The puzzle of online arbitrage and increased product returns: A game‐theoretic analysis

Online arbitrage, a recent trend on e‐commerce platforms, occurs when a firm (the “arbitrage firm”) copies the product description of another firm (the “designer firm,” who is the original seller of the product) and sells the product at a marked‐up price on a different platform from the designer firm. Once receiving a consumer's order, the arbitrage firm creates an order at the designer firm with a fake account and the consumer's shipping information. In this process, the designer firms fulfill all the purchase orders, and the arbitrage firm earns a profit without even touching the product. While the designer firm can enjoy a market expansion benefit, it also suffers from a high volume of product returns as some consumers eventually learn the true product price (from the receipt) and return the product they ordered from the arbitrage firm. We analyze the online arbitrage practice with a game‐theoretic model and show how the entry of an arbitrage firm can hurt the designer firm's profit. In the current practice, many designer firms cope with this issue by simply adjusting the price, but we show that such a strategy does not necessarily alleviate the problem. We propose a different strategy: the designer firm adjusts its refund policy to curb the greedy behavior of the arbitrage firm. We show that the proposed strategy leads the arbitrage firm to decrease its retail price, resulting in a smaller number of returns and higher profit for the designer firm.