The Impact of Consumer Loss Aversion on Returns Policies and Supply Chain Coordination

The Impact of Consumer Loss Aversion on Returns Policies and Supply Chain Coordination

Gulay Samatli-Pac, Wenjing Shen, Xinxin Hu
DOI: 10.4018/IJORIS.2018100101
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Product return is a common after-sale service. Existing literature has assumed loss neutral consumers, while in practice consumers are often more sensitive to utility losses than gains, i.e., customers are often loss averse. In this paper, we study the impact of such loss aversion on the retailer's optimal pricing and returns policies. We analyze three scenarios where the seller offers no refund, full refund and partial refund for the returned products. Under each scenario, the seller determines the optimal price, quantity, and refund amount (under partial refund case) in order to maximize the expected profit. Our results demonstrate that consumer loss aversion leads a no-refund retailer to charge lower price and order smaller quantity, has no impact on a full-refund retailer, and results in a more lenient returns policy for a partial-refund retailer. We also find contracts that coordinate supply chains selling to loss averse consumers. Therefore, this article sheds some lights on how the management of returns policies should be adapted when consumers are loss averse.
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1. Introduction

Many products, such as apparel, kitchen appliances, game controllers, and DVD players, are often referred to as “experience goods” (Che, 1996), since consumers need to “experience” them to determine the degree of satisfaction with the products. For example, a customer may hesitate before buying a dress or a PC game since she is unsure if the dress will match her existing wardrobe or whether she will enjoy the PC game. She may be particularly uncertain when buying online, because she is unable to know for sure the product attributes such as size, color, or material from product description. The exact value of the product, therefore, is not known to this consumer before purchase, even if the product has no quality problem. Valuation uncertainty decreases customers’ willingness of purchase. In order to reduce product fit uncertainty, improve customer satisfaction and boost sales, retailers offer a number of after-sale services. One such service is to accept the return of the products after sales have taken place, if they do not meet customers’ expectations. Indeed, customer returns policies are pervasive in today’s retail business environment. The value of goods returned by buyers in the U.S. during 2009 exceeded $180 billion, about 8% of total sales (NRF, 2009). Most returns are due to mismatch between buyers’ expectations and actual experiences. It is contended that between 11% and 20% of all the electronic items purchased are returned, though only about 5% of them are truly defective (NRF, 2009). Various types of returns policies have been implemented in practice. For instance, policies such as exchange only, all sales final, store credit, money back guarantee, and restocking fees, are all commonly adopted by retailers. These returns policies vary greatly with respect to the length of return window, the format of refund, and most notably, the amount of refund. The most generous ones, such as money back guarantee, allow customers to return a product and receive 100% of the price paid. This type of full-refund policies completely eliminates customers’ risk of product misfit. The retailer, however, not only loses the potential revenue from the returned products, but also may incur additional shipping and handling costs. Some retailers offer a more stringent returns policy by charging a “restocking fee” to cover processing and other related costs, i.e. only partially refunding customers the purchase price. In this case, the customers and the retailer share the product misfit risk as both may incur some losses when the products are returned. And finally, though not very popular, it is still observed that some retailers adopt the extreme policy of not allowing any return.

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