from Pepsiin Shanghai. (Italics added, Field surveyDecember 2004)

This competition helps explain why theparallel trade takes place between Shanghaiand Hangzhou, rather than between other

regional monopolies in China. This market-maximization policy is the strategic responseof Coca-Cola (China) to its intraregionalrivalry with Pepsi-Cola in Shanghai. A similarstrategy was pursued by Toyota and Nissanto compete with General Motors, Ford, andChrysler in the U.S. automobile market inthe 1970s (Johnson 1982, 1995).

In 2003, Shenmei set the selling price ofCoca-Cola to Jiashan at $5.99 (48.5 yuan)per case (each case has 12 bottles), whichis about 6 percent lower than Zhongcui’sselling price to the wholesalers in Hangzhou(see Table 2). With the prevailing wholesaleprice of Coca-Cola standing in the region of$6.30 to $6.43 (51 yuan to 52 yuan) per case,independently operating wholesalers thatsell the authorized Hangzhou Coca-Cola inHangzhou are in an embarrassing situa-tion, which ranges from suffering a loss of6.2 cents (0.5 yuan) per case to making aminimal profit of 0.5 yuan per case. Evenwith a lower wholesale price of parallel-traded Coca-Cola to retailers in Hangzhouat $6.18 (50 yuan) per case, the whole-salers are still able to earn a higher profitmargin up to 18 cents (1.5 yuan) per case ifno transportation costs need to be consid-ered by selling parallel-traded Coca-Colafrom Shanghai in Hangzhou.8 In fact, the


Table 2

Prices of Coca-Cola Supplied by Shenmei Food (Shanghai) and Zhongcui Food(Hangzhou), 2003

X

Per Case of 12 Bottles (1.25 liters each, approximately 42 ounces),in Yuan

Bottlers’ selling price to wholesalersWholesale price (to retailers) in HangzhouProfit margin of wholesalers in Hangzhou

Source: Interviews with various wholesalers in Shanghai and Hangzhou markets (Field survey April 2003).

Coca-Cola Supplied by Shenmei(Parallel-Traded Coca-Cola)

48.550.001.5

Coca-Cola Supplied byZhongcui in Hangzhou

51.551–52

–0.5 to 0.5

8 Because of the risk premium that is involvedin having stocks confiscated or having a fineimposed by Coca-Cola (China), the parallel-traded Coca-Cola in Hangzhou commands alower wholesale price (Field survey April 2003).


real price of Shanghai Coca-Cola in certainpackage formats is even more competitive.Apart from the lower nominal selling price,the volume in a 500-milliliter (about 16-ounce) can of Shanghai Coca-Cola is 52percent greater than that of a 330-milli-liter (about 12-ounce) can of HangzhouCoca-Cola. Furthermore, Jiashan’s sellingprice for parallel-traded Coca-Cola tomajor wholesalers in Hangzhou alreadyincludes the cost of transportat ion,which is why unauthorized Shanghai Coca-Cola has been able to capture up to 90percent of the beverage wholesale marketin the suburban and rural areas ofHangzhou and up to 20 percent of theCoca-Cola market in Hangzhou (Fieldsurveys July 2002, April 2003, June andDecember 2004).

As far as Shenmei is concerned, theconsequence of adopting the market-maxi-mization strategy by charging the lowestpossible price is a tiny net profit marginof x (a small-value single-digit) percent.By comparison, the average net profitmargin of Coca-Cola’s bottlers in China isabout three times higher, whereas the netprofit margin of Zhongcui is up to six timeshigher (at two digits), which is the highestamong Coca-Cola’s bottlers in China. It issmall wonder that a bottler’s managementexecutive complained that “we are oper-ating like a transportation company bysimply earning the fees to transport theCoca-Cola from our plant to wholesalers.|.|. we are all ‘coolies’!” (Field surveyDecember 2004). The market behavior ofShenmei is a typical example of sales-volume maximization that is subject to aminimal-profits constraint (Baumol 1967).Other similar predatory pricing policies toenlarge a firm’s market share can be foundin the Chinese beverage industry. Mr.Kon, for example, prices its products atthe lowest level in Tianjin, which is themajor market of its major competitor, Uni-President (Field survey December 2004).

Geographic and TheoreticalImplications of the ParallelTrade

There are several profound implicationsof the parallel trade in Coca-Cola for theprincipal, its agents, and the subagent.

