The impacts of money-back guarantees in the presence of parallel importation

Highlights

• We study the impacts of returns policies in the presence of parallel importation.

• The parallel importer is either a third-party agent or an authorized retailer.

• The net salvage value always matters in formulating firms’ returns strategies.

• The identity of the parallel importer is another crucial factor.

• Firms’ returns strategies may induce Pareto improvements in the equilibrium.

Abstract

This paper studies the impacts of money-back guarantees (MBGs) in the presence of parallel importation, where a manufacturer sells a product facing customer fit uncertainties in two markets and a parallel importer diverts unauthorized products from the low-price market to the high-price one. The two firms compete in both pricing and MBG strategies. We consider two types of parallel importers, a third-party agent and an authorized retailer in the low-price market, respectively. By applying the certainty equivalent pricing approach, we show that offering MBGs only changes firms’ marginal costs without affecting customers’ purchasing decisions directly. When the net salvage values of returned products are positive in the high-price market, both the manufacturer and the third-party agent offer MBGs. Whenever the manufacturer offers an MBG in the low-price market, there is a price inflation effect that counters parallel importation. Therefore the manufacturer may offer the MBG even if the net salvage value is negative. When the authorized retailer decides refund policies in two markets, the MBG strategy in one market changes the retailer’s profit from the authorized channel and that from the gray market in opposite directions, and has an interaction with the refund policy in another market. No refund may be preferred in either market even if the net salvage value is positive. We find that the manufacturer’s MBG strategy in the high-price market always deters parallel importation while other MBG strategies may achieve Pareto improvements in the equilibrium.

Introduction

Parallel importation or gray market is known as unauthorized channels which divert genuinely branded products from a market or channel with low prices (the low-price market) to another market or channel with higher prices (the high-price market). Gray markets can be found in various industries including consumer electronics, pharmaceuticals, automobile, luxury and so on. The emergence of gray markets leads to profit margin loss, brand image erosion, customer loyalty decline and so on. A survey by Deloitte in 2009 shows that US manufacturers’ sales are undercut by as much as $63 billion a year due to parallel importation (Bloomberg, 2009). Field (2010) suggests that companies on average may lose about 4.5% of their total profit due to parallel importation. With the rapid development of e-commerce and online trade platforms, international companies operating in geographically separate markets are facing even more severe challenges from gray markets (Swanson, 2014, Zhang, Feng, 2017).

Previous studies on parallel importation implicitly assume that customers have full information regarding whether the product fits their needs (Ahmadi, Yang, 2000, Iravani, Dasu, Ahmadi, 2016, Xiao, Palekar, Liu, 2011). However, rapid innovation and technological advancements are rendering more and more products increasingly complex and difficult to evaluate before purchase, e.g., smartphones. Because whether the product is satisfactory can only be revealed post-purchase, customers may hesitate to make a purchase. To mitigate the negative effects of fit uncertainties, many branded companies have adopted money-back guarantees (MBGs) to better serve their customers. As to gray market products, the risk of fit uncertainties seems to be unsecured as unauthorized products are generally not covered by branded companies’ returns policies. Thus, parallel importers have to compete with the authorized channels in MBG strategies as well as pricing strategies. For example, Apple offers an MBG only for the iPhones sold through its authorized channels, while almost all parallel importers on Taobao.com (the largest online marketplace for gray market sales in China) offer MBGs for gray market iPhones. As another example, Omega only allows returns for orders made through its authorized networks, while famous gray marketers, including AuthenticWatches, Jomashop, and Costco, offer MBGs for gray market watches. Clearly, MBGs offered by parallel importers help promote the sales of gray market products by relieving customers’ concerns about fit uncertainties in their transaction. This motivates us to study the impacts of MBGs in the presence of parallel importation.

The literature on MBG strategies mainly examines single-market settings (Davis, Gerstner, Hagerty, 1995, McWilliams, 2012, Yang, Chen, Chen, Chen, 2017). The common finding is that it is advantageous to offer an MBG if and only if the net salvage value of a returned product is positive. In the context of parallel importation, there are two marketplaces. One is the low-price market, where the manufacturer sells authorized products to both customers and parallel importers; another is the high-price market, where parallel importers compete with the manufacturer by reselling gray market products. In this paper, we examine: (1) Is it still beneficial for a firm to offer an MBG if and only if the net salvage value of a returned product is positive in the presence of parallel importation? (2) If not, what are other factors that drive firms’ MBG strategies? For example, should the manufacturer make use of MBGs to restrict gray market activities even if the net salvage value is negative? (3) Could their MBG strategies in equilibrium achieve Pareto improvements?

