Signaling Quality with a Money-Back Guarantee: The Role of Transaction Costs

Abstract

Direct marketing is witnessing explosive growth. As consumers increasingly purchase products from their homes, their ability to judge the quality of products they buy is significantly reduced. In this paper we study how money-back guarantees can signal product quality in such environments. We interpret product quality broadly to mean both the level of attributes promised as well as the firm's consistency in delivering on those promises. Key aspects of our formulation are the explicit consideration of transaction costs, and alternative signals of product quality. Transaction costs are the costs the seller or buyer faces when redeeming a money-back guarantee. We show that money-back guarantees signal quality by exploiting the higher probability of returns for a lower quality product, and the attendant higher transaction costs. However, if the seller's transaction costs are very large, then there are less costly ways to signal, namely charging a high price. We compare the signaling performance of (1) price, (2) price with uninformative advertising, and (3) price with a money-back guarantee. Whereas uninformative advertising does not work at all in our model, under certain conditions a money-back guarantee is necessary to signal, and under other conditions, a money-back guarantee is a useful supplement to price.money back guarantee, warranty, signaling quality, transaction costs, separating equilibrium

Internet Auction Features as Quality Signals

“…Although previous studies have documented quality signaling as a solution for information asymmetry (e.g., Anderson and Simester 2001;Balachander and Srinivasan 1994;Chu 1992;Desai 2000;Desai and Srinivasan 1995;Kalra and Li 2008;Kirmani and Rao 2000;Moorthy and Srinivasan 1995;Soberman 2003;Spence 1973;Srinivasan 1991;Wernerfelt 1988), we find no empirical tests of general signaling theory in an Internet auction setting (cf. Dewally and Ederington 2006).…”

“…Because multiple picture postings require nonrefundable costs, regardless of a sale, lowquality sellers are less likely to incur that cost, especially because multiple pictures may just reveal the true (poor) quality of the product. Thus, it is more costly for lowquality sellers to adopt this tool (Desai 2000;Kalra and Li 2008;Moorthy and Srinivasan 1995), and consumers can rely on this indicator to separate high-quality from lowquality products.…”

Valuation and management of money-back guarantee options

“…Early work modeled MBGs as a bundled, homogenous risk-reducing mechanism that increased demand (Mann & Wissinik, 1988, 1990Welling, 1991;Geistfeld & Key, 1991;Phillips, 1993;Davis, Gerstner & Hagerty, 1995) or as a signal for quality of either the product (Heal, 1977) or the retailer (Moorthy & Srinivasan, 1995). These studies treated MBGs as a single, well-defined product, ignoring variations in consumer product evaluation and uncertainty and market evidence showing that companies offer differentiated MBGs.…”

Pareto Improving Supply Chain Coordination Under a Money-Back Guarantee Service Program

“…One very useful way of convincing consumers to feel comfortable to purchase is the MBG service program. In fact, Moorthy and Srinivasan (1995) indicate specifically that the money-back guarantee service helps signal the product quality. Van den Poel and Leunis (1999) propose that the money-back guarantee service is recognized as one of the most important risk relievers for the Internet retailing, followed by offering a well-known brand and a price reduction scheme.…”

“…Undoubtedly, the ability to return the purchased items with a moneyback guarantee would attract more customers and stimulate demand. In particular, when the consumer cannot judge the quality of product prior to purchasing (e.g., in e-tailing), the money-back guarantee service can boost confidence, reduce risk (Heiman et al 2001), and signal the guaranteed product quality (Moorthy and Srinivasan 1995). In fact, money-back guarantee is commonly recognized as the most important risk reliever in e-tailing, followed by offering a well-known brand and a price reduction (Van den Poel and Leunis 1999).…”