The Role of Returns Policies on Manufacturers Competition

Thierno Diallo Dpartement des sciences conomiques et administratives, Universit du Qubec Chicoutimi (UQAC) January 2008 (Preliminary draft. Please, do not quote)

Abstract We investigate an oligopoly to determine the strategic effects of manufacturers returns policies on market competition. Each competing manufacturer produces and distributes a product through retailers in competition. The demand function is subject to random shocks. Manufacturers observe these shocks only after choosing simultaneously wholesale prices and returns policies. For each manufacturer, we derive the optimal wholesale and buy-back prices. In a comparative static analysis, we determine how prices (wholesale, retail, and buy-back), inventories, and welfare change with respect to returns policies. We show that returns policies decrease manufacturers profitability by increasing price competition.

1.

Introduction

Returns policies are commitment by sellers to take back excess inventories or unsatisfactory products from buyers. The format of returns policies varies across industries and across stages of the distribution channel. In upstream distribution channel the returns option is offered by the manufacturer (manufacturers returns policy), while in downstream distribution channel the returns option is offered by the retailer (retailers returns policy). Under returns policies, unsold goods are accepted for full or partial refunds of their purchase price. Most generous policies promise to refund all returned products with full wholesale price, while less generous policies offer credits against future orders.

What explains the returns policies adopted by the retailers is the fact that costumers are often uncertain about their valuation for a product at the time of purchase. Therefore to induce them to purchase, most retailers guarantee satisfaction of their products and offer an option to return in case consumers are not satisfied1.

Manufacturers allow returns by retailers because they face a problem of inducing retailers to optimally stock their products when these are subject to unpredictable demand. E.g. if products have one of the following characteristics: uncertain demand, finite selling season or finite lifetime, retail overstock is possible. Thus retailers may stock less of products than manufacturers would like. Therefore to coordinate the distribution channel, the manufacturers can offer to retailers a return option for their unsold products. These characteristics are present in a wide category of product market. The markets where returns policies are most prevalent are markets for books, newspapers, CDs, perishable goods, computer hardware and software, and pharmaceuticals.
There are many works on that subject. The important contributions are : Che (1996), who argues that the rationale of retailer returns policies is to help consumers to learn about their uncertain utility levels and he showed that a return policy cannot be optimal unless either consumers are sufficiently risk-averse or retail costs are sufficiently high, with the effect on welfare being ambiguous. Mixon (1999) provides an extension of the previous theoretical work of Che (1996) by way of empirical test regarding seller-provided information on return policies in advertising for search and experience goods. Davis et al. (1998) construct a model to identify potential causes for variation among retailers return policies.
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In this literature review, we look more specifically at the role of manufacturers returns policy. What does literature say about reasons for manufacturers returns policy? The details follow bellow.

2.

Manufacturers Returns Policy

In the literature of manufacturer returns policies two approaches have been used to model a distribution channel facing uncertain demand. The first approach use the classical newsboy or newsvendor problem2 under uncertain demand and derive the retailers optimal order product and the retail price before the resolution of the demand and salvages any overstock at some value less than the procurement cost. The second approach is the one of Padmanabhan and Png (1997), which uses a linear demand with random shift parameter. Here the demand is observed before the retailer sets the equilibrium price. We will review this latter methodology later in this paper.

There are many studies into the reasons why and when manufacturers should offer to accept unsold products from retailers instead of outright sales. The principal reasons given are related to three broad categories of objectives. The first objective is related to information issue, i.e. risk sharing, asymmetric and elicit information between manufacturers and retailers. The second objective is the alignments of incentives between manufacturers and retailers. These alignments of incentives are characterizing by an inventories and non inventories issue, i.e. returns policy are offered by manufacturers to ensure adequate inventories of their products in the inventories issue or to provide better representation in the non inventories issue. Finally, the third objective is the use of returns policies as a strategic device to induce retailers to compete more aggressively.

The newsboy or newsvendor problem, a stochastic inventory replenishment problem can be describe as follow: given a known stochastic distribution for the demand of a product, what is the optimal order quantity if only one order can be placed before actual demand is observed. This is a problem a newspaper vendor faces: how many newspaper to buy before the actual number of buyers is known.