Spatial Equilibrium, Disequilibrium,and Quasi-equilibrium of the Coca-Cola Distribution System

The market-division strategy and the asso-ciated penalty system that are implementedby Coca-Cola (China) are cost-effective waysto enforce contractual agreements and keepin check agency problems with its bottlers.This is to say that there is a spatial equilib-rium in the market boundary betweendifferent regional monopolies. This isespecially the case for the EJV bottlers inwhich Coca-Cola is a partner.

Under the market-maximization strategythat is implemented by Coca-Cola (China)in Shanghai, however, the market-divisionpolicy of the Coca-Cola system is essentiallyvoid because of the existence of agency prob-lems, the opportunism of the agents andsubagent, and the bounded rationality of theprincipal, whereby the focus is on Shenmei’smarket share, rather than on profit maxi-mization. Subsequently, the previous spatialequilibrium in the market boundary hasbeen transformed into a spatial disequilib-rium with interregional competition betweenregional monopolies in Shanghai andHangzhou.

The opportunism of Jiashan is motivatedby its relatively low transaction costs (andhence its higher profit margin) and its high-liquidity cash flow as a result of engagingin parallel trade in Coca-Cola. Jiashan isphysically located and registered inHangzhou, according to the official admin-istrative boundaries of the Chinese govern-ment, but according to the designatedmarket boundary of Coca-Cola, it is locatedin the Shanghai market (see Figure 4). Sincethe cost of delivering Coca-Cola fromShenmei to Jiashan is already incorporatedinto its selling price, the cost of transporting



parallel-traded Coca-Cola from Shanghai toHangzhou is relatively small to Jiashan.Obviously, the locational advantage ofJiashan lowers the transaction costs and thusfacilitates the existence of a parallel trade inCoca-Cola from Shanghai to the Hangzhoumarket (Field survey July 2002).

Apart from earning its profit margins,Jiashan profits from the substantial cash flowthat is generated by the parallel trade. Thewholesalers in Hangzhou have to settle theiraccounts with Jiashan by cash on delivery,whereas Jiashan settles its accounts withShenmei on a three-month credit basis. Theprofits that are generated from the cash floware not inconsiderable. Since an indepen-dent investigator has uncovered at least125,000 cases of parallel-traded Coca-Colaevery month, we can estimate that Jiashangenerates at least $749,000 (6.06 millionyuan) in cash flow per month (Field surveysJuly and November 2002). Obviously, thishigh-liquidity cash flow facilitates the busi-

ness operations of Jiashan, because the cashcan be used for other business activities,which, in turn, further strengthens the incen-tive for Jiashan to break into the regionalmonopolized market of Zhongcui.

Coca-Cola (China) is unable to controlJiashan’s opportunistic market behavior in adirect and cost-effective way, as is illustratedby the PAS framework (see Figure 3). Ratherthan impose administrative sanctions inthe form of fines, as it does with the bottlersover which it has certain administrativecontrol, Coca-Cola can seek to influence themarket behavior of Jiashan only indirectlyby putting pressure on Shenmei. Thisstrategy has proved to be ineffective andinefficient in comparison with the strategyused with vertically integrated tier-onesuppliers for the automobile industry thatwas described by Ó hUallachá in andWasserman (1999). It is clear that Coca-Cola(China) has relatively limited control over


Figure 4. The location of Jiashan Company.

N

C H I N A


the distribution of its products by oppor-tunistic subagents.

Theoretically, Coca-Cola (China) may beable to file a lawsuit against Jiashan fordisrupting its market-division policy on thegrounds of the national exhaustion of intel-lectual property rights. In reality, the hightransaction costs that would be involved insuch a lawsuit would prevent Coca-Cola(China) from taking legal action againstJiashan or other participants, such as chainsupermarkets, that are involved in theparallel trade. Legal redress is costly andoften inefficient in terms of the ongoingPA relationship (Tesler 1981). It may evenbe legally impossible for TNCs in foreignmarkets to enforce private contractual agree-ments that limit sales outside their desig-nated monopolized markets (Chard andMellor 1989). There are also no legal prece-dents for parallel trade cases in China.Should the court rule in favor of Coca-Cola (China), it would then leave theeffectiveness of its implementation in doubt,since Jiashan is operating independently ofthe Coca-Cola system. Furthermore,Coca-Cola (China) would be extremelyreluctant to disclose to the general publicthe operation of its market-division andmarket-maximization strategies in such acourt case because these are de factoregional monopoly and predatory pricingpolicies, respectively.

