The informational role of manufacturer returns policies: How they can help in learning the demand

Returns policies are usually thought of as being a way to insure retailers against excess inventory. The work of Pellegrini (1986), Chu (1993), Lin (1993) and Padmanabhan and Png (1997) highlights the fact that there is considerably more to returns policies than just a mechanism for insurance. Our work identifies a heretofore undocumented rationale for returns policy: its role in learning the demand for a new product. The model of manufacturer-retailer interaction assumes that the demand is uncertain but correlated across time periods. Thus, its true nature is revealed over time via the realization of sales. The speed of such learning depends on the size of the inventory at the retail level which in turn can be strategically influenced by the manufacturer through a returns policy. In such environments, we show that a returns policy may be a way for the manufacturer to learn the demand of a new product.