Information Issue
Risk sharing

The difference of attitude toward risk may exist between manufacturers and retailers. The risk arises because it is necessary to make partially irreversible investment prior to demand realization: production and distribution costs for the manufacturer, the inventory carrying cost for the retailer. Depending on the risk aversion of each side, the return policy will be offered fully, partially or not at all. When both sides are risk averse, the optimal risk sharing contract must allocate risk to both sides. High risk tolerance of the manufacturer induces him to bear higher proportion of risk under the return policy by offering higher buyback price. The opposite is true for the risk tolerance of the retailerthe higher it is, the lower should be the buyback price set by the manufacturer.

Asymmetric information

Examples of potential asymmetric information between manufacturers and retailers can be found in the market for newly introduced products, which are usually sold on consignment. Indeed before introducing a new product, every manufacturer conducts market tests to forecast sales. The forecasting should be optimistic for the manufacturer before taking the risk of introducing the product. However, if the retailer is not integrated to the manufacturer, he does not have access to the manufacturers data. Given the low success rate of new products, we can say that the manufacturers are inevitably more optimistic about their product than retailers. Therefore the returns policies can serve as a warranty for retailers and induce them to order more of the manufacturers products. As noted by Kandel (1996), This situation apply well to the industry of book publishing, where every new title is a new product and where the understandable optimism of the author and the editor is frequently not shared by bookstores.

Elicit Information

Another objective of returns policy is to better exploit the retailers private information regarding the demand. This role is analyzed by Arya and Mittendorf (2002). They showed that the manufacturer can use returns policy to elicit retailer information. They study a distribution channel in which the retailer is privately informed about the retail market conditions. To obtain more favorable price from the manufacturer, the retailer is inclined to underreport his assessment of market condition. Anticipating this behavior, the manufacturer responds by tailoring returns term to the retailers report. In particular, by offering high return allowances (instead of low prices) for unfavorable market report, the manufacturer dissuades the retailer from understating market conditions. Besides altering retailer reporting, returns policy can induce retailer behavior that conveys information to consumers. By limiting the retailers downside risk, generous returns policy can encourage retailers to focus product promotion to the high valuable consumers or dissuade them from offering product on clearance. [IS THIS STILL THE SAME ARGUMENT] These activities may boost consumer perception on manufactures product quality.

Alignement of Incentives
Non Inventories Related

The non inventories related are the incentives for product quality, service and promotion. Indeed consumers demand can be affected by actions taken by either retailers or manufacturers. The manufacturer can affect consumer demand by their choice of product quality, retailers can achieve the same purpose by provision of service, and both parties can promote the product let say by ads. These interventions are achieved optimally in the vertically integrated firm. When the two levels of a distribution channel are separately owned, the contract between them affects the incentives to increase the consumer demand. [THIS ALSO APPLIES TO ISSUE OF INVENTORIES] There is a double moral hazard problem: if the manufacturer supports all the risk, the retailer has less

incentive to provide better service or promotion. This is the case in the consignment contract. If the retailer has no return options for unsold products, the manufacturer has less incentive to provide high quality or to advertise the product. [WHY] Therefore the benefit from trade is not fully obtained in both cases. The provision of partial return options is clear: the two levels of the distribution channel must bear the risk for the provision of high product quality, high service and good promotion.