As for Shenmei, it has to overcome its ownagency problems to monitor the oppor-tunism of Jiashan (see Figure 3). Underthe bounded rationality of market maxi-mization, Shenmei has poor incentives forpreventing Jiashan from deviating from theself-enforcing contractual agreement withits principal and entering the unauthorizedmarket in Hangzhou, say, by restricting itssupply of Coca-Cola to Jiashan. The trans-action costs that would be incurred byShenmei (the agent) for monitoring Jiashan’s(the subagent) opportunistic involvement inthis parallel trade would certainly be higherthan the potential benefits of action: themost effective way to prevent Jiashan frombeing involved in the parallel trade in Coca-Cola would be for Shenmei to appoint

inspectors who are based at the distributorand other major wholesalers to record andinspect the delivery of goods. Moreover, itwould be extremely costly for Shenmei toreplace its existing distributor, since Jiashandistributes about 80 percent of Shenmei’soutput (Field survey December 2004).

To maintain the delicate quasi-equilib-rium between the regional monopolies ofShenmei and Zhongcui, Coca-Cola (China)has a penalty system in place to punishbottlers that violate its market-divisionstrategy. Coca-Cola (China), however,cannot and would not fully implement thispenalty system because of its insistence onits market-maximization strategy ofcompeting with Pepsi-Cola in Shanghai.Moreover, as the majority equity owner ofShenmei, Coca-Cola (China) has its ownbenefit at stake. In these circumstances,Coca-Cola (China) compromises its policyon the control of parallel trading (interre-gional competition) by fining the offendingbottler, since it has been unable effectivelyto curb the market behavior of its agent,Shenmei, and its subagent, Jiashan.Officially, Coca-Cola (China) imposes a fineon Shenmei of $1.85 (15 yuan) per case ofparallel-traded Coca-Cola once an allega-tion has been verified by an independentconsultant. As a compromise between theprincipal and its agents, however, the actualamount of the fine is negotiated by Coca-Cola (China), Shenmei, and Zhongcui. Theresult is that Coca-Cola (China) has finedShenmei over $2.47 million (20 million yuan)per year for engaging in parallel trade (Fieldsurveys June and November 2002, April2003, December 2004).

Can Zhongcui fight back against theparallel trade? Given the interregionalcompetition from Shenmei on lower pricing,the authorized Hangzhou bottler has fewcost-effective options to hold in check theentrance of parallel-traded Coca-Colafrom Shanghai, other than protesting againstthe practice to Coca-Cola (China). First, thetransaction costs of eliminating the paralleltrade are too high, since Jiashan is locatedin Hangzhou and thus has the locationaladvantage of low transportation costs when



engaging in parallel trade. Second,Zhongcui’s profit margin would be squeezedshould the company engage in a price warwith the parallel trader, Jiashan. Third, thereimbursement of the fines (about $206,400or 1.67 million yuan per month) that areimposed by Coca-Cola (China) on Shenmeifor its violation of the market-divisionstrategy helps mitigate Zhongcui’s loss ofprofits, but it does not prevent the erosionof its monopolized market share inHangzhou. This point is illustrated by theanimated statement of a management exec-utive from Coca-Cola:

Zhongcui cannot complain vigorously to Coca-Cola (China) as it is literally taking money bydoing nothing; .|.|. the reimbursement of finesalone is over 20 million yuan per year andaccounts for 15–20 percent of its total annualrevenue. What else do they want? .|.|. As longas their profitability is able to grow annually,the Hangzhou bottler will not complain toomuch [to Coca-Cola (China)].” (Field surveyDecember 2004)

Given that the present net profit marginis already the highest among Coca-Cola’sbottlers, Zhongcui actually has a limitedincentive to match the price to fend offparallel-traded Coca-Cola from Shanghai(Field surveys July and November 2002,December 2004). From this perspective, itappears that Zhongcui is passive in handlingthe issue of parallel-traded Shanghai Coca-Cola on the Hangzhou market, even thoughit is the authorized bottler and has theregional monopoly in the designated marketof Hangzhou.

