1 s2.0 S0925527317302530 Main

International Journal of Production Economics 193 (2017) 422–436
Contents lists available at ScienceDirect
International Journal of Production Economics

journal homepage: www.elsevier.com/locate/ijpe
Pricing and order decisions with option contracts in the presence of

customer returns
Chong Wang a, b, Jing Chen b, *, Xu Chen c
a
School of Management, Sichuan Agricultural University, Chengdu, 611130, PR China
b
Rowe School of Business, Dalhousie University, Halifax, NS B3H 4R2, Canada
c
School of Management and Economics, University of Electronic Science and Technology of China, Chengdu, 611731, PR China
A R T I C L E I N F O A B S T R A C T
Keywords: This paper develops a newsvendor model to examine the impact of customer returns on a firm's pricing and order
Join pricing and order decision decisions, in a case where the firm faces price-dependent stochastic demand and has the option of purchasing
Customer returns option contracts. The firm needs to decide the optimal initial order quantity, option order quantity, and retail
Option contracts
price simultaneously. The firm's joint optimal decisions are derived for both single- and multi-periods. We
examine the impact of two typical forms of customer returns: proportional to product sold, and increasing with
selling price. We demonstrate that when customer returns increase with products sold, the firm will set a higher
price and reduce both initial order quantity and option order quantity through the wholesale price contract and
option contract, respectively, for the single-period problem. In the multi-period problem, when customer returns
increase with products sold, the impact of customer returns depends strongly on the variation in product purchase
costs (order costs and purchase costs of options) in each period. When customer returns increase with selling
price, however, the firm will cut its price, and initially order more products with fewer options for both the single-
and multi-period problems. Furthermore, numerical examples confirm that the presence of customer returns
results in a significant decrease in the firm's profit. Option contract can be a tool to mitigate the negative impact of
customer returns as with the option contract, the more the customer returns, the more the firm is motivated to
provide a returns policy.
1. Introduction with customer returns, as they have to manage inventory of returned

