Full Quantity or Full Credit? Choosing the Right Buyback Policy for A Loss-Averse Retailer

Abstract

This paper compares two forms of buyback policies commonly adopted in practice -- a traditional full-quantity partial-credit (FQ) buyback contract and an alternative full-credit partial-quantity (FC) contract. Standard theory based on profit maximization suggests that both policies can achieve channel-coordinating solutions when applied in a dyadic supplier-retailer setting. Consequently, neither policy should dominate the other by simultaneously offering higher expected profits for both parties. However, prior behavioral research in buyback contracts suggests that retailer's ordering decisions are often subject to behavioral biases. First, through a controlled lab experiment, we discover that the ordering decisions made by human retailers are significantly higher under the FC contract than under the FQ contract, although standard theory predicts no difference. This phenomenon is consistent with the behavioral tendency of loss aversion. Next, we study how the performances of the two contracts compare as a result of the retailer's loss-averse behavior. On the one hand, from a contract designer's perspective, it becomes feasible to design a channel-coordinating FC buyback contract that makes both players better off compared with a coordinating FQ contract. On the other hand, when the supplier has the authority to set contract terms, she should choose the FC policy to maximize her expected profit. However, in a situation where the wholesale price is exogenously given, the supplier should instead choose a traditional FQ contract for a loss-averse retailer. Our results can help inform both the contract designers and the supply managers on what types of buyback policies to use in different settings.