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Let’s say that a clothing retailer currently oers a very strict return policy. Because

it has to pay an average of \$10 to clean and restock any returned items, it only gives

back the price of the item minus \$10 when you return it. A new CEO takes over and

decides to change the policy to oer 100% of the price back for returned goods. She

gured that only 1% of items were returned, so this should only add \$.10 to the cost

of each item.

(a) Suppose that shoppers at the clothing store will either love or hate any given item

of clothing, but they aren’t sure at the time they see it in the store. Instead, they

have a probability of loving the item { 98%, 50%, 10%, etc. Then they decide

whether to buy the item or not; if they buy it, they learn whether they love it or

hate it; then they return the item if they hate it.

Explain why, in the logic of adverse selection, the extra cost of \$.10 per item from

the policy change might be an underestimate: Why might more goods be returned

than before?

(b) Now suppose that shoppers don’t necessarily love or hate every piece, but some

of them might end up somewhere in the middle. Explain why, in the logic of

moral hazard, the more relaxed return policy might also lead to more returns

even among the shoppers who would have have bought an item of clothing under

the old strict return policy.

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