products. For example, the electronics industry in the US alone spends
Products returned by customers present a common problem in the some $14 billion annually on processing returned products (Petersen and
retailing industry (McWilliams, 2012). According to a recent report from Kumar, 2010).
the National Retail Federation (2015), total merchandise returns Failing to consider customer returns in order quantity and/or pricing
accounted for $260.5 billion and $28.3 billion in lost sales for US re- decisions has been proven to significantly impact a firm's profit and
tailers and Canadian retailers in 2015, respectively, representing a 66% competitive advantage (Vlachos and Dekker, 2003). In addition to
increase from five years previous. Product returns significantly affect the customer returns, retailers usually face high risks due to, for instance,
bottom line of manufacturers and retailers, costing as much as $100 demand uncertainty, and supply yield and price volatility, which may
billion annually or 3.8% of revenue, as shown by a recent report from also lead to dramatic losses. Contracts of various types, however,
Marketing Science Institution (Sahoo et al., 2016). Retail product returns including buyback policies (Chen and Bell, 2011b, 2012; Su, 2009), have
are a crucial component of the overall relationship between customer and been widely used to mitigate the negative impact of demand uncertainty
retailer (Rael and Billings, 2016). The average returns rate is 8%, but only as well as product returns. Recently, it has become increasingly popular
about 5% of these returns are defective products (Lawton, 2008). Many for retailers to adopt option contracts, especially contracts that combine a
retailers offer a full-refund returns policy to retain customer loyalty pure call option with a wholesale price, to hedge risks, including demand
(Schmidt and Kernan, 1985; Sorescu and Sorescu, 2016). As a conse- and supply uncertainties and price volatility (Nagali et al., 2008; Chen
quence, retailers and manufacturers incur significant costs in dealing and Shen, 2012; Hu et al., 2014; Chen et al., 2014).
* Corresponding author. Rowe School of Business, Kenneth C. Rowe Management Building, Dalhousie University, 6100 University Avenue, Halifax, NS B3H 4R2, Canada.
E-mail address: JChen@Dal.Ca (J. Chen).
http://dx.doi.org/10.1016/j.ijpe.2017.08.011
Received 12 April 2017; Received in revised form 8 August 2017; Accepted 10 August 2017
Available online 15 August 2017
0925-5273/© 2017 Elsevier B.V. All rights reserved.
C. Wang et al. International Journal of Production Economics 193 (2017) 422–436
In a call option contract, the option buyer/retailer first pays a reser- problem, the impact of customer returns depends strongly on the varia-
vation fee for a certain quantity of options. Each call option gives the tion of product purchase costs (order costs and purchase costs of options)
retailer the right (not the obligation) to buy one product at an exercise in each period. In both the single- and multi-period problems, however,
price after demand has been observed. Thus, the call option contract when customer returns increase with the selling price, the firm will cut its
reduces the risk of uncertain demand and can also secure the supply for retail price and order more products with fewer options. Furthermore, we
the retailer. Option contracts have been extensively used in industries show that customer returns negatively impact the firm in terms of
such as fashion apparel, electronics, and fast consumption (Barnes- reducing its profit. With option contract, the firm is motivated to provide
Schuster et al., 2002; Chen et al., 2014; Wang et al., 2015; Nosoohi and a returns policy when customer returns increase. Therefore, option
Nookabadi, 2016). These industries also face very significant customer contract can be used to mitigate the negative impact of customer returns
returns. Mostard and Teunter (2006) point out, for instance, that return for the firm. This research provides new insights for the firm that faces
rates of fashion items, for instance, have been estimated to be as high as customer returns and has the choice of an option contract. The proposed
74%. In the electronics industry, in 2000, Hewlett-Packard (HP) incurred model can be used for products that have a long production lead time but
$45 million in remanufacturing-related costs due to product returns a short selling season with a high customer returns rate, such as fashion
(Davey et al., 2005; Chen and Wang, 2015; Chen et al., 2016), and op- apparel, consumption electronics, toys, and gifts.
tions contracts such as call option contracts have been employed in 35% The rest of this article is organized as follows. Section 2 reviews the
of HP's procurement value (Chen and Shen, 2012; Chen et al., 2014). The relevant literature and Section 3 details the formulation and assumptions
retailer with a call option contract for order quantity and/or price is more of our model. Section 4 presents the single-period problem as a baseline.
profitable than the retailer without such a contract (Chen and Shen, Section 5 focuses on the multi-period problem. Section 6 reports nu-
2012; Wang and Chen, 2015). Thus, a retailer with option contracts may merical examples to illustrate our analytical results. Section 7 concludes
be more willing to provide a returns policy. This motivates us to inves- the article and gives directions for future research. All proofs are
tigate how retailers in such industries can leverage the negative impact of in Appendix.
customer returns to enhance profit by making joint decisions on order
quantity and selling price with option contracts. 2. Literature review
To hedge uncertainty in demand, in addition to adjusting price and
order quantity, option contracts are widely used (Chen and Shen, 2012). There are three streams of literature that are relevant to our work,
With an option contract, a retailer must balance not only the trade-off including the stochastic inventory problem with price-dependent de-
between overage cost and shortage cost, but also the trade-off between mand, customer returns, and risk hedging with option contracts.
high purchase cost and flexibility (Chen et al., 2014). If the retailer orders Research on the stochastic inventory problem with price-dependent
fewer products in the initial order with more options, the shortage cost demand has been extensively examined. Most of the studies focus on a
may be low and the flexibility may be high, but if the realized demand single-period problem. Early studies include Whitin (1955), who assumes
happens to be high the total purchase cost will also be high (due to the that the demand is uniformly distributed. Elmaghraby and Keskinocak
large quantity of exercised options). If the retailer orders more products (2003) provide excellent reviews of early work related to this issue.
in the initial order with fewer options, the purchase cost will be low due Petruzzi and Dada (1999) propose a unified framework to study the joint
to the lower option quantity, but the overage cost might be high and the pricing and order decision of a firm for both additive and multiplicative
flexibility might be low, so the retailer may suffer if the realized demand price-dependent demand. Their work has been extended through
happens to be low. A simultaneous decision on retail price and order consideration of other issues. Chiu et al. (2011) show that a channel with
quantity facilitates adjustment in pricing to maximize retailer's profit. price-dependent demand can be coordinated by a policy combined with
Product returns from customers, however, present a challenge to the wholesale price, channel rebate, and returns. Xu and Lu (2013) study
retailer making a joint decision on retail price and inventory with option price and quantity decisions for a firm under both supply and demand
contracts; they significantly affect the retailer's optimal decision and risks. Abad (2014) uses a chance-constrained formulation to examine the
expected profit. The impact of customer returns on the retailer's joint optimal order and pricing decisions for a firm under cycle service level.
decision on order quantity and price, with consideration of option con- Rubio-Herrero et al. (2015) study the optimal stocking policy for a
tracts, has been under studied in the literature. To fill this gap, we price-setting and risk-sensitive firm under mean-variance criteria. Luo
develop a model for a firm facing price-dependent stochastic demand and et al. (2016) identify the optimality conditions of a firm problem with an
customer returns with the choice of an option contract. The firm must additive–multiplicative demand. Ye and Sun (2016) study the
simultaneously decide the initial order quantity through the wholesale price-setting firm problem with strategic consumers. Raza and Rathinam,
price contract, the option order quantity through the call option contract, 2017 analyze the joint price differentiation and inventory policy for a
and the selling price, for both a single-period and a multi-period time risk-adjusted firm with demand leakage effects considering several
interval. We address the following research questions. important objectives. Zhang et al. (2017a) investigate the optimal policy
on ordering quantity and price discount for a firm issuing
(1) What are the optimal simultaneous pricing and order decisions for product-specific gift cards.
the firm with an option contract in the presence of customer There are limited studies examine joint pricing and order decisions
returns in both single and multi-period settings? for multiple periods. Federgruen and Heching, 1999 address combined
(2) How do customer returns influence the optimal decisions and inventory replenishment and pricing strategies in a multi-period setting
profits of the firm with the option contract? under demand uncertainty. They characterize the structure of the
(3) How should the firm use the option contract and pricing strategy optimal strategies with both finite and infinite horizon models. Song
to enhance its profit in the presence of customer returns? et al. (2009) analyze the optimal dynamic multi-period order and pricing
problem with multiplicative price-sensitive demand, lost sales, and fix-
To examine the impact of customer returns on the decisions of a firm ed/variable order cost. Bernstein et al., 2015study the joint decision on
with an option contract, we consider two typical forms of customer inventory and pricing with a positive lead time and backorders consid-
returns that are widely used in the literature: proportional to product ering both additive and multiplicative demand forms. Customer returns
sold, and increasing with selling price. Several new insights are obtained and option contracts are not considered in these works.
in this study. We demonstrate that when customer returns increase with Customer returns has been an increasingly popular topic of study in
number of products sold, the firm will set a higher price, and order fewer recent years. Product returns between supply chain partners has also
products and options through the wholesale price contract and option been considered. For example, Li et al. (2012) study optimal order and
contract, respectively, for the single-period problem. For the multi-period pricing policy for a B2B market with product returns. They also propose a
423
buyback contract to coordinate the chain. Jena and Sarmah (2016) We further extend the problem to a multi-period setting where products
investigate price and service co-operation between two firms in a returned in the previous period can be used in the following period. This
remanufacturing system with consideration of returned products. They paper fills this gap in the literature.
further develop a mechanism of quantity discount with return contract to
coordinate the system. Vlachos and Dekker (2003) analyze a firm's 3. Model and assumptions
optimal order quantity decision under various options for handling
customer returns, with the assumption that customer returns are a fixed We consider a firm (newsvendor) who faces stochastic price-
fraction of sales. Chen and Bell (2011a) investigate the coordination of a dependent demand and customer returns; its supplier offers a whole-
supply chain with price-dependent demand through a buyback policy for sale price contract and an option contract. The firm needs to decide
both unsold inventory and customer returns. Chen and Bell (2012) simultaneously for each period the selling price, initial order quantity
implement different customer returns policies, including full-refund and (through the wholesale price contract), and option quantity (through the
no-refund policies, to segment the market into a dual-channel structure. option contract simultaneously), to maximize its expected profit over
They also examine the impact of returns on the pricing and order de- multiple selling periods. Customers can return the product before the end
cisions of the firm. Liu et al. (2014) assume that the stochastic demand is of the selling period in which the product is purchased through a full-
refund-dependent, and show that supply chain coordination cannot be refund returns policy offered by the firm. We assume that customers
achieved by a buyback contract in that case. Huang and Yang (2015) and return products for reasons of fit and taste, and not for quality reasons.
Yan and Cao (2017) discuss the impact of asymmetric product return This is a reasonable assumption, as most returned products are non-
information on the decisions and performance of supply chain members. defects, as pointed out by Lawton (2008), Anderson et al., 2009 There-
They identify sufficient conditions for Nash equilibrium among the re- fore, for the multi-period problem, we assume that returned products can
tailers. Zhang et al. (2017b) propose a return and refund policy for be placed on the shelf as new products after simple inspection
products bundled with core services in a dual-channel setting. They also and repacking.
present an approximate algorithm to solve the problem. Yang et al. The sequence of events in our model is as follows. At the beginning of
(2017) examine the impact of customer returns with both vertical each period i, the firm orders products from its supplier under two con-
competition and horizontal competition. They find that a money-back tracts: a wholesale price contract and a call option contract. With a
guarantee expands the overall market and enhances the retailer's preliminary forecasted demand Di , the firm must decide the retail price
profit. Chen and Bell (2009) examine the impact of customer returns on a per unit product ðpi Þ, initial order quantity ðqwi Þ at a given unit wholesale
retailer's order and pricing decisions. Diggins et al. (2016), Abbey and price ðwi Þ, and call option order quantity ðqoi Þ at a given unit option price
Guide (2017), and Guo et al. (2017) have recently thoroughly reviewed ðoi Þ. The supplier guarantees to supply qi ¼ qwi þ qoi units to the firm.
the literature on customer returns. None of these studies, however, ex- Each call option also gives the firm the right (but not the obligation) to
amines the option contract and its impacts in the presence of buy an additional product at a pre-negotiated unit exercise price ðei Þ
customer returns. when actual demand information is realized, where i ¼ 1; 2; …; N; if the
Risk hedging with option contracts has attracted much attention in actual demand exceeds the initial order quantity, the firm can fulfill the
both academic research and industrial practice. As pointed out by Bar- additional demand with call options, while any unexercised options will
nes-Schuster et al. (2002), option contracts can provide flexibility to the have no value. The firm will incur a relatively high penalty cost ðgÞper
buyer to reduce demand risk. There are three types of options: named unit for the unmet demand. Denote by Ri ðpi ; Di Þ products returned by
call, put, and bidirectional option. Here we review studies of the call customers to the firm for full credit before the end of the period. Since
option, which is the version we consider in the present study. The sub- customers return the products due to taste and fit, we assume that any
sequent literature related to call option contracts mainly focuses on returned and unsold products can be carried over and resold in the
ordering, pricing, and coordination issues, including optimal ordering following period ði þ 1Þ. We introduce a holding cost h if an unsold
or/and coordination policies with limited purchasing budgets (Feng product must be carried to the next period. At the end of the last selling
et al., 2014; Cao et al., 2015), with supply uncertainty (Xu and Nozick, period N, any excess products, including returned and unsold products,
2009; Xu, 2010; Luo and Chen, 2015), with service requirements (Chen can be salvaged for a value of s per unit.
and Shen, 2012), for a loss-averse firm (Chen et al., 2014; Lee et al., To investigate how the firm should use the option contract and
2015), under vendor-managed inventory (Cai et al., 2015), and in a pricing strategy to enhance profit in the presence of customer returns, we
multi-period scenario (Inderfurth et al., 2013). As to the pricing issue, Fu develop a multi-period newsvendor model. Specifically, we model the
et al. (2012) study an inventory system in a multi-period setting with stochastic demand in an additive form (see, for example, Petruzzi and
price-sensitive demand in the presence of a spot market. They show that Dada, 1999): Di ðpi ; εi Þ ¼ yi ðpi Þ þ εi , where yi ðpi Þ ¼ ai bi pi ðai > 0; bi > 0Þ
the order-up-to type with a sequence of decreasing thresholds is the represents the expected demand, εi 2 ½Ai ; Bi , and Eðεi Þ ¼ μi . To ensure
optimal inventory replenishment policy, and the values of the option positive demand for some ranges of pi , we require that Ai > ai .
contracts are more significant when the market demand becomes more Following Chen and Bell (2009), we assume that customer returns are
volatile. Wang and Chen (2015) analyze the joint order and pricing de- proportional to the number of products sold and increase with selling
cision with both the wholesale price contract and the call option contract. price: Ri ðpi ; Di Þ ¼ αDi ðpi ; εi Þ þ βpi , where the first and second terms
They restrict their attention to the single-period problem, and do not represent customer returns in quantity proportional to products sold and
investigate the impact of customer returns. Wang and Chen (2017) increasing with selling price, respectively.
examine optimal option pricing and product ordering strategies for a The assumptions pi ð1 αÞ > oi þ ei and pi ð1 αÞ > wi correspond to
fresh produce supply chain using a Stackelberg game. They illustrate that the firm's participation constraints. We also assume that oi þ ei > wi and
the optimal option pricing policy of the supplier is independent of de- wN s > oN , to ensure that the firm will have an incentive to place orders
mand risk and wholesale price. None of these studies, however, considers through both the wholesale price contract and option contract. In addi-
customer returns. tion, the assumptions ei þ h > wiþ1 and eN > s prevent the firm from
To the best of our knowledge, studies on pricing and order decisions arbitraging by exercising options when there is no actual demand in the
with option contracts are very limited. In addition, the impact of current period, while the assumption wi þ h > wiþ1 prevents the firm from
customer returns on the order and pricing decision with option contracts arbitraging by ordering products when there is no actual demand in the
has not been discussed. This paper contributes to the literature by current period. We further assume that g > ei to ensure that the firm will
exploring how a profit-maximizing firm should jointly set the initial exercise options to meet demand in order to avoid a high penalty. The
order quantity, the option order quantity, and the retail price with option notation used in this paper is summarized in Table 1.
contracts in the presence of customer returns in a single selling period. To better understand the impact of customer returns on the firm's
424
decisions with option contracts, we begin by discussing the single-period þε þ βp, the general form of the expected returns function with sto-
problem and then extend our discussion to the multi-period problem. chastic demand can be written as
( )
4. The single-period problem z B
E½Rðp; yðpÞ þ εÞ ¼ α yðpÞ þ ∫ A εf ðεÞdε þ ∫ z zf ðεÞdε þ βp:
In a single-period problem, the firm decides ðp; qw ; qo Þ. Note that
zqo z
determining ðp; qw ; qo Þ is equivalent to determining ðp; qo ; qÞ as We define Λðqo ; zÞ ¼ ∫ A ðz qo εÞf ðεÞdε, Ωðqo ; zÞ ¼ ∫ zqo ðz
q ¼ qw þ qo . Then the profit function of the firm is: B
εÞf ðεÞdε, and ΘðzÞ ¼ ∫ z ðε zÞf ðεÞdε. Then, the expected profit of the
þ firm can be written as
πðp; qo ; qÞ ¼ pmin½q; Dðp; εÞ þ ðs hÞ½q qo Dðp; εÞ
ðp sÞmin½Rðp; Dðp; εÞÞ; Rðp; qÞ wðq qo Þ oqo E½πðp; qo ; zÞ ¼ Ψ ðpÞ Lðp; qo ; zÞ; (3)
e½minðDðp; εÞ ðq qo Þ; qo Þþ g½Dðp; εÞ qþ :
where
(1)
Ψ ðpÞ ¼ ½pð1 αÞ þ αs w½yðpÞ þ μ ðp sÞβp; (4)
The first term is the firm's revenue generated from selling products,
the second term is the net salvage value of unsold products (after sub-
tracting the holding cost), the third term is the loss due to customer Lðp; qo ; zÞ ¼ ½w ðs hÞΛðqo ; zÞ þ ðw eÞΩðqo ; zÞ þ ½pð1 αÞ þ g
returns, the fourth and fifth terms are the costs for ordering products and þ αs wΘðzÞ þ oqo ∫ A
zqo
f ðεÞdε
purchasing options, respectively, the sixth term is the cost for exercising B
options, and the last term is the shortage cost if the demand cannot þ ðo þ e wÞqo ∫ zqo f ðεÞdε:
be met. (5)
We define z ¼ q yðpÞ, where z is the stocking factor. If ε z qo ,
Eq. (4) represents the riskless profit function with deterministic de-
then leftovers come from the initial order quantity; if z qo < ε z, then
mand. Eq. (5) represents the loss function with uncertainty, which re-
leftovers come from the option order quantity while shortages will occur
flects an overage cost of Λðqo ; zÞ expected leftovers for products, an
if ε > z. Combined with Dðp; εÞ ¼ yðpÞ þ ε, Eq. (1) can be rewritten as:
overage cost of Ωðqo ; zÞ expected leftovers for options, an underage cost
πðp; qo ; zÞ ¼ pmin½yðpÞ þ z; yðpÞ þ ε þ ðs hÞ½z qo εþ of ΘðzÞ expected shortages for unmet demand, and a cost-plus for
ordering and exercising options in addition to a wholesale price contract.
ðp sÞmin½Rðp; yðpÞ þ εÞ; Rðp; yðpÞ þ zÞ w½yðpÞ þ z The expected profit is represented in Eq. (3), which is given by the dif-
þ þ
qo oqo e½minðε ðz qo Þ; qo Þ g½ε z : ference between the riskless profit and the expected loss.
(2) With the expected profit function of the firm with customer returns
and option contracts, for a given ðqo ; zÞ, we can derive the optimal selling
With Rðp; Dðp; εÞÞ ¼ αDðp; εÞ þ βp, i.e., Rðp; yðpÞ þ εÞ ¼ α½yðpÞ price for the firm, which is summarized in Lemma 1.
Lemma 1. For a given ðqo ; zÞ, E½πðp; qo ; zÞ is concave in p, and the unique
optimal selling price p* is a function of z and is given by
ð1αÞΘðzÞ
, where p*d ¼ ð1αÞðaþμÞþðwαsÞbþβs
Table 1
p* ≡pðzÞ ¼ p*d 2½ð1αÞbþβ 2½ð1αÞbþβ .
Table of notation.
Parameters: In Lemma 1, p*d is the optimal riskless price that maximizes the riskless
i Subscript, index of decision period, i 2 ½1; 2; …; N
profit Ψ ðpÞ. With ΘðzÞ 0, we can conclude that p* p*d , which implies
d Subscript, denoting deterministic demand
NO Subscript, denoting case without option contracts that facing uncertain demand, the firm will cut the retail price, as
NR Subscript, denoting case without customer returns compared to the deterministic demand case.
Di ðpi ; εi Þ Demand function for period i We now investigate the impact of customer returns on the pricing
εi Random variable that affects Di , where εi 2 ½Ai ; Bi , and Eðεi Þ ¼ μi
decision of the firm with option contracts for a given order policy. The
fi ðεi Þ PDF function of εi
Fi ðεi Þ CDF function of εi impact of two types of customer returns is summarized in Lemma 2.
hi ðεi Þ Hazard rate, where hi ðεi Þ ¼ fi ðεi Þ dp* dp*d dp*d *
1Fi ðεi Þ Lemma 2. For a given order policy, dα ¼ dα > 0 for β ¼ 0; dβ dp
dβ < 0
oi Unit purchase cost of options for period i (option price) for α ¼ 0.
wi Unit ordering cost of products for period i (wholesale price)
ei Unit exercising cost of options for period i (exercise price) The first part of Lemma 2 implies that when the firm faces customer
h Unit holding cost of unsold products carried to next period
returns that are proportional to product sold, as α increases, it should
s Unit salvage value of products at end of last period N
g Unit penalty cost for unfilled demand for any period
increase the retail price for both certain and uncertain demand cases. It
Ri ðpi ; Di Þ Amount of products returned by customers for period i also implies that customer returns has the same impact on the price,
α Returns as proportion of quantity sold for each period, 0 < α < 1 whether or not demand uncertainty is present. Further, let p*NR be the
β Returns that increases with selling price for each period, β > 0
optimal retail price without returns (that is, α ¼ 0). We conclude that
xi Inventory level before beginning of selling season for period i, and x1 ¼ 0
Other notation: p*d p* > p*NR , suggesting that customer returns that are proportional to
π i ð⋅Þ Profit function for period i product sold result in a high retail price. The implication is that the firm
Eð⋅Þ Expected value of a parameter should reduce the selling price to reduce the demand, resulting in fewer
½χþ Maximum value of 0 and χ
returned products, The second part of Lemma 2 implies that when the
χ Optimal value of a parameter χ
Decision variables:
firm faces customer returns that increase with selling price, as β in-
pi Unit selling price of product for period i creases, it should reduce the selling price no matter whether demand is
qwi Order quantity of products through wholesale price contract for period i deterministic or uncertain. Let p*NR be the optimal retail price without
(initial order quantity)
returns (that is, β ¼ 0). We conclude that p* p*d < p*NR , suggesting that
qoi Order quantity of options through call option contract for period i (option
order quantity) customer returns that increase with selling price result in a low retail
qi Total order quantity for period i, where qi ¼ qwi þ qoi price. The intuition is that to enhance profit, the firm should cut the price
to reduce the amount of customer returns. When the firm faces customer
425
returns that increase with both product sold and selling price, the impact contract and the option contract. Thus, the firm reduces the total order
of customer returns on the firm's selling price depends on which form of quantity. Furthermore, as compared to the case with no returns, the
customer returns is dominant. firm will set a higher price and order fewer products. Without
With the firm's expected profit in Eq. (3), for a given retail price we considering customer returns, Wang and Chen (2015) show that the
have the result in Lemma 3. firm with an option contract sets a higher price and makes a smaller
initial order quantity than without. Thus, the firm with the option
Lemma 3. For a given p, E½πðp; qo ; zÞ is jointly concave in qo and z, and the
contract is more willing to provide a returns policy than the firm
unique pair of optimal stocking factor and option order quantity ðz* ; q*o Þ is
without such a contract, when customer returns are proportional to
given by: z* ¼ F 1 1 ðpsÞð1αÞþgþse
o
and q*o ¼ z* F 1 eðshÞ
oþew
. quantity sold.
When customer returns increase with selling price ðα ¼ 0Þ, from
With Lemma 3, we can obtain the optimal total order quantity q* ¼ Proposition 1, the optimal price and order quantities are: p* ¼

yðpÞ þ z* and the initial order quantity q*w ¼ yðpÞ þ F 1 eðshÞ
oþew
. aþμþwbþβs
Θðz* Þ
¼ p *
Θðz* Þ
; z *
¼ F 1
1 o
; q* ¼ a bp* þ z* ;
2ðbþβÞ 2ðbþβÞ d 2ðbþβÞ p þge
*
oþew
1 ⇔ o w ðs hÞ, implying that the supplier should set the
eðshÞ
q*w ¼ a bp* þ F 1 eðshÞ
oþew
; and q*o ¼ z* F 1 eðshÞ
oþew
:
option price to be lower than ½w ðs hÞ. Lemma 3 implies that for a
given p, β has no impact on either the optimal initial order quantity ðq*w Þ The impact of customer returns on price and order quantities are
or the option order quantity ðq*o Þ, as price is fixed. As a result, we focus on summarized in Proposition 3.
the impact of α on the optimal order decisions. We summarize the results Proposition 3. When the firm faces customer returns that increase with
in Lemma 4.
retail price, and when it makes coordinated pricing and order decisions, p* , z*
* dq * dq*o dq*w
Lemma 4. dα ¼ dα ¼
For a given p, dz dα < 0 and dα ¼ 0. and q*o decrease with β, while q* and q*w increase with β.
Lemma 4 implies that as compared to the case in which the firm does Proposition 3 shows that when customer returns increase with selling
not face customer returns, the firm should maintain the same level of price, as β increases, the firm should reduce the retail price and the op-
initial order quantity while reducing the option order quantity; as a tion order quantity, and raise the initial order quantity and the total order
consequence, total order quantity will be reduced. Chen and Bell (2009) quantity. Since q* ¼ q*w þ q*o , the result in Proposition 3 also implies that
show that, facing customer returns and without option contracts, the firm ∂q*w ∂q*o
∂β > ∂β . The intuition is that as β increases, the firm sets a lower price
will reduce the initial order quantity. For a fixed retail price, the option
to attract more demand and it will increase the initial order quantity to
contract provides the firm with flexibility on the amount of products to
fulfill this demand. On the other hand, as β increases, the firm sets a lower
be purchased after additional information becomes available. Lemma 4
suggests that the firm can maintain the initial order quantity and take stocking factor ðz* Þ, in anticipation of lower demand uncertainty in the
advantage of the option order quantity to mitigate the variation due to selling season. Fu et al. (2012) and Wang and Chen (2015) show that the
the increase in returned products. Thus we conclude that the value of the value of the option contract is more significant when the market demand
option contract becomes more significant when customer returns become becomes more volatile. Thus, a lower anticipated demand uncertainty
more volatile. leads the firm to purchase fewer options. Furthermore, the cost of an
f ðεÞ order with option ðo þ eÞ is higher than that of the product itself ðwÞ,
With Lemma 1 and Lemma 3, as well as hðεÞ ¼ 1FðεÞ , hazard rate, the
which leads to a higher retail price for the firm with option contracts
firm's joint optimal decision on the price, initial order quantity, and (Wang and Chen, 2015). Given that the firm reduces the retail price as β
option order quantity can be summarized in Proposition 1. increases, the firm should reduce the option order quantity. As compared
to the case with no returns, the firm will set a lower retail price, reduce
2 2
Proposition 1. If and only if hðz* Þ > ð1αÞ ½1Fðz Þ *
2½ð1αÞbþβo , there exists a unique

optimal pricing and order policy for the firm, where p* , p*d , z* , and q*o are given option order quantity, and increase the initial order quantity and total
in Lemmas 1 and 3, respectively, and their relationship should satisfy: order quantity.
Proposition 2 and Proposition 3 further imply that although the
ð1αÞΘðz* Þ
1 αÞ p*d 2½ð1αÞbþβ þ g þ αs e 1 Fðz* Þ o ¼ 0, impact of the change in price and the resulting change in initial order
quantity on retailer's profit may counter-balance for the two forms of
for z* 2 ½A; B.
customer returns (proportional to the quantity sold and increasing
2 2
with the selling price), the firm's optimal decision is to reduce the
In Proposition 1, hðz* Þ > ð1αÞ ½1Fðz Þ*
2½ð1αÞbþβo is the existence condition for a

amount of customer returns to enhance its profit. More specifically,
unique optimal retail price ðp Þ. We then examine the impact of customer
from the pricing perspective, the firm should increase price when
returns on the joint pricing and order decision for the firm with op-
customer returns are proportional to quantity sold, while decrease
tion contracts.
price when customer returns increase with the selling price. On the
When customer returns are proportional to the quantity sold ðβ ¼ 0Þ,
other hand, the firm should order fewer options with a lower stocking
from Proposition 1, we have p* ¼ ð1αÞðaþμÞþðwαsÞb Θðz Þ Θðz Þ * *
2b ¼ pd 2b ;
*
2ð1αÞb factor for both cases, to hedge demand uncertainty and associated

customer returns.
z* ¼ F 1 1 ðp* sÞð1αÞþgþse
o
; q* ¼ a bp* þ z* ; q*w ¼ a bp* þ
We now discuss the impact of customer returns on the firm's pricing

and order decisions for a multi-period problem.
F 1 eðshÞ
oþew
; and q*o ¼ z* F 1 eðshÞ
oþew
:
The impact of customer returns rate ðαÞ on the price and order 5. The multi-period stochastic problem
quantities can be summarized in Proposition 2.
In the multi-period problem with customer returns and an option
Proposition 2. When the firm faces customer returns that are proportional contract, the firm decides ðpi ; qwi ; qoi Þ for each period. Similar to the
to product sold and when it makes the joint pricing and order decision, single-period problem, determining ðpi ; qwi ; qoi Þ is equivalent to deter-
p* increases with α, while z* , q* , q*w and q*o decrease with α. mining ðpi ; qoi ; qi Þ. Recall that xi is the inventory level before the begin-
Proposition 2 shows that when customer returns are proportional to ning of the selling season for period i ði ¼ 1; 2; …; NÞ, and x1 ¼ 0. The
the quantity sold, as α increases, the firm should raise the retail price profit function of the firm for period i ði ¼ 1; 2; …; N 1Þ is:
while reducing the order quantity through both the wholesale price
426
π i ðpi ; qoi ; qi Þ ¼ pi min½qi þ xi ; Di ðpi ; εi Þ pi min½Ri ðpi ; Di ðpi ; εi ÞÞ; Ri ðpi ; qi Li ðpi ;qoi ;zi Þ
8
þ
þ xi Þ h½qi qoi þ xi Di ðpi ; εi Þ wi ðqi qoi Þ >
> ðwi þ hÞΛi ðqoi ; zi Þ þ ðwi ei ÞΩi ðqoi ;zi Þ i ¼ 1;2;…;N 1
>
>
>
>
oi qoi ei ½minðDi ðpi ; εi Þ ðqi qoi Þ xi ; qoi Þþ > þ½pi ð1 αÞ þ g wi Θi ðzi Þ þ oi qoi ∫ zi qoi fi ðεi Þdεi
>
>
> Ai
þ >
>
g½Di ðpi ; εi Þ qi xi : < B
þðoi þ ei wi Þqoi ∫ ziiqoi fi ðεi Þdεi
¼
(6) >
> ½wi ðs hÞΛi ðqoi ;zi Þ i¼N
>
>
>
> þðw ÞΩ ðq ;z Þ þ ½p ð1 αÞ þ þ αs Θ ðz Þ
>
> e g w
xi ¼ ½qi1 qoði1Þ þ xi1 Di1 þ þ min½Ri1 ðpi1 ; Di1 Þ; Ri1 ðpi1 ; qi1
i i i oi i i i i i
>
>
>
> zi qoi Bi
þxi1 Þ in Eq. (6). We define zi ¼ qi þ xi yi ðpi Þ, in which zi is the : þoi qoi ∫ Ai fi ðεi Þdεi þ ðoi þ ei wi Þqoi ∫ zi qoi fi ðεi Þdεi
stocking factor for period i. Similar to the single-period problem, for
period i, εi zi qoi , zi qoi < εi zi , and εi > zi indicate that in period i, (10)
there are leftover products from the initial order quantity, leftover op-
tions from the option quantity, and shortages, respectively. With Ji1 qoði1Þ ; zi1 ¼ wi Λi1 qoði1Þ ; zi1 αwi Θi1 ðzi1 Þ;
(11)
Di ðpi ; εi Þ ¼ yi ðpi Þ þ εi , Eq. (6) can be rewritten as: i ¼ 1; 2; …; N
π i ðpi ; qoi ; zi Þ ¼ pi min½yi ðpi Þ þ zi ; yi ðpi Þ þ εi pi min½Ri ðpi ; yi ðpi Þ Similar to the single period problem, Eq. (9) represents the riskless
n profit function with deterministic demand, and Eq. (10) represents the
þ εi Þ; Ri ðpi ; yi ðpi Þ þ zi Þ h½zi qoi εi þ wi yi ðpi Þ loss function due to uncertainty. Eq. (11) reflects an overage cost of
h iþ Λi1 ðqoði1Þ ; zi1 Þ for expected leftovers of products and an underage cost
þ zi qoi zi1 qoði1Þ εi1
of Θi1 ðzi1 Þ for expected shortages due to unmet demand in period i 1.
min½Ri1 ðpi1 ; yi1 ðpi1 Þ þ εi1 Þ; Ri1 ðpi1 ; yi1 ðpi1 Þ Expected profit is represented by Eq. (8), which is given by the riskless
o profit subtracting the expected loss, and including the impact of expected
þ zi1 Þ oi qoi ei ½minðεi ðzi qoi Þ; qoi Þþ cost in period i 1 on period i.
Based on the results in the single-period problem, we now examine
g½εi zi þ :
the joint pricing and order decision for the firm with customer returns
(7) and option contracts, for the multi-period stochastic problem. With
fi ðεi Þ
We now consider the general form of the returns function with sto- hi ðεi Þ ¼ 1F i ðεi Þ
, hazard rate, the optimal pricing and order decisions are
chastic demand: summarized in Proposition 4.
E½Ri ðpi ; yi ðpi Þ þ εi Þ ¼ αE½minðqi þ xi ; Di ðpi ; εi ÞÞ þ βpi Proposition 4. E½π i ðpi ; qoi ; zi Þ is a concave function of pi , qoi and zi , and
( )
ð1αÞ2 ½1F ðz* Þ2
z B
¼ α yi ðpi Þ þ ∫ Ai εi f ðεi Þdεi þ ∫ zi zi f ðεi Þdεi þ βpi : 1) For period i ði ¼ 1; 2; …; N 1Þ, if and only if hi ðzi* Þ > 2½ð1αÞbi þβo
i i
i
,
there exists the unique joint optimal price and order quantity, which is
ð1αÞΘ ðz* Þ
Then, Eq. (7) can be rewritten as: given by: p*i ¼ p*di 2½ð1αÞbi i þβi
, where p*di ¼ ð1αÞðai þμ2½ð1αÞb
i Þþðwi αwiþ1 Þbi þβwiþ1
i þβ
;

ð1αÞΘ ðzi* Þ
π i ðpi ; qoi ; zi Þ ¼ pi ð1 αÞmin½yi ðpi Þ þ zi ; yi ðpi Þ þ εi βp2i 1 α p*di 2½ð1αÞbi i þβ þ g þ αwiþ1 ei 1 Fi ðzi* Þ ¼ oi , and
n
þ
h½zi qoi εi wi yi ðpi Þ þ zi qoi oi þei wi
q*oi ¼ zi* Fi1 ei ðw for zi* 2 ½Ai ; Bi .
iþ1 hÞ
h iþ
ð1αÞ2 ½1F ðz* Þ2
zi1 qoði1Þ εi1 αmin½yi1 ðpi1 Þ 2) For the last period N, if and only if hN ðzN* Þ > 2½ð1αÞbN þβo
N N
, there exists a
N
o unique optimal pricing and order policy for the firm, which is given by:
þ zi1 ; yi1 ðpi1 Þ þ εi1 βpi1 oi qoi ð1αÞΘN ðzN Þ
P*N ¼ p*dN 2½ð1αÞb N þβ
, where p*dN ¼ ð1αÞðaN2½ð1αÞb
þμN ÞþðwN αsÞbN þβs
N þβ
;
þ þ
ei ½minðεi ðzi qoi Þ; qoi Þ g½εi zi : * ð1αÞΘ ðzN Þ*
1 α pdN 2½ð1αÞbNN þβ þ g þ αs eN 1 FðzN* Þ ¼ oN , and

z qoi
Define Λi ðqoi ; zi Þ ¼ ∫ Aii ðzi qoi εi Þf ðεi Þdεi ,
z
Ωi ðqoi ; zi Þ ¼ ∫ zii qoi
B q*oN ¼ zN* FN1 oeNNþe N wN
for zN* 2 ½AN ; BN .
ðzi εi Þf ðεi Þdεi , and Θi ðzi Þ ¼ ∫ zii ðεi zi Þf ðεi Þdεi . Note that any returned ðshÞ
and unsold products will be salvaged in the last period. That is, as
Proposition 4 illustrates that only when the hazard rate for period i
compared to period i ði ¼ 1; 2; …; N 1Þ, there will be extra revenue of
ði ¼ 1; 2; …; N 1Þ is sufficiently large, there exists the unique joint
sfα½yN ðpN Þ þ μN þ βpN g þ sΛN ðq2N ; zN Þ αsΘN ðzN Þ for period N, which
optimal pricing and order decision. The optimal decisions of the firm are
comes from the salvage value of the returned products. The expected profit
highly dependent on the purchase cost of the product for the next period
of the firm over N periods can be written as
i þ 1, that is, wiþ1 . Proposition 4 also shows that the optimal price and
XN n o order quantity decisions for the last period ðNÞ in the multi-period
E πi ðpi ; qoi ; zi Þ ¼ Ψ i ðpi Þ Li ðpi ; qoi ; zi Þ þ Ji1 qoði1Þ ; zi1 problem are the same as those in the single-period problem.
i¼1;2;…;N i¼1 We now examine the different impacts of the two types of customer
(8) returns on the pricing and order decisions of the firm in the multi-period
problem. When customer returns are proportional to the quantity sold
where ðβ ¼ 0Þ, from Proposition 4, the pricing and order decisions are:
8
>
> ½p ð1 αÞ wi ½yi ðpi Þ þ μi βp2i i ¼ 1;2;…;N 1 1) For period i ði ¼ 1; 2; …; N 1Þ, p*i ¼ ð1αÞðai þμi Þþðwi αwiþ1 Þbi

Θi ðzi* Þ
< i " # 2ð1αÞbi 2bi ¼
þαwi ½yi1 ðpi1 Þ þ μi1 þ βwi pi1
Ψ i ðpi Þ ¼ Θi ðzi* Þ
> ½pi ð1 αÞ þ αs wi ½yi ðpi Þ þ μi ðpi sÞβpi i ¼ N
> p*di zi* ¼ Fi1 1 ðp* w
2bi ; ; q*i þ xi* ¼ ai bi p*i þ zi* ;
oi
: iþ1 Þð1αÞþgþwiþ1 ei
þαwi ½yi1 ðpi1 Þ þ μi1 þ βwi pi1
i

(9) q*wi þ xi* ¼ ai bi p*i þ Fi1 oi þei wi oi þei wi
;and q*oi ¼ zi* Fi1 ei ðw ;
ei ðwiþ1 hÞ iþ1 hÞ
427
ΘN ðzN* Þ ΘN ðzN* Þ
2) For period N, p*N ¼ ð1αÞðaN2ð1αÞb
þμN ÞþðwN αsÞbN
¼ p*dN ; zN* ¼ costs within each period does not influence the direction of the impact of
" # N 2bN 2bN
customer returns. In a special case, when wi ¼ wiþ1 , p*i ¼ ai þμ2ðb
i þðbi þβÞwi

FN1 1 oN
ðp*N sÞð1αÞþgþseN
; q*N þ xN* ¼ aN bN p*N þ zN* ; q*wN þ xN* ¼ i þβÞ
Θi ðzi* Þ
2ðbi þβÞ is the solution when there are no returns and supposing that the
oN þeN wN 1 oN þeN wN
aN bN p*N þ FN1 eN ðshÞ ; and q*
oN ¼ zN
*
F N eN ðshÞ : demand curve is yi ðpi Þ ¼ ai ðbi þ βÞpi .
Proposition 5 and Proposition 6 imply that to reduce customer returns
and enhance the firm's profit, the firm should adjust its optimal decision
Since for period N, the optimal policy for the firm is the same as the
in each of multiple periods. It is interesting that the firm should have a
single-period problem, we focus on the impact of customer returns on the
different strategy in adjusting its optimal decision for two forms of
optimal policy of the firm for period i ði ¼ 1; 2; …; N 1Þ and summarize
customer returns: when customer returns are proportional to the quantity
the results in Proposition 5.
sold, its pricing and contracting strategies depend strongly on the vari-
Proposition 5. For period i ði ¼ 1; 2; …; N 1Þ, if wi > wiþ1 and ation in product purchase costs in each period; when customer returns
wi wiþ1 > oi , p*i increases with α, while zi* , q*i þ xi* , q*wi þ xi* and q*oi increase with the selling price, the firm's pricing and contracting strate-
decrease with α; if wi < wiþ1 , p*i decreases with α, q*wi þ xi* increases with α, gies are the same as those in the single-period problem. The results imply
the impacts of α on zi* , q*i þ xi and q*oi are parameter-dependent. that it is important for the firm to identify which form of customer returns
it faces when it adjusts pricing and contracting strategies to reduce
Proposition 5 suggests that when customer returns are proportional customer returns and enhance its profit.
to quantity sold, for period i ði ¼ 1; 2; …; N 1Þ the impact of customer
returns on price depends strongly on the variation in product purchase 6. Numerical examples
costs in each period. Specifically, when the order cost for products has a
decreasing trend ðwi > wiþ1 Þ and the purchase cost of options is rela- In this section, we use numerical examples to illustrate our results,
tively low ðwi wiþ1 > oi Þ, the firm will order fewer products ðq*wi Þ and and particularly the impact of customer returns on the firm's expected
options ðq*oi Þ; in the same period, it will set a high price to cut back profit with option contracts. We set Di ðpi ; εi Þ ¼ 350 10pi þ εi , where εi
demand and customer returns, as it anticipates the low replenishment is normally distributed, Ai ¼ 300, Bi ¼ 700, μi ¼ 200, and σ i ¼ 60. Let
cost in the following period. When the order cost of products shows an oi ¼ 1, ei ¼ 12, h ¼ 5, s ¼ 2, and g ¼ 25. The ordering cost of products is
increasing trend ðwi < wiþ1 Þ, however, the firm will order more products set to be wi ¼ 9 in the single-period problem, and is varied in the multi-
and cut the price to generate more demand and customer returns, in period problem. We vary α and β for sensitive analysis to obtain addi-
order to reduce the cost of expensive replenishment products in the tional insights. The values of the parameters we set in this section satisfy
dp* the assumptions of our model and the existence conditions of the optimal
following period. For the special case when wi ¼ wiþ1 , since dαi ¼
solution that we presented in Sections 4 and 5.
½1F ðz* Þ2 ðp* w Þ 2bi hi ðzi* Þoi
i2bi h ðz* iÞo iþ1 2b h ðz* Þo ½1F ðz* Þ2 ð1αÞ
< 0, the firm will still order
i i i i i i i i i i
more products and set a low price to generate more demand and 6.1. The single-period problem
customer returns, which can be sold in the following period without any
loss. For the last period N, as α increases, the firm will reduce the order In the single-period problem, we vary α from 0 to 0.2. Let β be 0, 0.5,
quantity and set a high price to reduce demand and customer returns. and 1, respectively. We focus on the impact of customer returns on the
From Proposition 4, when customer returns increase with the selling joint optimal pricing and order decision and corresponding maximum
price ðα ¼ 0Þ, the optimal price and order quantities are: expected profit of the firm with option contracts. The results are shown in
Figs. 1 and 2.
1) For period i ði ¼ 1; 2; …; N 1Þ, Fig. 1 shows that if customer returns are proportional to quantity

ai þμi þbi wi þβwiþ1 Θi ðzi* Þ Θi ðzi* Þ sold, as α increases, the firm will set a higher price and reduce the total
p*i ¼ 2ðbi þβÞ 2ðbi þβÞ ¼ p*di zi* ¼ Fi1 1 p* þge
2ðbi þβÞ,
oi
; q*i þ
i i order quantity; if customer returns increase with retail price, as β in-

oi þei wi
creases, the firm will set a lower price and increase the total order
xi* ¼ ai bi p*i þ zi* ; q*wi þ xi* ¼ ai bi p*i þ Fi1 ei ðw iþ1 hÞ
; and
quantity. This numerical result also verifies Proposition 2 and Propo-

oi þei wi
sition 3. This result implies that the firm's pricing and contracting
q*oi ¼ zi* Fi1 ei ðw iþ1 hÞ
; strategies depend strongly on the form of customer returns, and this
Θ ðz* Þ Θ ðz* Þ suggests that the management of the firm should identify its form of
2) For period N, p*N ¼ aN þμ2ðb N þbN wN þβs
2ðbNN þβÞ
N
¼ p*dN 2ðbNN þβÞ
N
; zN* ¼
N þβÞ
customer returns through collection and analysis of sales data.
FN1 1 pN þge
oN
N
; q*N þ xN* ¼ aN bN p*N þ zN* ; q*wN þ xN* ¼ aN Furthermore, according to Fig. 1, increasing α and/or β will decrease
the expected profit of the firm. Thus, to be more profitable, the firm
bN p*N þ FN1 oeNNþe N wN
ðshÞ ; and qoN ¼ zN FN
* * 1 oN þeN wN
eN ðshÞ should make sufficient effort to reduce customer returns. These efforts
include identifying customer expectations through, for example, mar-
Then the impact of customer returns can be summarized in Proposi- ket research and customer reviews.
tion 6. In accordance with Fig. 2, as α increases, the firm will reduce both the
initial order quantity and the option order quantity. As β increases, the
Proposition 6. For period i (i ¼ 1; 2; …; N), p*i , zi* and q*oi decrease with β, firm will increase the initial order quantity and reduce the option order
while q*i þ xi and q*wi þ xi* increase with β. quantity. This numerical result also verifies Proposition 2 and Proposi-
tion 3. This result implies that the impact of price change, and the
Proposition 6 suggests that when customer returns increase with
resulting change in initial order quantity and option order quantity, on
selling price, the impact of customer returns on the optimal policy of the
retailer profit may be opposite for the two forms of customer returns,
firm in the multi-period scenario is consistent with the single-period
proportional to the quantity sold ðαÞ and increasing with selling price ðβÞ.
scenario. That is, as β increases, the firm will reduce the retail price
Thus, the firm should identify which form of customer returns is domi-
and the option order quantity, while raising the initial order quantity and
nant before deciding its decision on selling price, initial order quantity,
the total order quantity. Furthermore, the variation in product purchase
and option order quantity.
428
Fig. 1. Impact of customer returns on the firm's optimal decisions and expected profits.
Fig. 2. Impact of customer returns on optimal order quantities.
6.2. The multi-period stochastic problem last period. This is because returned products can be sold in the following
period, which reduces the overage risk, and the benefit of hedging de-
In the multi-period problem, we examine a three-period problem mand risk through options is realized mainly in the last period. The result
ðN ¼ 3Þ. Since the optimal decisions of the firm are highly dependent on implies that customer returns will significantly reduce the firm's profit.
the relationship between wi and wiþ1 , we vary wi . For a decreasing pur-
chase cost ðwi > wiþ1 Þ, we set ðw1 ¼ 10Þ, w2 ¼ 9:5 and w3 ¼ 9; for an
increasing purchase cost ðwi < wiþ1 Þ, we set w1 ¼ 9, w2 ¼ 9:5 and 6.3. Impacts of option contracts
w3 ¼ 10. We first let β ¼ 0 and vary α from 0 to 0.2; results are shown in
Table 2 and Table 3. Then we set α ¼ 0 and vary β from 0 to 1; the results In this subsection, we investigate the impact of option contracts on
are shown in Table 4 and Table 5. the optimal decisions and profit of the firm with customer returns taking
As α increases, if customer returns are proportional to quantity sold, the wholesale price only contract model as a benchmark. This benchmark
the firm should decrease the total order quantity to reduce returns, model is explored by Chen and Bell (2009), so here we present the model
especially in the last period (Proposition 5). If customer returns increase and main results only briefly. Since the main results of the multi-period
with selling price, the firm should decrease the retail price to reduce problem are consistent with those of the single-period problem, we
returns, especially in the last period (Proposition 6). Furthermore, focus on the single-period problem.
whether α increases or β increases, the firm should reduce the initial Under the wholesale price only contract, the profit function of the
order quantity and increase the option order quantity significantly in the firm is πðpNO ; qNO Þ ¼ pNO min½qNO ; D þ ðs hÞ½qNO Dþ
429
C. Wang et al.
Table 2
Impact of customer returns ðαÞ on optimal decisions and maximum expected profits with decreasing ordering cost.
α p*i q*i þ xi* q*wi þ xi* q*oi E½π i ðp*i ; q*wi ; q*oi Þ Total profit
i¼1 i¼2 i¼3 i¼1 i¼2 i¼3 i¼1 i¼2 i¼3 i¼1 i¼2 i¼3 i¼1 i¼2 i¼3
0.00 32.47 32.22 31.97 343.77 346.07 348.48 210.07 218.34 192.90 133.70 127.74 155.58 4745.40 4843.30 4851.20 14439.90
0.05 32.49 32.23 32.16 342.95 345.35 345.84 209.95 218.21 191.07 133.00 127.14 154.78 4487.20 4579.40 4507.20 13573.80
0.10 32.50 32.25 32.36 342.21 344.51 343.01 209.81 218.07 189.03 132.40 126.44 153.98 4229.00 4315.60 4164.00 12708.60
0.15 32.51 32.26 32.59 341.36 343.66 339.93 209.66 217.92 186.75 131.70 125.74 153.18 3970.90 4051.70 3821.60 11844.20
0.20 32.53 32.28 32.84 340.48 342.78 336.57 209.48 217.75 184.19 131.00 125.04 152.38 3712.80 3787.90 3480.20 10980.90
430

Table 3
Impact of customer returns ðαÞ on optimal decisions and maximum expected profits with increasing ordering cost.
α p*i q*i þ xi* q*wi þ xi* q*oi E½π i ðp*i ; q*wi ; q*oi Þ Total profit
0.00 31.97 32.22 32.47 348.48 346.07 343.77 235.30 227.77 174.78 113.18 118.30 169.00 4968.10 4864.90 4667.30 14500.30
0.05 31.96 32.21 32.68 348.01 345.61 340.88 235.43 227.91 172.68 112.58 117.70 168.20 4709.90 4612.40 4325.20 13647.50
0.10 31.94 32.19 32.92 347.47 345.07 337.85 235.59 228.07 170.35 111.88 117.00 167.50 4451.70 4359.90 3984.10 12795.70
0.15 31.93 32.18 33.18 346.94 344.64 334.34 235.76 228.24 167.75 111.18 116.40 166.60 4193.60 4107.40 3644.20 11945.20
0.20 31.91 32.16 33.47 346.44 344.13 330.61 235.95 228.43 164.82 110.48 115.70 165.80 3935.50 3854.90 3305.50 11095.90
C. Wang et al.
Table 4
Impact of customer returns ðβÞ on optimal decisions and maximum expected profits with decreasing ordering cost.
β p*i q*i þ xi* q*wi þ xi* q*oi E½π i ðp*i ; q*wi ; q*oi Þ Total profit
0.00 32.47 32.22 31.97 343.77 346.07 348.48 210.07 218.34 192.90 133.70 127.74 155.58 4745.40 4843.30 4851.25 14439.95
0.25 31.80 31.55 31.22 350.14 352.54 355.64 216.84 225.10 200.46 133.30 127.44 155.18 4563.50 4660.90 4617.49 13841.89
0.50 31.15 30.90 30.50 356.18 358.58 362.43 223.28 231.55 207.66 132.90 127.04 154.78 4390.60 4487.40 4394.88 13272.88
0.75 30.54 30.29 29.81 362.03 364.33 368.80 229.43 237.69 214.52 132.60 126.64 154.28 4226.00 4322.20 4182.63 12730.83
1.00 29.95 29.70 29.15 367.49 369.89 374.95 235.29 243.55 221.08 132.20 126.34 153.88 4069.20 4164.80 3980.05 12214.05
431

Table 5
Impact of customer returns ðβÞ on optimal decisions and maximum expected profits with increasing ordering cost.
β p*i q*i þ xi* q*wi þ xi* q*oi E½π i ðp*i ; q*wi ; q*oi Þ Total profit
0.00 31.97 32.22 32.47 348.48 346.07 343.77 235.30 227.77 174.78 113.18 118.30 169.00 4968.08 4864.90 4667.30 14500.28
0.25 31.31 31.56 31.70 354.72 352.42 351.05 241.94 234.42 182.46 112.78 118.00 168.60 4792.93 4690.40 4425.90 13909.23
0.50 30.68 30.93 30.97 360.75 358.35 357.87 248.27 240.75 189.77 112.48 117.60 168.10 4626.41 4524.50 4196.00 13346.91
0.75 30.07 30.32 30.28 366.38 363.98 364.45 254.30 246.78 196.75 112.08 117.20 167.70 4467.90 4366.60 3976.80 12811.30
1.00 29.50 29.75 29.61 371.84 369.44 370.70 260.06 252.54 203.41 111.78 116.90 167.30 4316.85 4216.10 3767.70 12300.65
Table 6
Impact of option contracts on the firm's optimal decisions and maximum expected profits.
Price Total order quantity Profit Profit surplus
p*NO p* q*NO q* E½πð*NO Þ E½πð*Þ ðE½πð*Þ E½πð*NO ÞÞ=E½πð*NO Þ
α 0.0 31.75 31.97 292 348 4466 4885 9.38%

0.1 31.95 32.19 288 345 3858 4266 10.58%
0.2 32.22 32.47 284 341 3252 3648 12.18%
β 0.0 31.75 31.97 292 348 4466 4885 9.38%
0.5 30.35 30.57 305 362 4062 4475 10.17%
1.0 29.07 29.29 317 374 3695 4102 11.01%
E½πð*NO Þ represents E½πðp*NO ; zNO

