Pricing and Assortment Strategies with Product Exchanges

Lenient return policies enable consumers to return and/or exchange products they are unsatisfied with, which boosts sales. Unfortunately, they also increase retailer costs. We develop a search framework where consumers sequentially learn about products' true value and evaluate whether to keep, exchange or return them. Our formulation results in a tractable attraction demand model that can be used for optimization. We show that when pricing is not a decision, the assortment problem is NP-complete. When prices and assortment can be controlled, the optimization becomes tractable: product prices can either be set so that potential return costs are added to the product price, or reduced to ensure that customers choose to evaluate them after an exchange, or set so high so that the items are excluded from the assortment. Finally, we find that retailers prefer to pass all return costs to the consumers, but this measure decreases customer surplus and welfare.