A free gift card alternative to price discounts in the newsvendor problem

In this paper, we develop a newsvendor model in which the retailer gives “free” gift cards to consumers who purchase a regularly priced product at the end of the selling season instead of discounting the product. The model is developed for a market with patient consumers. We derive the sufficient optimality condition for the retailer's stocking level in the first period and the optimal gift card value in the second period. We also investigate the conditions under which giving gift cards results in higher expected profits than discounting the product. We find that five factors determine the effectiveness of gift cards. The first three factors are consumers' valuation per $1 of gift card, gift card redemption rates, and the average gross margin of the retailer. The last two factors are the degree to which consumers use gift cards to pay for products which they would have purchased from the retailer in the future with cash, and the additional spending above the gift card value consumers make when they redeem the card. The last two factors have a strong interaction. We also find that gift cards can be profitable when patient consumers consistently value each $1 by their redemption probability, even with 100% redemption. Numerical analysis shows that in the presence of patient consumers, increases in the redemption rate may lead to an increase in the expected profit. Similar counter-intuitive behavior of the expected profit occurs with changes in other problem parameters. The analysis also shows that gift cards' profit advantage over discounting increases with the variability of demand. The analysis also indicates that gift cards are most effective for low to medium priced products sold by high margin retailers.