*
Þ; E½πð*Þ represents E½πðp* ; q*o ; z* Þ.
ðpNO sÞmin½RðpNO ; DÞ; RðpNO ; qNO Þ wqNO g½D qNO þ , where D≡D customer returns strongly depends on the variation in product purchase
ðpNO ; εÞ ¼ yðpNO Þ þ ε. The expected profit of the firm is E½πðpNO ; zNO Þ ¼ costs (order costs and purchase costs of options) in each period. When
½ð1 αÞpNO þ αs w½y ðpNO Þ þ μ ðpNO sÞβpNO ½w ðs hÞΛðzNO Þ customer returns increase with selling price, for both the single- and
½ð1 αÞpNO þ αs þ g wΘðzNO Þ, where yðpNO Þ ¼ a bpNO , zNO ¼ multi-period problems, the firm should cut price and order more products
z B with fewer options. Furthermore, numerical examples show that the
qNO yðpNO Þ, ΛðzNO Þ ¼ ∫ ANO ðzNO εÞf ðεÞdε, ΘðzNO Þ ¼ ∫ zNO ðε zNO Þf
presence of customer returns significantly decreases the firm's profit.
ðεÞdε. The firm's joint optimal decision on the price and order quantity
Option contract is useful in mitigating the negative impact of customer
ð1αÞΘðz* Þ
is p*NO ¼ p*NOd 2½ð1αÞbþβ
NO
, q*NO ¼ yðp*NO Þ þ zNO
*
, where p*NOd ¼ returns. Our result show that when the firm has the choice of an option

ð1αÞðaþμÞþðwαsÞbþsβ * contract, it is motivated to provide a returns policy as customer
, zNO ¼ F 1 1 ðp* sÞð1αÞþgþh
wðshÞ
. We let α be 0, 0.1, and
2½ð1αÞbþβ NO returns increase.
0.2, and β be 0, 0.5, and 1, respectively. The impact of option contracts on This research provides the implications of and new insights on the
the optimal decisions and profit of the firm with customer returns and a optimal pricing and order decisions for the firm that faces two different
wholesale price only contract is shown in Table 6. forms of customer returns and has the choice of an option contract. We
Table 6 shows that as compared to the case without option contracts, show that in the presence of customer returns, the firm can simulta-
the firm with such contracts will price higher ðp* > p*NO Þ, order more neously use pricing strategy, order quantity, and option contracts to
enhance its profit. For single-period selling, the firm's pricing and con-
ðq* > q*NO Þ, and be more profitable ðE½πð*Þ > E½πð*NO ÞÞ. This result is
tracting strategies depend on the form of customer returns. Thus, the
consistent with the situation when there are no customer returns (this
management of the firm should carefully collect and analyze the market
case is considered by Wang and Chen (2015), looking at a special case of
sales data to identify which form of customer returns it faces. For multi-
our model). In a joint pricing and order situation, an option contract
period selling, the firm's pricing and contracting strategies depend not
results in two effects, as compared to a wholesale price contract: a higher
only on the form of customer returns but also on the variation in product
ordering cost ðo þ e > wÞ (negative effect) and a higher flexibility (posi-
purchase costs in each period. Therefore, the firm should identify which
tive effect). The negative effect induces a higher retail price and hurts the
form of customer returns is dominant and estimate order costs for periods
firm, while the positive effect causes a higher order quantity and benefit
in the planning horizon. Our research also implies that to mitigate the
the firm. Since the firm with option contracts will always be more prof-
negative impact of customer returns, besides pricing strategy, the firm
itable, the numerical result implies that the positive effect dominates the
can consider the option contract.
negative effect of the option contracts. Furthermore, when α and/or β
The current research can be extended by considering three issues: (1)
increases, the profit of the firm with or without option contracts de-
in this paper, we only study optimal pricing and order decisions from a
creases, but the firm with option contracts will have an increasing profit
single firm's perspective. The study could be extended to a supply chain
surplus as compared to the firm without. For example, as α increases from
setting, in which the option pricing strategy of the supplier and the co-
0 to 0.1 and 0.2, the profit surplus increases by 9.38%, 10.58% and
ordination of the chain in different channel structures, namely vertical
12.18%; and as β increases from 0 to 0.5 and 1, the profit surplus in-
competition can be further examined (Chen and Wang, 2015; Chen et al.,
creases by 9.38%, 10.17% and 11.01%. Thus, option contract can be a
2016, 2017; Chen and Chen, 2017); (2) it would also be interesting to
tool to mitigate the negative impact of customer returns as with the
consider a multi-supplier or multi-retailer setting to examine the impact
option contract, the more the customer returns (either proportional to
of horizontal competition on the decisions and profit of the chain
product sold and/or increasing with selling price), the more the firm is
members; (3) as option contracts can deal with not only demand risks but
motivated to provide a returns policy.
also supply risks, supply risks on the supplier's side, such as random yield
or supply disruption, could be considered (Luo and Chen, 2015).
7. Conclusion
Acknowledgments
This paper examines the impact of customer returns on a firm's
pricing and order decisions with both a wholesale price contract and an
The authors are supported by the Natural Sciences and Engineering
option contract for single- and multi-period settings. We examine the
Research Council of Canada (No. 372400) and the National Natural
impact of two typical forms of customer returns: proportional to product
Science Foundation of China (Nos. 71602134, 71671081, 71331004,
sold and increasing with selling price. We demonstrate that when
71432003, 91646109), the National Social Science Foundation of China
customer returns increase with products sold, for the single-period
(No. 15ZDB169), and the China Scholarship Council (No.
problem, the firm should set a higher price, and order fewer products
201606915003).
and options. For the multi-period problem, however, the impact of
Appendix
Proof of Lemma 1
432
∂E½πðp;qo ;zÞ ∂2 E½πðp;qo ;zÞ

When ðqo ; zÞ is given, ∂p ¼ ð1 αÞða bp þ μÞ ½pð1 αÞ w þ αsb βp ðp sÞβ ð1 αÞΘðzÞ and ∂p2 ¼ 2½ð1 αÞb þ β < 0.
∂E½πðp;qo ;zÞ ð1αÞΘðzÞ
Thus, E½πðp; qo ; zÞ is concave in p. Then, for a given ðqo ; zÞ, p is set by *
∂p ¼ 0, i.e., p ≡pðzÞ ¼*
p*d 2½ð1αÞbþβ, where p*d ¼ ð1αÞðaþμÞþðwαsÞbþβs
2½ð1αÞbþβ .
Proof of Lemma 2
dp*d dp*d
For β ¼ 0, from Lemma 1, we have p* ¼ ð1αÞðaþμÞþðwαsÞb ΘðzÞ ΘðzÞ dp * dp *
2b ¼ pd 2b , and dα ¼ ¼ 2ð1αÞ 2 . As w s > 0, dα ¼ > 0. For α ¼ 0, from Lemma 1,

* ws
2ð1αÞb dα dα
aþμþwbþβs ΘðzÞ ΘðzÞ dp*d dp* ΘðzÞ½aþμþbðwsÞ B z
we have p ¼ *
2ðbþβÞ 2ðbþβÞ ¼ p*d 2ðbþβÞ, and dβ dβ ¼ 2ðbþβÞ2
. As ΘðzÞ ¼ ∫ z ðε zÞf ðεÞdε ¼ μ z þ ∫ A FðεÞdε and
z
dp*d dp* abðwsÞ∫ A ½1FðεÞdε
w s > 0, dβ dβ ¼ 2ðbþβÞ2 < 0.
Proof of Lemma 3
∂E½πðp;qo ;zÞ ∂2 E½πðp;qo ;zÞ
When p is given, ∂qo ¼ ½e ðs hÞFðz qo Þ ðo þ e wÞ, ∂q2o
¼ ½e ðs hÞ f ðz qo Þ < 0,
∂E½πðp;qo ;zÞ
∂z ¼ ½e ðs hÞFðz qo Þ ½pð1 αÞ þ g þ sα eFðzÞ þ pð1 αÞ þ g þ sα w,
∂2 E½πðp;qo ;zÞ ∂2 E½πðp;qo ;zÞ
¼ ∂ E½πðp;qo ;zÞ ∂2 E½πðp;qo ;zÞ
2
∂z2 ¼ ½e ðs hÞ f ðz qo Þ ½pð1 αÞ þ g þ sα e f ðzÞ < 0, ∂qo ∂z ∂z∂qo ¼ ½e ðs hÞ f ðz qo Þ. Since ∂q2o
¼
2
∂ E½πðp; qo ; zÞ ∂ E½πðp; qo ; zÞ
2

∂q2o ∂qo ∂z

½e ðs hÞ f ðz qo Þ < 0 and ¼ ½pð1 αÞ þ g þ sα e½e ðs hÞ f ðz qo Þf ðzÞ > 0, the Hessian matrix of
∂2 E½πðp; q ; zÞ ∂2 E½πðp; q ; zÞ
o o

∂z∂qo ∂z2
E½πðp; qo ; zÞ is negative definite. Thus, E½πðp; qo ; zÞ is jointly concave in qo and z. The unique q*o and unique z* are set by ∂E½πðp;q ∂qo
o ;zÞ
¼ 0 and ∂E½πðp;q
∂z
o ;zÞ
¼ 0,

i.e., z* ¼ F 1 1 ðpsÞð1αÞþgþse
o
, q*o ¼ z* F 1 eðshÞ
oþew
. Thus q* ¼ yðpÞ þ z* , and q*w ¼ q* q*o ¼ yðpÞ þ F 1 eðshÞ
oþew
.
Proof of Lemma 4

From Lemma 3, for a given p, z* ¼ F 1 1 ðpsÞð1αÞþgþse
o
and q*o ¼ z* F 1 eðshÞ
oþew
. Let x ¼ ðpsÞð1αÞþgþse
o
. Thus, x increases with α. Because

*
F 1 ½1 x decreases with x, F 1 ½1 x decreases with α, i.e., dz 1 oþew
* dq dz*
dα < 0. With q*
¼ yðpÞ þ z *
, we have dα ¼ dα < 0. Further, as q*
o ¼ z *
F eðshÞ ,

dq*o dz* 1 oþew dq*w
dα ¼ dα < 0. And as qw ¼ yðpÞ þ F eðshÞ , dα ¼ 0.
*
Proof of Proposition 1

We first prove the existence condition for a unique optimal retail price ðp* Þ. From Lemma 3, we have z* ¼ F 1 1 ðpsÞð1αÞþgþse o
and

q*o ¼ z* F 1 eðshÞ
oþew
. Let 1 ðpsÞð1αÞþgþse
o
¼ ρ, then z* ¼ F 1 ðρÞ. Substituting z* ≡zðpÞ, q*o ≡qo ðpÞ into E½πðp; qo ; zÞ, we obtain

1 o þ e w
oþew
F 1 ðρÞ
E½πðpÞ ¼ E½π d ðpÞ þ ½p ðp sÞα e þ g∫ A εf ðεÞdε gμ þ ½ðs hÞ e∫ eðshÞ FðεÞdε ðw o eÞF , where E½π d ðpÞ ¼ ½ðp wÞ ðp sÞαy
A
e ðs hÞ
dE½π d ðpÞ F 1 ðρÞ ð1 αÞo 2 * Þ3
¼ 2½ð1 αÞb þ β þ ð1αÞf ðz½1Fðz
2
ðpÞ ðp sÞβp. Then we have dE½πðpÞdp ¼ þ ð1 αÞ∫ A εf ðεÞdε þ z* , d E½πðpÞ * Þw . Thus, the ex-
ðp sÞð1 αÞ þ g þ s e dp
dp 2
0
2 2
i.e., hðz* Þ> ð1αÞ ½1Fðz Þ
2 *
istence condition for a unique optimal retail price ðp* Þ is d E½πðpÞ
dp2 <0, 2½ð1αÞbþβo .
We then prove the existence condition for a unique stocking factor ðz* Þ. Substituting p* ≡pðzÞ into E½πðp; qo ; zÞ, we obtain

∂E½πðpðzÞ;qo ;zÞ

∂qo ¼ ½e ðs hÞFðz qo Þ ðo þ e wÞ, ∂E½πðpðzÞ;q
∂z
o ;zÞ ð1αÞΘðzÞ
¼ ½e ðs hÞFðz qo Þ þ 1 α pd 2½ð1αÞbþβ þ g þ sα e 1 FðzÞ ðw eÞ.
From Lemma 1, let ∂E½πðpðzÞ;q

∂qo
o ;zÞ
¼ 0, and ∂E½πðpðzÞ;q
∂z
o ;zÞ
¼ 0, respectively. Then, we obtain that the unique z* ðz* 2 ½A; BÞ sat-

* ð1αÞΘðz* Þ

isfies 1 α pd 2½ð1αÞbþβ þ g þ αs e 1 Fðz* Þ o ¼ 0.

