Abstract
This study examines the extent to which warranties can represent risk sharing arrangements between consumers and the firm. In particular, we argue that this approach can explain limited warranties and limited warranty duration. The existing literature on warranties is ambivalent about the relationship between quality of products and warranties. In contrast, we argue that there is a definite relationship between warranties, technological complexity of products, and the degree to which consumers exercise due diligence in the use of the product. We also examine the relationship between warranty and the intensity of use by the consumer. It has also been demonstrated that risk aversion can explain the choice of extended warranties though the result is somewhat circumscribed. We also show that warranties and risk sharing aggravate the lemons problem instead of mitigating it.
Based on content from “Limited Warranties, Extended Warranties and Risk Sharing” first published in The Indian Journal of Economics, 90(357), 2009, pp. 747–772. Content reproduced here with permission from University of Allahabad.
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Notes
- 1.
A review of many aspects of this problem can be found in Murty and Djamaludin (2002).
- 2.
MacLeod (2007), for instance, noted that the quality of a product is its characteristic that the buyer would like the seller to select. It may not be the ex post or realized quality performance of the product. As such, considering y as the choice variable of the firm is in order. Murty and Blischke (2000, p.44) also noted that the quality of a product need not be one dimensional. “Other dimensions of quality include maintainability, availability, repairability, and many aspects of product performance that may, under certain circumstances, be covered under warranty.”
- 3.
The practical import of this warranty arrangement can be illustrated as follows. Suppose an automobile manufacturer expects a car that he manufactures to give a maximum of 50,000 km. Assume that he also knows that it can breakdown after 20,000 km. That is, he expects that y = 30,000. He may, for instance, offer a warranty for only 25,000 km. Similarly, suppose a firm knows that the maximum life of its product is 5 years. Let its expected life at the time of failure be 2 years. That is, y = 3. The firm may offer a warranty for only 2.5 years. Of course, on some occasions, it has been observed that the firm pretty much knows that the product will not break down within the warranty offered. Emons (1989b) considered this possibility earlier.
- 4.
Some products do not seem to offer any warranties. Dybvig and Lutz (1993) argued that this will be observed whenever δ is small enough to make y < y 2/2δ for, then, the cost of providing the warranty far exceeds the collective benefit to both the consumer and the firm.
- 5.
In practice, for a given δ, a highly risk-averse consumer may yet seek a higher p. He wants a good-quality product with significant warranty. We will consider this possibility in the sequel.
- 6.
Experimental evidence seems to suggest that the p defined by the model may not hold when it is close to 0 or 1. There can be bunching around these values for, when the firm is quite confident that its product is of good quality, it may offer a near full warranty. See, for example, Coricelli and Luini (2003). Heal (1977) also suggested earlier that risk sharing may lead to excessive warranty for he argued that a risk-neutral firm will bear the entire risk which a risk-averse consumer experiences. This is generally not valid.
- 7.
Cooper and Ross (1985), Emons (1988), and Dybvig and Lutz (1993) acknowledged that the consumers can adjust the care with which they use the product. Thus, the consumers can exert some influence on the failure of the product depending on the way they use it. The issue is this. What determines the adjustments in δ? λσ 2 is surely one of the determinants. Emons (1988) argued that p, viz., the warranty offered, may itself determine the choice of δ. Similarly, following the argument of Murty and Blischke (2000), it can be argued that even the firm makes adjustments in several characteristics of its product when it recognizes the pertinent dimensions of consumer risk aversion. This may include the warranty and the σ 2 itself. We will not consider these alternatives in detail here.
- 8.
In much of the existing literature, the usual argument is that the firm signals good quality by offering greater warranty. Similarly, greater warranty will provide an incentive to the consumer to buy a product when he is not sure of the quality a priori. The present result appears far more plausible for, when η > 1, the consumer is exercising more than adequate caution to neutralize his risk aversion. Hence, it becomes necessary for the firm to signal its compliance by offering a greater warranty. This need not depend on the quality of the product. Similarly, if η < 1, the consumer is not adequately diligent. A higher warranty will then provide an incentive to the consumer to use the product better. In either case, the consumer may consider warranty as an insurance that the firm offers to convince him that it is sincere about maintaining the product if it were to fail. Of course, there is no guarantee that any of these mechanisms result in the desired outcome.
- 9.
Cooper and Ross (1985) noted that the consumers would demand greater warranties when their cost of effort in maintaining the product is higher.
- 10.
The converse is also true. The best known example is that of high-quality Japanese cars that offer very low warranty.
- 11.
- 12.
If the firm is the decision maker with respect to the warranty, we expect p to increase with k for the firm knows that there will be fewer failures if the consumer follows the prescribed preventive maintenance schemes. But, here the consumer expressed incentive constraints that are binding on the firm.
- 13.
Suppose we interpret ky 2 as the cost, to the consumer, of availing warranty. In such a case, the consumer may express a preference for a lower p as k increases.
- 14.
For all practical purposes, the cost, to the consumer, of preventive maintenance is ky 2 + λp 2 σ 2. The advantage of warranty is py. