Price Markdowns to Induce Customers to Opt Out of Free Returns

With consumers increasingly relying on online shopping, returns have become a considerable issue in the retail e-commerce industry. Major e-retailers typically impose either "free returns" or "partial refund" policy. This paper studies a flexible return policy in which customers get to self-select return options. We consider a setting where, alongside the conventional free return (FR) option, consumers are offered an additional return alternative called opt-out of free return (FO). Choosing FR allows consumers to return items within a grace period for a full refund. Alternatively, selecting FO gives them a price markdown but involves paying a fixed and variable penalty if they choose to return the product. We aim to derive managerial insights on when offering FO would be beneficial to firms and, if so, how to set the optimal markdown level. 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 FR. 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 high (low), higher (lower) uncertainty in the valuation distribution makes it more likely that offering FO alongside FR is advantageous to the firm.