In practice, both third-party agents and authorized retailers in the low-price market can conduct parallel importation. Taobao.com is a typical marketplace for third-party parallel importation, while a good example of retailer parallel importation is that Costco privately diverts products of Calvin Klein, Omega, and Yves Saint Laurent (Bryant, 2015). There are two important differences between the two types of parallel importers. One is who decides the MBG strategy in the low-price market: it is the manufacturer under third-party parallel importation but the authorized retailer under retailer parallel importation because firms who directly contact customers are more suitable to offer MBGs to customers. Another is the source of their profits: the profit of the third-party agent comes from reselling gray market products exclusively while the authorized retailer earns from both the authorized channel and the gray market. In this paper, we shed some light on the crucial role of the parallel importer’s identity in forming firms’ MBG strategies by studying the two types of parallel importers, respectively. We are curious about: (4) How would the MBG strategy in the low-price market be reformulated when the policy maker’s identity switches from the manufacturer to the authorized retailer? (5) How does the structure of profit source(s) affect the parallel importer’s MBG strategy in the high-price market?

To answer these questions, we first consider a setting where a manufacturer (she) sells a single branded product in two differentiated markets and a third-party agent (he) engages in parallel importation, as shown in Fig. 1(a). The manufacturer decides her MBG strategies in both markets while the parallel importer decides his MBG strategy in the high-price market. Then, the manufacturer determines the selling prices in both markets followed by the parallel importer’s pricing decision in the high-price market. Next, we consider another setting where the manufacturer sells through an authorized retailer (he) in the low-price market and the authorized retailer organizes flows of gray market products, as illustrated in Fig. 1(b). The manufacturer decides her MBG strategy in the high-price market while the authorized retailer decides his MBG strategies in both markets. Then, the manufacturer determines the wholesale price in the low-price market and the selling price in the high-price market. After that, the authorized retailer determines the retail price in the low-price market and the reselling price in the high-price market.

By applying the certainty equivalent pricing approach (Huang, Ren, & Chen, 2018), we derive firms’ pricing strategies for each MBG strategy combination and characterise the equilibrium MBG strategy combination under the two models, respectively. Our study contributes to the literature on parallel importation and MBG strategies, which will be reviewed in the next section, in the following aspects.

• In line with the previous studies on MBG strategies, offering MBGs only changes firms’ marginal costs without affecting customers’ purchasing decisions directly. On account of the marginal cost reduction, it is always the manufacturer’s dominant strategy to offer an MBG in the high-price market if and only if the net salvage value of a returned product is positive, no matter whom the parallel importer is.

• When the manufacturer decides the MBG strategy in the low-price market, there is a price inflation effect in the presence of the MBG. That is, the manufacturer charges a higher purchasing price for gray market products without affecting the effective prices paid by customers as the third-party agent buys for resale without using the returns option. Because the price inflation effect deters parallel importation, the manufacturer may choose to offer an MBG in the low-price market even if the net salvage value is negative. For the third-party agent, because his profit comes from the gray market exclusively and reducing marginal costs is always beneficial to him, offering an MBG in the high-price market is his dominant strategy if and only if the net salvage value is positive.

• When the authorized retailer decides the MBG strategy in the low-price market, there is no price inflation effect. Now the retailer chooses his MBG strategies to maximize his total profit from two markets. On one hand, offering an MBG in either market changes his profit from the authorized channel and that from the gray market in opposite directions. On the other hand, whenever MBGs are offered in both markets, there is a substitution or complementary effect depending on the signs of the net salvage values. As a result, the net salvage values in two markets and the attractiveness of the high-price market all play an active role in formulating the retailer’s best MBG strategy combination. Interestingly, no refund may be preferred in either market even if the net salvage value in that market is positive.

• No matter whom the parallel importer is, the manufacturer’s MBG strategy in the high-price market always deters parallel importation while other MBG strategies may induce Pareto improvements in the equilibrium.

The remainder of this paper is organized as follows. Section 2 reviews literature. Section 3 examines the model under third-party parallel importation. Section 4 analyses the model under retailer parallel importation. Section 5 concludes. All proofs are provided in Appendix.