Policy and Theoretical Implications

As long as parallel-traded Coca-Cola isnot disrupting Coca-Cola’s distributionsystem excessively and the spatial quasi-equi-librium between the regional monopoliescan be maintained, Coca-Cola (China) maynot be keen to eliminate the existence ofparallel trade and thus does not have tocontrol the opportunistic market behaviorof Jiashan because the key priority ofCoca-Cola (China) is to dominate the

Chinese soft-drink market, rather than toregulate the boundary disputes betweenregional monopolies. First, the existence ofa parallel trade in Coca-Cola will not havea negative impact on the reputation andquality of Coca-Cola because the trade isstill in genuine Coca-Cola, not a counterfeitproduct. Second, the existence of the paralleltrade promotes interregional competition inCoca-Cola between the regional monopo-lies in Shanghai and Hangzhou, which willincrease, rather than decrease, the totalmarket share of Coca-Cola in China becauseof the relatively lower retail prices of theparallel-traded Coca-Cola. Third, Coca-Cola(China) could benefit from the higherdemand for concentrate, from which thecompany derives the majority of its revenuesfrom the wholly owned Coca-ColaConcentrate Plant Co. in Shanghai, shouldthe total demand for Coca-Cola in Chinaincrease owing to the existence of the paralleltrade. It is thus not surprising that a manage-ment executive from Coca-Cola said, “Coca-Cola cares, most of all, about market shareand the sale of concentrate, from which itderives its revenues.|.|.|. Bottlers have toexecute the marketing [pricing] strategyimplemented by the division [Coca-Cola(China)], even if they are not earning aprofit” (Field survey December 2004). If thisexplanation holds water elsewhere, then itmay also explain why parallel imports ofCoca-Cola exist in other parts of the world.

Our findings are incompatible with Scott’s(1992) argument that firms have to inter-nalize their activities to counter the existenceof imperfect and asymmetrical information.It is not the strategy of Coca-Cola to inter-nalize its supply chains backward and itsdistribution channels forward, since theinternalization of the distribution channelsinvolves a tremendous amount of investmentin a vast country like China (Mok, Dai, andYeung 2002). We have also made a case forparallel trade, which is different fromanalyses, such as the one by Cavusgil andSikora (1988), that have focused on thedisruptive effects of parallel trade, sayingthat it should not be tolerated. Instead ofunraveling the distribution system, our



analysis has shown that the existence of inter-regional competition in the form of paralleltrade is inherent in regional monopolies inthe particular context of intraregionalcompetition between different TNCs. Thisargument is largely consistent with themodel developed by Dutta, Bergen, andJohn (1994), which concluded that theoptimal enforcement policy for manufac-turers is to tolerate some level of parallelimports because doing so reduces the trans-action costs on self-enforcing contracts withdistributors. Given that the transaction costsof effectively policing parallel trade andeffectively maintaining the market-divisionstrategy of Coca-Cola are higher than theeconomic benefits that can be gained byCoca-Cola in the entire Chinese market, itseems that Coca-Cola (China) is content totolerate the existence of parallel trade in theShanghai and Hangzhou markets.Theoretically, this point can be explained bythe Coase theorem (Coase 1960): the exis-tence of parallel trade has no effect on theultimate penetration into China’s carbon-ated soft-drink market (the ultimate alloca-tion of resources in a society), but affectsonly the division of market share and prof-itability between Shanghai and Hangzhoubottlers.

As a strategic response to the intraregionalrivalry with Pepsi-Cola in Shanghai, Coca-Cola (China)’s market-maximization strategyhas an intrinsic spatial disequilibrium withits market-division strategy. Under itsmarket-division strategy, Coca-Cola createsa de facto regional monopoly in eachdesignated market, while under its market-maximization strategy, Coca-Cola creates anartificial price difference between theregional monopolies in Shanghai andHangzhou. This approach not only explainsthe emergence of the spatial disequilibriumin the form of parallel trade betweenShanghai and Hangzhou, but also accountsfor the creation of unintentional interre-gional competition between these tworegional monopolies, which may contributeto an increase in the market share of Coca-Cola in China. This strong argument can bepartially verified by the experience of two

bottlers in Liaoning province. Liaoning isthe only province in China to have more thanone Coca-Cola bottler, one in Shenyang andthe other in Dalian (both of which arecontrolled by Kerry Beverages, but each ofwhich has its own local EJV partners andgeneral manager). The spatial disequilibriumin the form of parallel trade in Coca-Colahere is not as significant as it is in theHangzhou market, but the intraregionalcompetition between these two regionalmonopolies has actually led to a significantincrease in market share, and Liaoning hasthe highest per capita consumption of Coca-Cola in China at 24–25 bottles per person(Field survey December 2004). An inter-view with an experienced manager of anauthorized distributor of popular Japaneseelectronic products in Hong Kong also lendssupport to this proposition: parallel trade(imports) promotes interregional competi-tion between regional monopolies (autho-rized dealers) because they realize that theirmarket shares are not guaranteed (Fieldsurvey December 2004).