With p* ¼ p*d Θðz Þ ∂p* ∂p* dz*
*
dp* 1 dz* dp*
2b , we have dα ¼ ∂α þ ∂z dα . As z *
¼ F 1 o
ðp sÞð1αÞþgþse
* , dα ¼ *
o
f ðz Þ½ðp sÞð1αÞþgþse2 dα ð1 αÞ ðp *
sÞ . With

½1Fðz* Þ2 dp* Θðz* Þ
z* ¼ F 1 1 ðp sÞð1αÞþgþse
*
o o
, we have ðp sÞð1αÞþgþse ¼ 1 Fðz* Þ. Then, dz dα ¼ f ðz* Þo dα ð1 αÞ ðp sÞ . With p ¼ pd 2b , we have
* * *
" #" #
Þ ∂p*d 3
∂p* ∂p*
½1Fðz Þ 2bf ðz* Þo
* *
dp*
∂z ¼ 1Fðz
2b , ∂α ¼ ∂α ¼ 2ð1αÞ
ws
2 . Then we obtain dα ¼ ws
2ð1αÞ2 2bf ðz* Þo
ðp* sÞ 2bf ðz* Þoð1αÞ½1Fðz* Þ3
. From Proposition 1, when β ¼ 0, we have
dp* dp*
2bf ðz* Þo ð1 αÞ½1 Fðz* Þ3 > 0. Then the second term of dα is greater than 0. Since ss, the first term of dα , i.e.,
3 2
½1Fðz* Þ2 2
ðwsÞbf ðz* Þð1αÞ½1Fðz* Þ2
½1Fðz Þ ½1Fðz Þ ðp sÞ ½1Fðz Þ
* * * *
ws
2ð1αÞ2 2bf ðz* Þo
ðp* sÞ ¼ 2ð1αÞ
ws
2 2bf ðz* Þ½ðpsÞð1αÞþgþse >
ws
2ð1αÞ2
2bf ðz* Þð1αÞ
. Since w s > o, ws
2ð1αÞ2
2bf ðz* Þð1αÞ
¼ 2bf ðz* Þð1αÞ2
Þoð1αÞ½1Fðz* Þ2
> bf ðz
* *
Generally, as price increases, the firm should reduce order quantity, that is: dq
2bf ðz* Þð1αÞ2
. dp*
< 0. Since q* ¼ a bp* þ z* ; we need

dq* 1 ð1αÞ½1Fðz* Þ2 *
dp*
dz*
¼ b þ dp* < 0. With z ¼ F
*
1 ðp* sÞð1αÞþgþse
o dz*
, we have dp* ¼ f ðz* Þo
. Then dq
dp*
< 0 requires bf ðz* Þo ð1 αÞ½1 Fðz* Þ2 > 0. Thus, the first
dp* *
term of dα is also greater than 0. Then, we obtain dp
dα > 0.

2
¼ ∂q þ ∂q ¼ ½1Fðz Þ *
dq* * dp* *
dz* dz* dp*
Next, with q* ¼ a bp* þ z* , we have dα ∂p* dα ∂z* dα . Remember that dα f ðz* Þo dα ð1 αÞ ðp* sÞ . Then
433
" #
bf ðz* Þoð1αÞ½1Fðz* Þ2 * sÞ½1Fðz* Þ2
dq* dp*
ðp
* *
dα ¼ f ðz* Þo dα f ðz* Þo
. We also have bf ðz* Þo ð1 αÞ½1 Fðz* Þ2 > 0 and dp dq
dα > 0. Thus, we obtain dα < 0.

Next, with the proof of Proposition 1, let RðzÞ ¼ ∂E½πðpðzÞ;q∂z
o ;zÞ
. By the implicit function rule, dz*
dα ¼ ∂Rðz* Þ
∂α
∂Rðz* Þ
∂z * . Then, we get

∂Rðz* Þ
p*d Θðz
*Þ
∂α ¼ ð1αÞ
1
2b ð1 αÞ w þ αs þ 2
ws
1 Fðz* Þ < 0. As z* is the largest z in the region ½A; B that satisfies ∂E½πðpðzÞ;q∂z
o ;zÞ
¼ 0, and
RðBÞ ¼ o < 0, we get ∂Rðz Þ * *

∂z*
< 0. Thus dz < 0.
dα
* dq*w dp* dq*o
Finally, with q*w ¼ a bp* þ F 1 eðshÞ
oþew
and dp
dα > 0, we obtain dα ¼ b dα < 0. With qo ¼ z F
* * 1 oþew dz* dz*
eðshÞ and dα < 0, we obtain dα ¼ dα < 0.
" #( )
Θðz Þ aμðwsÞbþΘðz* Þ 2ðbþβÞf ðz* Þo
¼ ∂p ∂p
*
dp* * *
dz*
With p* ¼ p*d 2ðbþβÞ , we have dβ ∂β þ ∂z dβ ¼ 2ðbþβÞ2 2ðbþβÞf ðz* Þo½1Fðz* Þ3
. From Proposition 1, when α ¼ 0, we have
dp* B z*
2ðb þ βÞf ðzÞo ½1 FðzÞ3 > 0. Then the second term of dβ is greater than 0. As Θðz* Þ ¼ ∫ z* ðε z* Þf ðεÞdε ¼ μ z* þ ∫ A FðεÞdε and w s > 0,
z * *
a μ ðw sÞb þ Θðz* Þ ¼ a ðw sÞb ∫ A ½1 FðεÞdε < 0. Thus, the first term of dp dp
dβ is smaller than 0. Then, we obtain dβ < 0.
( )
dq* ∂q* dp* ∂q* dz* 1 dz* ½1Fðz* Þ2 dp* dq* bf ðz* Þo½1Fðz* Þ2 dp*
Next, with q ¼ a bp þ z , we have dβ ¼ ∂p* dβ þ ∂z* dβ . As z ¼ F
* * * *
1 p* þge , dβ ¼ f ðz* Þo dβ . Then dβ ¼
o
f ðz* Þo dβ . Generally,
* * *
as price increases, the firm should reduce order quantity. And dq dp*
< 0 requires bf ðz* Þo ½1 Fðz* Þ2 > 0. Combined with dp dq
dβ < 0, we obtain dβ > 0.

* ½1Fðz* Þ2 dp* dp* dz* 1 oþew dp* dq*w dp*
Next, we have dz dβ ¼ f ðz* Þo dβ . As dβ < 0, we obtain dβ < 0. With qw ¼ a bp þ F eðshÞ and dβ < 0, we obtain dβ ¼ b dβ > 0. Finally, with qo ¼
* * *

dq*o
z* F 1 eðshÞ
*
dz*
dβ < 0, we obtain dβ ¼ dβ < 0.
oþew
and dz
∂E½π i ðpi ;qoi ;zi Þ i ðpi Þ
For period i ði ¼ 1; 2; …; N 1Þ, when ðqoi ; zi Þ is given, ∂pi ¼ ð1 αÞ½yi ðpi Þ þ μi þ ½pi ð1 αÞ wi þ αwiþ1 dydp i
2βpi þ βwiþ1
∂ E½π i ðpi ;qoi ;zi Þ
2
∂E½π i ðpi ;qoi ;zi Þ
ð1 αÞΘi ðzi Þ and ∂p2i
¼ 2½ð1 αÞbi þ β < 0. Thus, E½π i ðpi ; qoi ; zi Þ is concave in pi . Then, for a given ðqoi ; zi Þ, p*i is set by ∂pi ¼ 0, i.e.,
ð1αÞΘi ðzi* Þ ð1αÞðai þμi Þþðwi αwiþ1 Þbi þβwiþ1
p*i ≡pi ðzi Þ ¼ p*di 2½ð1αÞbi þβ, where p*di ¼ 2½ð1αÞbi þβ . Substituting p*i ≡pi ðzi Þ into π i ðpi ; qoi ; zi Þ, we obtain
∂E½π i ðpi ðzi Þ;qoi ;zi Þ ∂2 E½π i ðpi ðzi Þ;qoi ;zi Þ
∂qoi ¼ ½wiþ1 þ ei þ hFi ðzi qoi Þ ðoi þ ei wi Þ, ∂q2oi
¼ ½ei wiþ1 þ hfi ðzi qoi Þ < 0 (recall that ei þ h > wiþ1 ),
∂E½π i ðpi ðzi Þ;qoi ;zi Þ
∂zi ¼ ½ei wiþ1 þ hFi ðzi qoi Þ þ ½p*i ð1 αÞ þ g þ αwiþ1 ei ½1 Fi ðzi Þ ðwi ei Þ,
∂2 E½π i ðpi ðzi Þ;qoi ;zi Þ
¼ ½ei wiþ1 þ hfi ðzi qoi Þ ½p*i ð1 αÞ þ g þ αwiþ1 ei fi ðzi Þ < 0, ∂ E½πi ðp i ðzi Þ;qoi ;zi Þ
¼∂ E½π i ðpi ðzi Þ;qoi ;zi Þ
2 2
∂zi2 ∂qoi ∂zi ∂zi ∂qoi ¼ ½ei wiþ1 þ hfi ðzi qoi Þ. Since
2
∂ E½π i ðpi ðzi Þ; qoi ; zi Þ ∂2 E½π i ðpi ðzi Þ; qoi ; zi Þ

∂qoi ∂zi
∂q2oi
∂2 E½π i ðpi ðzi Þ;qoi ;zi Þ
< 0 and ¼ ½ð1 αÞp* þ g þ αwiþ1 ei ½ei wiþ1 þ hfi ðzi Þfi ðzi qoi Þ > 0, the Hessian matrix of
∂qoi2 i
∂ E½π i ðpi ðzi Þ; qoi ; zi Þ ∂ E½π i ðpi ðzi Þ; qoi ; zi Þ
2 2

∂zi ∂qoi ∂zi2
E½π i ðpi ðzi Þ; qoi ; zi Þ is negative definite. Thus, E½π i ðpi ðzi Þ; qoi ; zi Þ is jointly concave in qoi and zi , and E½π i ðpi ; qoi ; zi Þ is a concave function of pi , qoi and zi . Let
∂E½π i ðpi ðzi Þ;qoi ;zi Þ ∂E½π i ðpi ðzi Þ;qoi ;zi Þ
∂qoi ¼ 0, and ∂zi ¼ 0, respectively. Then, we find that the unique zi* (zi* 2 ½Ai ; Bi ) satisfies

ð1αÞΘ ðzi* Þ
oi þei wi
1 α p*di 2½ð1αÞbi i þβ þ g þ αwiþ1 ei 1 Fi ðzi* Þ ¼ oi , q*oi ¼ zi* Fi1 ei ðw iþ1 hÞ
.

