Price Drop Protection Policy with Forward Looking Consumers

Abstract

Have you ever purchased an item only to notice a short while later that its price was reduced? Many retailers now offer to refund customers the full price difference as long as the price discount occurred within a specified short period of time after the original purchase (e.g. Amazon, Walmart, Neiman Marcus). Such price difference refund policy looks very attractive to consumers as it shields them from future price fluctuations. But can this policy be advantageous for the retailer who has to refund the money if prices drop? Despite the recent popularity of such policies, the existing research on the topic is scarce. In this paper we investigate the price difference refund policy (commonly referred to as price adjustment) and demonstrate how it can improve retailer's profits. We show that contrary to common belief, price adjustment can result in higher profits even if all consumers request and receive the refund.Further, the existing literature and practice both assume that if price adjustment policy is employed, the consumers should get the full price difference back. In this paper we consider a generalized price adjustment policy where we endogenize the refund amount, allowing the retailer to determine the optimal percentage of price difference to be returned to consumers. We fully characterize the conditions under which it is optimal to offer only a partial refund to customers as well as the optimal refund fraction. Additionally, we demonstrate that the practice of limiting the price adjustment option to a short period after the purchase is not necessarily in the best interest of retailers.