The effect of risk aversion on distribution channel contracts: Implications for return policies

Abstract

The return policy is often used in retailing supply chains. However, it is controversial in judging their practical value. In the literature, various theoretical and modeling explanations of why the return policy is used in practice and is preferred by the retailer and manufacturer have been put forth. The literature focusing on the channel agents’ risk attitudes to explain the adoption seems to have led to the conclusion that the two agents׳ preferences for adopting the full-return policy over the no-return policy are always in conflict, and thus the risk attitudes do not explain the adoption of return policy in practice. In this paper, we reinvestigate this issue. We first identify two distinct phases of risk averseness, high or low, for each of the two agents. We show distinct behaviors of how the wholesale price and order size are set in each phase. Then, we show that the full-return policy can be preferred over the no-return policy by both the agents if both of them are high risk averse. This implies that the agents’ risk attitudes can explain the adoption of return policy. This is a new theoretical result, which is contrary to the existing understanding in the literature. Our result highlights the importance and intricacy of channel policies especially when the risk attitudes of agents are considered.