When ðpi Þ is given, we can obtain zi* ¼ Fi1 1 pi ð1αÞþgþαw oi
iþ1 ei
. Let 1 pi ð1αÞþgþαw
oi
iþ1 ei
¼ ρi , then zi* ¼ Fi1 ðρi Þ. Substituting zi* ≡zi ðpi Þ, q*oi ≡qoi ðpi Þ
oi þei wi
F 1 ðρ Þ e ðw hÞ
into E½π i ðpi ; qoi ; zi Þ, we obtain E½π i ðpi Þ ¼ E½π di ðpi Þ þ ½pi ðpi wiþ1 Þα ei þ g ∫ Aii i εi fi ðεi Þdεi gμi þ ½ðwiþ1 hÞ ei ∫ Ai iþ1 Fi ðεi Þdεi

F 1 ðρ Þ
ðwi oi ei ÞFi1 ei ðw oi þei wi
iþ1 hÞ
, where E½π di ðpi Þ ¼ ½ðpi wi Þ ðpi wiþ1 Þαyi ðpi Þ ðpi wiþ1 Þβpi . And dE½πdpi ðpi i Þ ¼ dE½πdpd ðp
i
i Þ
þ ð1 αÞ∫ Aii i εi fi ðεi Þdεi
ð1αÞoi 2
E½π i ðpi Þ ð1αÞ2 ½1Fi ðzi* Þ3 2
E½π i ðpi Þ
þzi* ðpi wiþ1 Þð1αÞþgþwiþ1 ei
,d dp2i
¼ 2½ð1 αÞbi þ β þ fi ðzi* Þoi
. Then the existence condition for a unique optimal retail price ðp*i Þ is d dp2i
< 0,
ð1αÞ2 ½1Fi ðzi* Þ2
i.e., hi ðzi* Þ > 2½ð1αÞbi þβoi .
For period N, the expected profit function is the same as the single-period problem. Thus, the proof is the same as the proof of Proposition 1.
" #" #
dp*i wi wiþ1 ½1Fi ðzi* Þ3 ðp*i wiþ1 Þ 2bi f ðzi* Þoi
Similar to the proof of Proposition 2, we obtain dα ¼ 2ð1αÞ2
2bi fi ðzi* Þoi 2bi fi ðzi* Þoi ½1Fi ðzi* Þ3 ð1αÞ
dp*i dp*i
2bi fi ðzi* Þoi ð1 αÞ½1 Fi ðzi* Þ3 > 0. Then the second term of
dα is greater than 0. Since g > ei , the first term of dα , i.e.,
wi wiþ1 ½1Fi ðzi* Þ3 ðp*i wiþ1 Þ wi wiþ1 ½1F ðz* Þ2 ðwi wiþ1 Þbi fi ðzi* Þð1αÞ½1Fi ðzi* Þ2
2ð1αÞ2
2bi fi ðzi* Þoi
> 2ð1αÞ2 2b f ðz*i Þð1αÞ
i
¼ 2bi fi ðzi* Þð1αÞ2
. Generally, as price increases, the firm should reduce order quantity, that is:
i i i
dðq*i þxi* Þ dðq*i þxi* Þ dp*i
dp*i
< 0. Then dp*i
<0 requires oi bi fi ðzi* Þ ð1 αÞ½1 Fi ðzi* Þ2 > 0. Thus, if wi > wiþ1 and wi wiþ1 > oi , the first term of dα is greater than 0; if
dp* dp*
wi < wiþ1 , it is smaller than 0. Then, we obtain that if wi > wiþ1 and wi wiþ1 > oi , dαi > 0; if wi < wiþ1 , dαi < 0.
434
" #
dðq*i þxi* Þ oi bi fi ðzi* Þð1αÞ½1Fi ðzi* Þ2 dp*i ðp*i wiþ1 Þ½1Fi ðzi* Þ2
Next, with q*i þ xi* ¼ ai bi p*i þ zi* , we have dα ¼ fi ðzi* Þoi dα fi ðzi* Þoi
. We also have
dðq*i þxi* Þ dðq*i þxi* Þ

oi bi fi ðzi* Þ ð1 αÞ½1 Fi ðzi* Þ2 > 0. Thus, we obtain that if wi > wiþ1 and wi wiþ1 > oi , < 0; if wi < wiþ1 , whether is larger or smaller than
" # dα dα
oi bi fi ðzi* Þð1αÞ½1Fi ðzi* Þ2 dp*i ðp*i wiþ1 Þ½1Fi ðzi* Þ2
0 depends on the sign of fi ðzi* Þoi dα fi ðzi* Þoi
.

dzi* ∂Ri ðzi* Þ ∂Ri ðzi* Þ
Next, with the proof of Proposition 4, let Ri ðzi Þ ¼ ∂E½πi ðpi ðzi Þ;qoi ;zi Þ
∂zi . By the implicit function rule, dα ¼ ∂α ∂zi* . Then, we get

∂Ri ðzi* Þ wi wiþ1 ∂Ri ðzi* Þ ∂Ri ðzi* Þ
∂α ¼ ð1αÞ pi ð1 αÞ wi þ αwiþ1 þ 1 Fðz* Þ. If wi > wiþ1 , ∂α < 0. If wi < wiþ1 , whether ∂α < 0 is larger or smaller than 0 depends on
1 *
2
∂E½π i ðpi ðzi Þ;qoi ;zi Þ

the sign of p*i ð1 αÞ wi þ αwiþ1 þ wi w
2
iþ1
. As zi* is the largest zi in the region ½Ai ; Bi that satisfies ∂zi ¼ 0, and Ri ðBi Þ ¼ oi < 0, we get
∂Ri ðzi* Þ dzi* dzi*
∂zi*
< 0. Thus, if wi > wiþ1 , < 0. If wi < wiþ1 , whether dα is larger or smaller than 0 depends on the sign of
dα αÞ wi þ αwiþ1 þ wi w 2
iþ1
. p*i ð1

oi þei wi dðq þx Þ
* *
dp *
dðqwi þxi Þ
* *
Finally, with q*wi þ xi* ¼ ai bi p*i þ Fi1 ei ðw iþ1 hÞ
, we obtain widα i ¼ bi dαi . Then, if wi > wiþ1 and wi wiþ1 > oi , dα < 0; if wi < wiþ1 ,

dðq*wi þxi* Þ oi þei wi dq* dz* dq* dq*
dα > 0. With q*oi ¼ zi* Fi1 ei ðw iþ1 hÞ
, we obtain dαoi ¼ dαi . Then, if wi > wiþ1 , dαoi < 0. If wi < wiþ1 , whether dαoi is larger or smaller than 0 depends on
the sign of p*i ð1 αÞ wi þ αwiþ1 þ wi w

2
iþ1
.
" #( )
dp*i ai μi ðwi wiþ1 Þbi þΘi ðzi* Þ 2ðbi þβÞfi ðzi* Þoi
Similar to the proof of Proposition 3, we obtain dβ ¼ 2ðbi þβÞ2 2ðbi þβÞfi ðzi* Þoi ½1Fi ðzi* Þ3
dp*i B
2ðbi þ βÞfi ðzi* Þoi ½1 Fi ðzi* Þ3 > 0. Then the second term of dβ is greater than 0. As Θðz* Þ ¼ ∫ z* ðε z* Þf ðεÞdε < yi ðpi Þ ¼ ai bi p*i and wi þ h > wiþ1 ,
dp*i dp*i
ai μi ðwi wiþ1 Þbi þ Θi ðzi* Þ < μi ½p*i ðwiþ1 wi Þbi < μi ðp*i hÞbi < 0. Thus, the first term of dβ is smaller than 0. Then, we obtain dβ < 0.
( )
dðq*i þxi* Þ bi fi ðzi* Þoi ½1Fi ðzi* Þ2 dp*i
Next, with q*i þ xi* ¼ ai bi p*i þ zi* , we have dβ ¼ fi ðzi* Þoi dβ . Generally, as price increases, the firm should reduce order quantity,
dðq*i þxi* Þ dðq*i þxi* Þ dp* dðq* þx* Þ

that is: dp*i
< 0. Then when α ¼ 0, dp*i
requires bi fi ðzi* Þoi ½1 Fi ðzi* Þ2 > 0. Combined with dβi < 0, we obtain idβ i > 0.
<0

dzi* ½1Fi ðzi* Þ2 dp*i dp*i dzi* 1 oi þei wi dp* dðq* þx* Þ dp*
Next, we have dβ ¼ fi ðzi* Þoi dβ . As dβ < 0, we obtain dβ < 0. With qwi þ xi ¼ ai bi pi þ Fi
* * *
ei ðwiþ1 hÞ and dβi < 0, we obtain widβ i ¼ bi dβi > 0.

oi þei wi dzi* dq*oi dzi*
Finally, with q*oi ¼ zi* Fi1 ei ðwiþ1 hÞ and dβ < 0, we obtain dβ ¼ dβ < 0.
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International Journal of Production Economics 193 (2017) 422–436

Contents lists available at ScienceDirect

International Journal of Production Economics

Pricing and order decisions with option contracts in the presence of

1. Introduction with customer returns, as they have to manage inventory of returned

2½ð1αÞbþβo , there exists a unique

2½ð1αÞbþβo is the existence condition for a

1 α pdN 2½ð1αÞbNN þβ þ g þ αs eN 1 FðzN* Þ ¼ oN , and

Fig. 2. Impact of customer returns on optimal order quantities.

International Journal of Production Economics 193 (2017) 422–436

International Journal of Production Economics 193 (2017) 422–436

Price Total order quantity Proﬁt Proﬁt surplus

p*NO p* q*NO q* E½πð*NO Þ E½πð*Þ ðE½πð*Þ E½πð*NO ÞÞ=E½πð*NO Þ

α 0.0 31.75 31.97 292 348 4466 4885 9.38%

E½πð*NO Þ represents E½πðp*NO ; zNO

∂E½πðp;qo ;zÞ ∂2 E½πðp;qo ;zÞ

2b ¼ pd 2b , and dα ¼ ¼ 2ð1αÞ 2 . As w s > 0, dα ¼ > 0. For α ¼ 0, from Lemma 1,

From Lemma 1, let ∂E½πðpðzÞ;q

RðBÞ ¼ o < 0, we get ∂Rðz Þ * *

dðq*i þxi* Þ dðq*i þxi* Þ

∂E½π i ðpi ðzi Þ;qoi ;zi Þ

the sign of p*i ð1 αÞ wi þ αwiþ1 þ wi w

dðq*i þxi* Þ dðq*i þxi* Þ dp* dðq* þx* Þ

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pNO p qNO q E½πðNO Þ E½πðÞ ðE½πðÞ E½πðNO ÞÞ=E½πð*NO Þ

E½πðNO Þ represents E½πðpNO ; zNO

dðqi þxi Þ dðqi þxi Þ

dðqi þxi Þ dðqi þxi Þ dp* dðq* þx* Þ