Question

Let’s say that a clothing retailer currently offers a very strict return policy. Because it has to pay an average of $10 to clean and restock any returned items, it only gives back the price of the item minus $10 when you return it. A new CEO takes over and decides to change the policy to offer 100% of the price back for returned goods. She figured that only 1% of items were returned, so this should only add $.10 to the cost of each item. (a) Suppose that shoppers at the clothing store will either love or hate any given item of clothing, but they aren’t sure at the time they see it in the store. Instead, they have a probability of loving the item – 98%, 50%, 10%, etc. Then they decide whether to buy the item or not; if they buy it, they learn whether they love it or hate it; then they return the item if they hate it. Explain why, in the logic of adverse selection, the extra cost of $.10 per item from the policy change might be an underestimate: Why might more goods be returned than before? (b) Now suppose that shoppers don’t necessarily love or hate every piece, but some of them might end up somewhere in the middle. Explain why, in the logic of moral hazard, the more relaxed return policy might also lead to more returns even among the shoppers who would have have bought an item of clothing under the old strict return policy

Answer 1

First, we need to understand theoretically what the two terms mean and then use that understanding to decode the retail store and customer dynamics w.r.t. returns of items purchased. It is important to understand that both these terms are associated with problems arising out of asymmetric information between the parties engaged in a transaction in the market.

1) Adverse selection:  Simply put, adverse selection occurs when there is asymmetric information between a buyer and a seller prior to the contract is finalized/deal is struck, i.e. one of the parties (buyer or seller) has more accurate and different information than the other. As a result, it is obvious that the party with less information is at a disadvantage to the party with more information in their contractual arrangemet.

2) Moral hazard: Moral hazard, on the other hand, occurs when there is asymmetric information between the two parties and there is an observed change in the behavior of one party after a deal is struck. Simply put, when one of the parties (buyer or seller) decides to reveal incomplete or misleading information to the other party w.r.t. a deal/contract/transaction, motivated by the fact that they won't have to face any consequences for their actions then that party is said to be having a moral hazard problem.

In the example cited above, the retailer store is at the receiving end of lesser accurate information. The 1% return rate persisted when the store had the policy of accepting returns after deducting $10. The new proposed policy uses the 1% return result of the past policy to devise the new policy of refunding the entire amount to customers. There is a clear adverse selection problem here where the retail store had less information about actual customer behaviour w.r.t. returns, before they actually made the decision to start refunding the entire amount to the customers. It is because of the fact that the 1% return rate was an outcome of the contract the company had with its customers when there was a $10 deduction in refunds to customers. The customers, on the other hand, have more information about their actual behaviour w.r.t. returns which the retail firm is unaware of. Given the moral hazard problem (which I will discuss in the next paragraph), customers are likely to increase the returns given there are no costs to returns in the new policy. In that case, the anticipated cost to the retail firm could exceed more than the estimated $0.10 per unit. This asymmetry of information would in most likely hurt the firm's interests and thus, the extra cost of $.10 per item from the policy change might be an underestimate.

The customers, however, might change their behaviour in response to the new policy that assures full refund in events of return of items purchased from the retail store. Earlier, even if one did not like the purchased item there might have been a reluctance to return any item purchased given that the customer would have received $10 less on the purchase price. There was a monetary loss to one party (the customer) if it returned the item. Now, after this new contract where the firm assures 100% refund on the items returned, the customer might be tempted to return the product if it is not to one's liking. It is important to understand that the change in behaviour some customers might demonstrate, i.e. by returning more of purchased items, is a response after the contract was finalized (the rollout of the new policy of relaxed return with 100% refund). And since the customers who return the product do not bear any transactional loss in the process, they shall have an incentive to increase their returns which they would not have done in the older policy environment. This is the moral hazard that plagues some customers to increase the rate of returns.

Hope this helps.

Best of luck! :)