Since the parallel-traded Coca-Cola fromShanghai already accounts for up to 20percent of the market in Coca-Cola inHangzhou, parallel trade sends a strongsignal to the Hangzhou bottler: its regionalmonopolized market cannot be taken forgranted, and it is up to the sales team tomaintain its market share and profitability.Feeling the heat of parallel-traded Coca-Cola, Zhongcui implemented a series ofmarketing campaigns to try to defend itsmarket share in Hangzhou. In 2002,Zhongcui twice implemented a “bundling”sales strategy for its Coca-Cola in Hangzhou,whereby each wholesaler would get threebottles of mineral water at no extra chargefor every case of Coca-Cola that it ordered.Nonetheless, this marketing strategy wasineffective in eliminating the parallel tradein Hangzhou, since the nominal price ofHangzhou Coca-Cola, at $6.37 (51.5 yuan)per case, was still higher than the parallel-traded Coca-Cola from Shanghai, at $5.99(48.5 yuan) per case, without even takinginto consideration the differences in volume(Field surveys July 2002, April 2003).



ConclusionsThis investigation of the parallel trade in

the Chinese beverage industry hascontributed to the literature of economicgeography in two major ways: it is the firststudy of the existence of parallel trade andits geographic implications on the product-distribution system of a TNC, and it intro-duced a PAS framework to analyze thecomplex relationship between regionalmonopoly and interregional and intrare-gional competition through a representativecase study—the parallel trade of Coca-Cola in two regional monopolized marketsin Shanghai and Hangzhou in China.

First, our article analyzed the issue ofparallel trade, which is an importantphenomenon that reveals the inefficiencyand limitations of TNC distribution networksin foreign markets. Given the opportuni-ties for arbitrage, market players have theincentive and means to break into the marketboundaries of the regional monopolies thathave been devised by Coca-Cola’s market-division strategy. Jiashan, the exclusivedistributor of Coca-Cola in the Shanghaimarket, can enter the nondesignatedHangzhou Coca-Cola market only throughparallel trade when the gap between thewholesale prices in the Shanghai andHangzhou markets is higher than thetransaction costs of engaging in paralleltrade. The fortuitous location of Jiashan inHangzhou gives it the locational advantageof lower transportation costs to conduct itsparallel trade in Coca-Cola in Hangzhou.Moreover, Coca-Cola’s policy of attemptingto regulate the parallel trade and to main-tain the regional monopoly ’s marketboundary by imposing a fine upon theresponsible bottler has proved to be inef-fective because the offending bottler,Shenmei (Shanghai), is under the directmanagement of Coca-Cola (China). In suchcircumstances, Coca-Cola (China) cannotact as an impartial referee in a case of arbi-trage that involves parallel trade. As astrategic response to the intraregional rivalrywith Pepsi-Cola in Shanghai, the Shanghaibottler has to obey the market-maximization

strategy of Coca-Cola (China) and chargethe lowest possible price for Coca-Cola soas to compete for its market share withPepsi-Cola in Shanghai. This situationcontributes to the spatial quasi-equilib-rium with other regional monopolies thathave been artificially created by Coca-Colaand has resulted in the occurrence of aparallel trade in Coca-Cola in the nondes-ignated market in Hangzhou. This circum-stance is consistent with the manufacturers’-dealers’ quasi-equilibrium hypothesized byDutta, Bergen, and John (1994). However,it is different from the conventional mech-anism whereby parallel imports facilitate amanufacturer’s penetration of the market bymaintaining the price competitiveness of themanufacturer’s products or by serving toclear excessive stock (Maskulka and Gulas1987; Cavusgil and Sikora 1988). The rela-tively limited control that Coca-Cola (China)has over the distribution of its products intwo presumably regional monopolizedmarkets in China is a prima facie case inwhich although one of the largest and mostpowerful TNCs in the world may have tight-ened control over production networkswithin and between different countries, itactually has limited control over the distri-bution and redistribution of its products incompetitive foreign markets. In addition toshowing the importance of the corporatestrategy of a dominant TNC, this articlehas highlighted the limits of corporateauthority over the wider value chain ofproduct distribution, thus responding toO’Neill’s (2003) criticism of the lack ofcorporate research in mainstream economicgeography.

