Return Policy as a Signaling Device in Horizontally Differentiated Products

We consider a market for horizontally differentiated product in which the information about the location of the product is asymmetric between a monopolist and buyers. The vertical characteristic of the product (i.e., quality) is assumed to be common knowledge. Product differentiation is modeled a la Hotelling. Three types of sellers are assumed: A and C at two endpoints and B at the center. We analyze two signaling games, one with price being a signaling device and another with return policy. We show that return policy is a more efficient signaling device than price. When return policy can be adopted, (a) for most parameter values, there exists a separating equilibrium in which only seller B uses the return policy; (b) A pooling equilibrium in which all sellers use the return policy also exists; (c) Whenever return policy is adopted by some seller, it improves social welfare.