Customization and Returns
52 Pages Posted: 5 Sep 2019 Last revised: 11 May 2020
Date Written: May 8, 2020
Recent advances in information technology, advanced manufacturing (robotics, 3D printing, etc.) and logistics allow firms to customize their products to the specifications of individual consumers, who, of course like such products more than the standard ones. However, in an unlikely event that customized products do not match expectations, consumers often feel entitled to a return. This creates a non-obvious tension, as firms can salvage little value from customized products' returns.
We examine this tension via a Stackelberg game model in which the firm (leader) decides the prices and returns policies for its products (customized, standard, or both), and consumers (followers) decide which product to buy given the initial noisy valuations, and whether, upon experiencing the product, to return it or not. Both parties act strategically: forward-looking consumers incorporate the real option value of possible returns into their initial purchasing decisions, and the firm incorporates consumers' best purchase and return response into its pricing and returns policy decisions. Beyond this overarching principle, our model combines the approaches from both customization and returns bodies of literature, and possesses multiple realistic features: Hotelling-like heterogeneity in consumer preferences, uncertainty in ex-post valuations and the associated stochastic dominance for customized versus standard products, and increase in valuations from customization (“IKEA effect”), -- all in an elegant stylized model amenable to the analytical investigation.
Our main insight is two-fold. First, we show that the benefits from allowing customized products returns are smaller than for standard products, but the costs are bigger, and thus allowing returns of customized products is rarely profitable by itself. However, -- and most importantly, -- we also show that a firm that offers both standard and customized products could use customized products returns policy as a way to nudge consumers to self-select from buying standard products toward buying customized, and by doing so reduce returns. Since returns represent an enormous cost for manufacturers and retailers alike, this novel linkage between customization and returns provides insight to numerous firms across multiple industries, and has the potential to affect millions of consumers.
Keywords: customized products, consumer returns, Stackelberg game, IKEA effect, real option, strategic, forward-looking consumers
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