Inventories Related

This is the most popular objective of returns policy. Here, manufacturers want retailers to optimally stock their products or ensure adequate inventories of their products under uncertain demands. However, Marvel and Peck (1995) showed that not all demand uncertainty matters. Indeed they show that manufacturers decision to accept returns depend crucially on the nature of the demand uncertainty. Uncertainty over the valuation consumers will place on a manufacturers product leads the manufacturer to avoid returns in favor of outright sales, while uncertainty over the number of customers who arrive at the retailer favors returns systems. [EXPLAIN THE DIFFERENCE IN TYPES OF UNCERTAINTY] In other words manufacturers offer returns policies if uncertainty enters simply as a random arrival process for customers, where it is quantity uncertainty, not uncertainty over valuation that matters. For quantity uncertainty the manufacturer is able to extract the entire retailers surplus buy choosing a wholesale price equal to consumers valuation and ensuring that the optimal inventory is held by paying for unsold goods by accepting full returns. On the other hand, for valuation uncertainty, a returns policy eliminates the cost to retailer to stock excessively. [EXPLAIN WHY THERE IS A DIFFRENCE IN THE EFFECT OF RETURNS POLICIES]. Thus the returns options provided by manufacturers can be exploited by the retailers to push retail prices above the manufacturers desired level. In other words the returns policies distort pricing without offsetting inventory effects, and are therefore not employed when there is uncertainty only over the consumers valuation. For the general case where both uncertainties are present, they show that the manufacturer must offer to reimburse partially unsold products. The manufacturer must balance the effect of reducing the level

of reimbursement since that reduces the quantity ordered from the manufacturers desired level.

Kandel (1996) and Marvel and Wang (2000) take account an additional factor which affect the decision of the manufacturers to offer returns policies for inducing retailers to optimally stock their products. Kandel (1996) showed that the difference in opportunities for the disposal of unsold products, i.e. the different scrap values of unsold products is an important factor, while Marvel and Wang (2000) demonstrated that returns policies can be used to achieve optimal price dispersion, i.e. to provide better representation of the product in all state of consumers demand.

Different scrap values

In the vertically integrated firm, the unsold product is placed at the disposal of the party which obtains its highest scrap value. [EXPLAIN] Thus when the two levels of the distribution channel are separately owned, the choice of the disposal of the overstock is important for determining the nature of the contract between the manufacturer and the retailer. Examples of products with similar characteristics of demand uncertainty yet different in terms of their scrap values: milk, flowers and apparel. There is not much supermarket can do with unsold milk. However, the manufacturer of milk can use it to make ice cream or other dairy products. This explains the prevalence of returns policies or consignment contracts in milk distribution. Collecting and reprocessing unsold flowers is not economical; selling them at a discount at the same store offers a better scrap value. Thus return options are not widely observe in flower distribution contract. Unsold apparel, especially fashion items, can be discounted as well, rather than being sent back to manufacturers, which involves lost time, damage, and high transportation costs. The scrap value at the store is higher than at the manufacturers location indicating why return options is not so much offer in these type industries.

Optimal price dispersion

Marvel and Wang (2002) proposed a model that shows that returns policies can be used to achieve optimal price dispersion if the manufacturer does not know the distribution of the demand uncertainty. They found that only retailers need to have knowledge about demand uncertainty for returns policies to induce optimal inventory holding from the manufacturers desired level without requiring the manufacturer to have the same level of information. The result of imposing returns policy in this setting is price dispersion. This explains why manufacturers prefer to control inventories through returns policies as opposed to price maintenance which require more information on market conditions for the manufacturer. [WHAT DOES THIS PAPER DO THAT PREVIOUS PAPER DID NOT DO] These results are proved for a monopolist manufacturer and for two differentiated but competing manufacturers selling to consumers through competitive retailers. First, they show that if the marginal production cost is zero, the manufacturers unique optimal strategy is to accept full returns and retailers choose a retail price equal to the wholesale price. The optimality of full returns is easy to understand when marginal production cost is zero. Since the product can be offered at no cost, the manufacturer wants to induce the retailer to order an inventory as high as possible in order to satisfy all orders. Also the manufacturer wants to charge consumers the optimal retail prices. To achieve both objectives, a policy offering full credit for returns is necessary. Second, with constant marginal cost of production and linear demand, the manufacturer splits the production cost of unsold inventory equally with retailers. Consequently only partial refund is offered. They also found the presence of the upstream competitor does influence the manufacturers buy-back price. Precisely they found that the returns allowances are less generous with the oligopoly than the monopoly.

Strategic
Pasternack (1985) examines how a manufacturer can use returns policies to induce multiple retailers to carry the optimal level of stocks. He shows first that the two extremes cases of returns policies which are full return for all unsold products and no

returns of unsold products are suboptimal. He proved that full credit, i.e. buy-back price equal wholesale price for partial returns achieves channel coordination even if the optimal buy-back price will be function of retailer demand. [WHY] This implies that in a multi-retailers environment this policy is also suboptimal. His main result is to prove in a single-period setting with the manufacturer as a channel leader, i.e. the returns policy is decided by the manufacturer, that a designed policy allowing complete returns at price less than the wholesale price, i.e. offering partial credit for all unsold products can coordinate the channel to the benefit of both sides of the industry in a multi-retailers environment. Donohue (2000) extends this latter result for a two period-model. Pellegrini (1986) shows that by providing a returns policy, a manufacturer can encourage retailers to carry larger stocks and thereby improve sales of its brand relative to competing products.

Intensify competition at retail market

Padmanabhan and Png (1997) point out that insurance does not seem a plausible explanation for returns schemes. Manufacturers who accept returns are often much smaller and less diversified than the retailers who ship them unsold goods. They give the following examples: in books, Ten Speed Press (revenues of $ 2 million) accepts returns from Barnes and Noble (revenues of $ 1087 million); in record music, Windham Hill (revenues of $25 million) accepts returns from Wherehouse Entertainments (revenues of $457 million); in clothing apparel, Aris Isotoner (revenues of $6449 million) accepts returns from Macys (revenues of $6163 million). They propose another explanation for returns policies. They first consider the benchmark where there is a single retailer and a single manufacturer and show that a returns policy makes no difference in that case. Then they consider the case of a single manufacturer and two competing retailers. They show that returns policies can be used strategically to increase the level of competition between retailers and consequently the profits of the manufacturer. [EXPLAIN INITUTIVELY WHY] They developed a framework that explains when and how a manufacturer should adopt returns policies and analyzed the costs and benefits of returns policies. They found that when retailing is competitive and there is no uncertainty in demand, a return policy

induces retailer to compete more intensively. Thus the provision of a return option reduces retail prices without affecting the manufacturers prices, thereby enhancing its profits. When however, demand is uncertain and retailing is a monopoly, they show that a returns policy encourages the retailer to overstock and so decrease the manufacturer profits. When both markets characteristics are present, i.e. competing retailers and demand is uncertain, there is a trade-off for the manufacturer between the benefits provided by more intense retail competition and the costs of excessive stocking due to the return options.

However Wang (2004) show that if retailers face stock constraints, returns policies do not change manufacturer profitability when demand is certain and retailing competitive. The reason is that Padmanabhan and Png (1997) unreasonably assume that the retailers would never face stock constraints, thus change the retail competition from a Cournot-like competition to a Bertrand competition.

Recently Padmanabhan and Png (2004) show that when there is end-user demand uncertainty and retailing competitive, returns policies do increase manufacturer profitability if the marginal cost of production is sufficiently low and demand parameters satisfy particular conditions by attenuating retailer price competition when demand is low and intensifying competition when demand is high. Indeed by accepting returns, the buyback price will serve as a floor to the retail price when demand is low. Therefore in case of low demand this price floor attenuates price competition and thus raises the retailers profits. Manufacturer can consequently charge a higher wholesale price. But when demand is high, the returns policy induces more intense price competition because by providing a returns policy the manufacturer eliminate the retailers cost of excess inventory and through its impact on retail competition, the returns policy encourages retailers to order larger stocks. [IT IS IMPORTANT TO GIVE THE SEQUENCE OF EVENTS IN THE GAME] Thus when offering a returns policy, the manufacturer must balance between the cost of products returned in the even that demand is low (disadvantage) to the possible higher wholesale price when demand is low and the increase of the stock when demand is high (advantage). Given that the production cost is

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sufficiently low and the high demand is not too much larger than the low demand, the advantages are greater than the disadvantage when the manufacturer offers a returns policy. From the manufacturers standpoint, since its profitability conditions are weaker when retailing is a duopoly than when retailing is a monopoly they conclude that returns policies serve not only to resolve or reduce demand uncertainty but also to manage competition and mitigate demand uncertainty by showing that manufacturers profitability conditions are weaker when retailing is a duopoly than when retailing is a monopoly.

To sum up note that the options to return unsold products are relevant only when there is a significant degree of uncertainty about retail demand, products are identifiable and the marginal cost of production is a relative small portion of retail price (low marginal cost).

Now, we turn to another popular method the manufacturers use in order to support adequate inventory holdings by the retailers. This method refers to resale price maintenance (RPM). Since both marketing strategies can help to achieve adequate inventories holdings, which reasons guide the manufacturers choice between them? We define first resale price maintenance (RPM), and then we compare it to returns policies.

3.

Returns Policy Vs Resale Price Maintenance

Resale price maintenance (RPM) is the specification of the final price imposed by a manufacturer on wholesale or retail resellers of its own products. Types of this restriction include specifying only a price ceiling, i.e. maximum resale price stipulation, or price floor, i.e. minimum resale price stipulation.

Different theories have been developed to explain the use of RPM by manufacturers. The usual justifications are: eliminating double mark-up problems, preventing free riding, preventing discounting, and collusive effects. One line of justifications is the free riding theories. These theories assume that the demand for a manufacturers product depends on some informational services provided by the retailers. RPM assures the retailers to

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capture the demand generated by the services and thus provides incentive for them to invest in those services. RPM then improves social efficiency by enhancing demand. However, for the products that do not need extensive sale services, Deneckere, Marvel and Peck (1996, 1997) showed that the use of RPM or more precisely the use of minimum resale price stipulation by a manufacturer facing uncertain demand can help like returns policies to support adequate inventory holdings by the retailers. They analyzed a model with a monopoly manufacturer selling to competitive retailers in market where demand is uncertain. They find that with RPM, the monopoly manufacturer has higher wholesale demand and makes more profits.

We have already mentioned that when the marginal product cost is positive full returns policy is merely a second best way of achieving minimum resale price stipulation (RPM). It does not achieve the manufacturers first-best. Nevertheless, there is wide category of industrial products where a returns policy instead of minimum resale price stipulation is offered (books, newspapers, CDs, perishable goods, computer hardware and software, and pharmaceuticals). [WHY]

First, the use of RPM in many countries has not always been allowed since they restrict free trade. It is prohibited per se with possible exemptions. [WHERE] Whereas, the returns policies is always allowed when they are offered without any form of discrimination.

Second the problems of enforcement, the allocation of risk between the parties, and the economic incentives under the two alternative vertical agreements are different. For example under RPM, to enforce the contract the manufacturer must monitor the actual details of transaction that the parties involved might wish to hide. While under returns policy, the physical return of the good or proof of goods destruction is enough to enforce, even if they are some possibilities of retailers moral hazard or high cost of administrating the system of returns. On these facts, minimum resale price stipulation (RPM) actually seems more costly than returns policy for the manufacturer to administer and to enforce.

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As noted by Faith and Nairu (2000), besides the enforcement, full and partial returns and RPM also differ in how they divide risk between manufacturers and retailers and in how they structure economic incentives. They showed that under a full return system manufacturer bears all the risk and the retailer none. A partial return system divides the risk between the manufacturer and the retailer. [DID THEY HAVE TO SHOW THIS]

The economic incentives reason is to better exploit the manufacturers private information regarding the demand. This reason is explained by Faith and Nairu (2000). They demonstrated that only the one that bear the risk of unsold goods has an economic incentive to collect private information about demand and act appropriately. If the manufacturers information regarding the likely future demand is superior to the retailers, then a full return system is indicated, but if retailers information is superior then minimum retail price stipulation might be indicated.

To sum, the advantages of returns policy over resale price maintenance (RPM) are first the legality of returns policy and second the less information required in returns policy to achieve the quasi same purposes.

4.

