Price Markdowns to Induce Customers to Opt Out of Free Returns

Abstract

We study a newly emerging product return policy in the retail e-commerce industry. Alongside the conventional free return option, consumers (who face valuation uncertainty pre-purchase) are offered an additional return alternative called opt-out of free return (FO). If the free return option is chosen by consumers, they can return the purchased item over a predetermined grace period for a full refund. However, if consumers forego free return and self-select FO, the firm offers them a price markdown. If the consumers pick this option, they can still return the product during the grace period, but they will have to pay a fixed penalty and a variable penalty proportional to the product's purchase price. With consumers increasingly relying on online shopping, returns have become a considerable issue for e-retailers. This research is primarily motivated by practice where a major e-retailer (Jet.com, the new e-commerce operation of Walmart) has recently initiated implementing the FO policy for some categories of their products. We aim to derive managerial insights on when offering FO would be beneficial to firms, and if they offer it, how the firm can set the optimal markdown level. We formulate the problem as a stochastic optimization problem and analyze and characterize the structure of the optimal policy. We characterize the conditions that lead to the offering of the FO option alongside the free return option. (i) We find that the uncertainty level in the consumers' valuation distribution has a subtle impact on the profitability of providing the FO option alongside the free returns. While conventional wisdom suggests that offering the FO option is more likely to be beneficial as customers' uncertainty about the product's valuation pre-purchase increases, we show that the opposite could be true. Specifically, we show that if the product's expected valuation is large, higher uncertainty in the valuation distribution makes it more likely that offering FO alongside FR is advantageous to the firm. However, with low expected valuation, the lower the uncertainty in consumers' valuation distribution is, the more likely that the FO option is advantageous. (ii) We also examine how the profitability of the FO option is affected when the product's valuation (stochastically) decreases. We find that the salvage value of returns plays a crucial role in how the firm can benefit from offering the FO option as product's valuation decreases. Specifically, offering FO along with FR is more likely to be beneficial as consumers' valuation decreases if the salvage value of a returned product is sufficiently small. Our analysis reveals that offering FO alongside free returns can indeed have a significant positive impact on a retailer's profitability across various settings, demonstrating that the FO policy can be effectively used as a practical remedy in retail to partially recoup the revenue losses associated with returns.