Second, this article has proposed a PASframework for analyzing the complex rela-tionship between regional monopoly andinterregional and intraregional competi-tion through the case of parallel trade inCoca-Cola. The conventional PA analyticalframework (Jensen and Meckling 1976)explains the basic contractual relationshipbetween Coca-Cola (China) (the principal)and its bottlers (agents). However, the exten-sion of this framework—the proposed PASparadigm—not only serves to explain the



contractual nexus of Coca-Cola (China) (theprincipal), its bottlers (agents), and theirdistributors (subagents), but it also providesan analytical framework for the existenceof a spatial quasi-equilibrium in forms ofparallel trade in Coca-Cola between tworegional monopolized markets in Shanghaiand Hangzhou. It furthermore accommo-dates the effects of a market-maximizationstrategy implemented by the principal as astrategic response to its intraregional rivalrywith Pepsi-Cola in Shanghai (see Figures 1and 3). Moreover, the PAS is able to explainthat, under the circumstances of boundedrationality (Simon 1957, 1982) and thehigh transaction costs that are needed toenforce the contractual agreements withagents and subagents (Williamson 1975,1979, 1985; North 1990), TNCs (the prin-cipals) may actually have relatively limitedcontrol over the distribution and redistrib-ution of their products by the oppor-tunistic agents and subagents. This articlehas demonstrated that the simplified styl-istic representations of market area analysisthat have been produced under the geog-raphy-of-enterprise tradition (see Hayterand Watts 1983) do not take into accountphenomena such as parallel trade and thecomplexities of constructing and maintainingmarket areas by TNCs.

Another significant contribution of thisarticle has been to provide a prima facie casefor the proposition that the efficiency of aregional monopoly can be improved by theintroduction of interregional competitionthrough parallel trade (or parallel imports,as a result of intraregional competition), andthat the theoretically deadweight loss ofregional monopolies (vis-à-vis a perfectlycompetitive market) can be minimized. Thepolicy and theoretical implications of thisfinding are profound, if they are verified inother regions and industrial sectors, suchas the parallel imports of electronic appli-ances from Japan into other Asian countriesand the parallel imports of automobilesamong different European countries. Fromthe perspective of efficiency, should weencourage a view that there should be aglobal or national regime of parallel trade

(imports)? Further research could usefullybe conducted in these areas.

ReferencesAmin, A. 1997. Placing globalization. Theory,

Culture and Society 14:123–37.Barfield, C. E., and Groombridge, M. A. 1998.

The economic case for copyright owner controlover parallel imports. Journal of WorldIntellectual Property 1:903–39.

Baumol, W. J. 1967. Business behavior, value,and growth. New York: Harcourt, Brace andWorld.

Brannstrom, C. 2000. Coffee labor regimes anddeforestation on a Brazilian frontier,1915–1965. Economic Geography 76:326–46.

Cavusgil, S. T., and Sikora, E. 1988. How multi-nationals can counter gray market imports.Columbia Journal of World Business 23:75–85.

Cespedes, F. V.; Corey, E. R.; and Rangan, V. K.1988. Gray markets: Causes and cures.Harvard Business Review 4:75–82.

Chard, J. S., and Mellor, C. J. 1989. Intellectualproperty rights and parallel imports. The WorldEconomy 12:69–83.

China is the sixth largest market for Coca-Cola.2004. China Business Times, 10 November,14.

Coase, R. H. 1960. The problem of social cost.Journal of Law and Economics 3:1–44.

Coe, N. M.; Hess, M.; Yeung, H. W.-c.; Dicken,P.; and Henderson, J. 2004. “Globalizing”regional development: A global productionnetworks perspective. Transactions of theInstitute of British Geographers 29:468–84.

Dai, Y. 2004. China to become Coke’s top Asianmarket. China Daily, 22 June, 10.

Dicken, P. 2003. Global shift: Reshaping theglobal economic map in the 21st century, 4thed. London: Sage.

Dicken, P.; Kelly, P. F.; Olds, K.; and Yeung,H. W.-c. 2001. Chains and networks, territo-ries and scales: Towards an analytical frame-work for the global economy. Global Network1:89–112.

Dicken, P., and Malmberg, A. 2001. Firms interritories: A relational perspective. EconomicGeography 77:345–63.

Dicken, P., and Thrift, N. 1992. The organiza-tion of production and the production of orga-nization: Why business enterprises matter inthe study of geographical industrialization.Transactions of the Institute of BritishGeographers 17:279–91.