Our Contribution to The Literature on Returns Policy

To our knowledge, the literature on manufacturers returns policies, except the one of Marvel and Wang (2002), considers a monopolist manufacturer which offers returns policies in their analysis. However, Marvel and Wang (2002) have looked for the strategic effects of returns policies on the retail market. We know that relative to monopolists, oligopolists have additional strategic incentives to use selling strategies like advertising, most- favored customer clauses or raincheck [Cooper (1996), Salop (1986), Hamilton (2000)]. [EXPLAIN WHY] These selling strategies are instruments for each firm for being more competitive. Since returns policies also have this latter characteristic, we investigate a duopoly market structure for determining the strategic effects of returns policies on manufacturers competition. We consider two competing manufacturers each

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producing and distributing a product through a single retailer. Demand will be taken to be a stochastic linear function of price and affected by the degree of product differentiation. [EXPLAIN] We assume that each manufacturer sets his quantity and its returns policy strategy to maximize its profit subject to the response of the competing manufacturer and the retailer. We derive for each manufacturer the optimal return option and obtain the industry equilibrium. Then we analyze this equilibrium to see how prices (wholesale, retail, and buy-back), inventories, and welfare evolved.

We follow the framework of Padmanabhan and Png (2004) [WHY] to develop and analyze this model of price competition with manufacturers returns policies. In this model, the manufacturers have identical cost functions and they produce differentiated products. To allow a role for manufacturers returns policies, we introduce exogenous uncertainty about consumers demand.

Four types of price subgames can result in this setting: The first type of subgame (N, N), results when no manufacturer offers a return policy on their products. The second subgame (R, R) results when both manufacturers offer a return policy on their products. The third and fourth type of sub-game (R, N) or (N, R), result when one manufacturer offers a return policy and the other do not.

The rest of the paper is organized as follow: we present a benchmark model with monopolist retailer in section 2. We present the model with oligopolistic manufacturer with differentiated products and provide some results in section 4. Section 5 presents results to describe when firms choose to offer returns policies. Section 6 contains some conclusion and discusses the welfare effect of manufacturers return policies.

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4.1 Monopolist manufacturer and perfectly competitive retailers

We consider a market structure with a monopolist manufacturer and perfectly competitive retailers. We assume that the demand function is subject to random shocks. This introduces the possibility of desiring to overstock products by the retailers. The Manufacturer observes these shocks only after choosing wholesale price and returns policies. The information structure and sequence of actions will be as follows. First the state of the demand which could be high or low ( = H or L respectively ) is
uncertain for all parties. The probability of being high is . In the first stage the manufacturer sets a distribution policy comprising a wholesale price w and whether to accept returns.

In the second stage, the retailers order stock s to the manufacturer. We assume that the true state of the demand is reveled to all parties after the second stage. Then in the third stage the retailers set the price p in state . The direct demand function is given by:
q = p , with > 0

4.1.1 No Returns Policies of the manufacturer (N R)

In this case, the manufacturer sets a wholesale price w and does not accept returns of unsold products. Since retailers are in perfect competition, they price such that they have zero profit. For constant average and marginal production costs, this yields the unique equilibrium price equals marginal cost (Bertrand equilibrium). Here the marginal cost is the wholesale price, if we assume that retail costs are negligible. Formally, we have:
w = p H + (1 ) p L (1)

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Two cases arise with no returns (graphic 1). Case 1: the retailers can order a stock greater than L ( s L ) Case 2: the retailers can order a stock smaller that L ( s < L )

If s L , then p L = 0 . Therefore, by (1) w1 = p H = (

H s1 ) . This implies that:

(2)

s1 = H

w1

If s < L , then p L 0 . Therefore by (1)

w2 = p H + (1 ) p L = (

H s2 s2 ) + (1 )( L ) . This implies that:

(3)

s 2 = H + (1 ) L w2

In each case, the manufacturer sets its price w to maximize its profits:

M = ( w c) s ( w) .
The first order condition with respect to the wholesale price yields:
d M = s ( w) + ( w c) s ( w) = 0 dw In case 1, w1 satisfies s ( w1 ) + ( w1 c) s ( w1 ) = 0 . This implies that:

H
Therefore
w1NR = s1NR =

w1 ( w1 c) = 0

H c + 2 2

(4) (5) (6)

H
2

c 2

1M ( NR ) =

( H c) 2 4

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In case 2, w2 satisfies s ( w2 ) + ( w2 c) s ( w2 ) = 0 . This implies that:

H (1 ) L w2 ( w2 c) = 0
Therefore
NR w2 =

H + (1 ) L + c 2 H + (1 ) L
2

(7) (8) (9)

