Product quality and return policy in a supply chain under risk aversion of a supplier

This study aims to identify the relationship between return policy and product quality decisions in a decentralized system. We consider a supply chain situation, as in a retail or OEM supply chain system, where a buyer decides a return policy for consumers and delegates the product quality decision to a supplier. We consider the supplier׳s different risk attitudes, whether risk averse or risk neutral. A penalty contract is introduced to control the supplier׳s hidden action, conveying external failures due to returns to the supplier. We show the conditions for supply chain coordination and demonstrate that product quality enhancement needs to precede a generous return policy setting in view of the prevalent business environment and current supply chain management practices. Moreover, we indicate the optimal conditions for a generous return policy setting without quality enhancement.