Duhan, D. F., and Sheffet, M. J. 1988. Graymarkets and the legal status of parallel impor-tation. Journal of Marketing 52(3):75–83.

Dutta, S.; Bergen, M.; and John, G. 1994. Thegovernance of exclusive territories whendealers can bootleg. Marketing Science13(1):83–99.

Eng, I. 1997. Flexible production in late indus-trialization: The case of Hong Kong. EconomicGeography 73:26–43.

Fama, E., and Jensen, M. 1983a. Separation ofownership and control. Journal of Law andEconomics 26:301–26.

———. 1983b. Agency problems and residualclaims. Journal of Law and Economics26:327–50.

Hays, C. L. 2000. In Japan, what price Coca-Cola? “Throwaway” lawsuit grows into a far-reaching case. New York Times, 26 January, 1.

Hayter, R., and Watts, H. D. 1983. The geog-raphy of enterprise: A reappraisal. Progress inHuman Geography 7:157–81.

Henderson, J.; Dicken, P.; Hess, M.; Coe, N.;and Yeung, H. W.-c. 2002. Global produc-tion networks and the analysis of economicdevelopment. Review of International PoliticalEconomy 9:436–64.

Horowitz, I. 1981. Market definition in antitrustanalysis: A regression-based approach.Southern Economic Journal 48(1):1–16.

Jack, A. 2005. Drugs groups seek cure for irrita-tion of parallel trading: Importers areexploiting the widely varying prices of medi-cines in the EU. Financial Times, 10 August,18.

Jensen, M., and Meckling, W. 1976. Theory ofthe firm: Managerial behavior, agency costsand ownership structure. Journal of FinancialEconomics 3:305–60.

Jin, D. J., and Stough, R. R. 1998. Learning andlearning capability in the Fordist and post-Fordist age: An integrative framework.Environment and Planning A 30:1255–78.

Johnson, C. A. 1982. MITI and the Japanesemiracle: The growth of industrial policy,1925–1975 . Stanford, Calif. : StanfordUniversity Press.

———. 1995. Japan—Who governs? The riseof the developmental state. New York: W. W.Norton.

Liu, B. 2004. The Coca-Cola challenge: DouglasDaft’s impending departure creates leadershipdoubts at the drinks giant. Financial Times, 10March, 17.

MacKinnon, D., and Phelps, N. A. 2001a.Regional governance and foreign direct invest-ment: The dynamics of institutional change in

Wales and North East England. Geoforum32:255–69.

———. 2001b. Devolution and the territorialpolitics of foreign direct investment. PoliticalGeography 20:353–79.

Malueg, D. A., and Schwartz, M. 1994. Parallelimports, demand dispersion, and internationalprice discrimination. Journal of InternationalEconomics 37:167–96.

Maskell, P. 2001. The firm in economic geog-raphy. Economic Geography 77:329–44.

Maskulka, J. M., and Gulas, C. S. 1987. The long-term dangers of gray-market sales. Business37:25–31.

Maskus, K. E. 2000. Parallel imports. The WorldEconomy 23:1269–84.

Maskus, K. E., and Chen, Y. M. 2004. Verticalprice control and parallel imports: Theory andevidence. Review of International Economics12:551–70.

McGregor, R. 2004. Coke explores the Chinesecountryside. Financial Times, 26 February, 13.

Mok, V.; Dai, X. D.; and Yeung, G. 2002. Aninternalization approach to joint ventures: Thecase of Coca-Cola in China. Asia PacificBusiness Review 9(1):39–58.

National Economic Research Associates (NERA).1999. The economic consequences of the choiceof regime in the area of trademarks. London:NERA.

Nolan, P. 1995. Joint ventures and economicreform in China: A case study of the Coca-Cola business system, with particular refer-ence to the Tianjin Coca-Cola Plant. WorkingPaper No. 24, December, ESRC Centre forBusiness Research, University of Cambridge,U.K.

Norcliffe, G. 1997. Popeism and Fordism:Examining the roots of mass production.Regional Studies 31:267–80.

North, D. 1990. Institutions, institutional changeand economic performance. Cambridge, U.K.:Cambridge University Press.

O’Neill, P. 2003. Where is the corporation in thegeographical world? Progress in HumanGeography 27:677–80.