NR s2 =

c
2

2M ( NR ) =

H + (1 ) L ( c) 2 4

M Note that when H = L , i.e. = 1 (no uncertainty) we have 1M = 2

2 pH

p1 H

w
2 pL

s2

s1

Graphic (1): no returns accepted by the manufacturer (NR)

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4.1.2 Returns Policies of the manufacturer (R)

Here the manufacturer sets its wholesale price w and gives to retailers a refund r (the buy back price), with 0 < r w , for its unsold products. Also the perfect competitive retailers price such that price equal marginal cost. Two cases arise with returns policies (grahpic 2).
Case 1: the retailers can order a stock greater than s ( s s )
Case 2: the retailers can order a stock smaller that s ( s < s )
Where s is defined as the stock level such that p L = r , i.e. such that the retailers are

indifferent between selling the product when demand is low at price p L and to return it to manufacturer to obtain r .

If s s , then r p L . Therefore, by (1) w1 = p H + (1 )r = ( This implies that:

H s1 ) + (1 )r .

s1 =

H + (1 )r w

(10)

If s < s , then r < p L . Therefore by (1)

w2 = p H + (1 ) p L = (

H s2 s2 ) + (1 )( L )

(11)

In each case, the manufacturer sets its price w to maximize its profits:

M = ( w c) s ( w) (1 )rz (r , w)

(12)

The first orders conditions with respect to the wholesale price and buy back price yield:

d M ds z = s ( w) + ( w c) (1 )r =0 dw dw w

(13)

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d M ds z = ( w c) (1 ) z (1 )r =0 dr dr r

(14)

In case 1, z (r , w1 ) 0 and w1 satisfies s ( w1 ) + ( w1 c) implies that:

ds1 z s1 (1 )r = 0 . This dw1 s1 w1

w1 =
r* =

H c + (1 )r + 2 2
(15)

L (3 1)
1 . 3

Note that the buy back price is defined for >

Consequently we have:

w1R =

h (1 ) L c + + 2 (3 1) 2
2 (1 ) L ( H c) 2 + (2 1) 4 (3 1) 2

(16)

1M ( R ) =

(17)

In case 2, z (r , w2 ) = 0 and p L 0 . This is similar to the problem of case 2 in the no returns policies in part 1. Therefore we deduce immediately that:
R NR w 2 = w2 =

H + (1 ) L + c 2
2

(18)

R NR s2 = s2 =

H + (1 ) L

c
2

(19) (20)

2M ( R ) = 2M ( NR ) =

H + (1 ) L ( c) 2 4

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2 pH

p1 H

w
p
2 L

s2

s1

Graphic (2): returns accepted by the manufacturer (R)

4.1.3 Analysis and comparison of returns policies v. no returns policies

To compare the profitability of returns policies to no returns policies for the manufacturer, we must compare its profits under each retailersstock ordering possibility. The possibilities are: (a) (b) (c)

L s
s s < L

0<s<s

For L s , the manufacturers profits with returns policies are greater than those with no returns options if:
2 (1 ) L 2 ( R) = ( H c) + (2 1) > 1M ( NR ) = ( H c) 2 2 4 4 (3 1) M 1

This inequality is true for >

1 . 2

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 For s s < L , the manufacturers profits with returns policies are greater than those with no returns options if:
2 (1 ) L 1 M L c) 2 ( H c) 2 + (2 1) > 2 ( NR ) = ( H + 2 4 4 (3 1)

1M ( R) =

This inequality is true for >

1 . 2

For 0 < s < s , the manufacturers profits are equals under both regimes of returns options.

2M ( R ) = 2M ( NR )
In summary, we derive lemma 1.

Lemma 1: The manufacturers profits with returns policies are greater than those with
no returns options.

4.2 Oligopolist manufacturers and perfectly competitive retailers

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Mostard, J, and Teunter, R (2002), The Newsboy Problem with Resalable Returns, Working Paper, Erasmus University Padmanabhan, V., and I.P.L. Png (2004), Do returns Policies Intensify Retail Competition? Working Paper INSEAD

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