Mises Wire

Returns, Refunds, and Opportunity Cost

Economics is not hard. In fact, as soon as you realize what economic theory means, it is obvious. But the application of it seems hard. For example, all students learn the concept of opportunity cost, but they have no idea how to use this insight. And they typically fail when they try.

Similarly, that value is subjective is obvious when you think about it. And it is equally obvious that voluntary exchange happens when both parties value what the other has more than when they give up in exchange. But somehow the abstract insight isn’t applied. In my experience, most people typically understand and even agree with the economic insight while acting as though they have never heard of it.

Consider common business practice today, where businesses offer their goods with a “money back guarantee” to make sure the customer goes through with the purchase and is satisfied with it. This is good economics, since the customer anticipates finding greater satisfaction in the good than in the money.

But if this turns out not to be the case, he or she will feel disappointment. This could reflect badly on the business, since the customer may, after the fact, feel cajoled and tricked into purchasing the good. So if the business offers to give their money back, this means those customers who made an error in assessing the value of the good can reverse the exchange. In other words, the customer will get the greater value: the good or the money. And they will know that they made the right choice, because either the good was worth it and then they’re satisfied with the exchange — or it wasn’t, and then they reverse the trade.

This is, however, very different from offering the same guarantee for faulty products. Many businesses think that they are generous to offer money back if the product turns out dysfunctional or broken. Perhaps they sold out and thus cannot replace the good, but instead offer a full refund to customers whose products don’t work.

This is, from a value perspective, very different from the money back guarantee. It perhaps looks the same from the point of view of business accounting, but the customer experience is very different. A business that attempts to make up for a broken product by offering to refund the full price will always end up with disappointed customers. This befuddles business owners and entrepreneurs, apparently. But it is really as obvious as the money back guarantee, and is the very same concept.

A customer who is happy with a product they purchased is necessarily valuing it higher than the price paid. It’s again about subjective value and unequal valuation as a precondition for voluntary exchange. Because they value the product higher than the price they paid, they will not be happy with getting their money back if the product stops working. They will be less disappointed than if they had received nothing at all, but it is an error to believe the customer is fully made whole by getting a refund.

If the business cares about satisfied customers, which it should, then offering something of lesser value in return for a faulty product (which is the fault of the business, not the customer!) is not the way to do it. If the product cannot be swiftly replaced by an equally serviceable good, then to fully repair the customer would require a full refund and then some. This could be in the form of an apology or an additional amount; very often the gesture is worth a lot.

To run a business is to practice economic action, and to do so successfully it is important to understand economic theory not only in the abstract. One also needs to understand what it means to apply economic theory.

A business owner who cannot understand why a customer is not happy — or even very disappointed — with getting a full refund for a faulty product has failed to grasp very fundamental economic concepts: that value is subjective and that it was the customer’s ranking of wants that made him or her go through with the purchase. Rolling back the exchange will not make the customer whole, but may make the customer suffer a loss.

Economics is not hard. But applying it often is.

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