Ó hUallacháin, B. 1997. Restructuring theAmerican semi-conductor industry: Verticalintegration of design houses and wafer fabri-cations. Annals of the Association of AmericanGeographers 87:217–37.

Ó hUallacháin, B., and Wasserman, D. 1999.Vertical integration in a lean supply chain:Brazilian automobile component parts.Economic Geography 75:21–42.

Palia, A. P., and Keown, C. F. 1991. Combatingparallel importing: Views of U.S. exporters to



the Asia-Pacific region. InternationalMarketing Review 8(1):47–56.

Palmeter, N. D. 1988. Gray market imports: Noblack and white answer. Journal of WorldTrade Law 22:89–92.

Peking University, Tsinghua University, andUniversity of South Carolina (PU-TU-USC).2000. Economic impact of the Coca-Colasystem on China, August. Available online:http://research.moore.sc.edu/research/studies/China

Phelps, N. A. 1992. External economies, agglom-eration and flexible accumulation. Transactionsof the Institute of British Geographers17:35–46.

Pietrykowski, B. 1995. Fordism at Ford: Spatialdecentralization and labor segmentation at theFord Motor Company, 1920–1950. EconomicGeography 71:383–401.

Rose, M., and Beck, E. 1999. Coke’s public-rela-tions trouble was worsened by gray trade. WallStreet Journal, 6 July, A12.

Scott, A. J. 1988a. New industrial spaces: Flexibleproduction, organisation and regional devel-opment in North America and WesternEurope. London: Pion.

———. 1988b. Metropolis: From the divisionof labor to urban form. Berkeley: Universityof California Press.

———. 1988c. Flexible production systems andregional development. International Reviewof Urban and Regional Research 12:171–85.

———. 1992. The Roepke lecture in economicgeography—The collective order of flexibleproduction agglomerations: Lessons for localeconomic development policy and strategicchoice. Economic Geography 68:219–33.

Simon, H. A. 1957. Models of man: Social andrational mathematical essays on rationalhuman behavior in social setting. New York:John Wiley and Sons.

———. 1982. Models of bounded rationality.Cambridge, Mass.: MIT Press.

Sparke, M.; Sidaway, J. D.; Bunnell, T.; andGrundy-Warr, C. 2004. Triangulating theborderless world: Geographies of power in theIndonesia-Malaysia-Singapore GrowthTriangle. Transactions of the Institute of BritishGeographers 298:485–98.

Stigler, G. J., and Sherwin, R. A. 1985. The extentof the market. Journal of Law and Economics28:555–85.

Storper, M., and Salais, R. 1997. Worlds ofproduction: The action frameworks of theeconomy . Cambridge, Mass.: HarvardUniversity Press.

Taylor, M., and Asheim, B. 2001. The concept offirm in economic geography. EconomicGeography 77:315–28.

Tesler, L. 1981. A theory of self-enforcing agree-ment. Journal of Business 53:27–44.

Wang, Y. 2004. Soft drink giant steps up salesgrowth efforts. China Daily, 13 December,10.

Williamson, O. E. 1975. Markets and hierarchies:Analysis and antitrust implication. New York:Free Press.

———. 1979. Transaction-cost economics: Thegovernance of contractual relations. Journal ofLaw and Economics 22:233–61.

———. 1985. The economic institutions of capi-talism: Firms, markets, relational contracting.New York: Free Press.

———. 1989. Transaction cost economics. InHandbook of industrial organization, ed. R.Schmalensee and R. Willig, 135–182.Amsterdam: North-Holland.

Yeung, G. 2001. Foreign investment and socio-economic development in China: The case ofDongguan. Basingstoke, U.K.: Palgrave.

Yeung, H. W.-c. 1994. Critical reviews ofgeographical perspectives on business organ-isations and the organisation of production:Towards a network approach. Progress inHuman Geography 18:460–90.

———. 1996. The historical geography of HongKong investments in the ASEAN region.Singapore Journal of Tropical Geography17:66–82.

———. 1997. Business networks and transna-tional corporations: A study of Hong Kongfirms in the ASEAN region. EconomicGeography 73:1–25.

———. 1998. Transnational corporations andbusiness networks: Hong Kong firms in theASEAN region. London: Routledge.

———. 2002. The limits to globalization theory:A geographic perspective on global economicchange. Economic Geography 78:285–305.

Yeung, H. W.-c., and Lin, G. C. S. 2003.Theorizing economic geographies of Asia.Economic Geography 79:107–28.


parallel trade & coca cola - national university of singapore

Documents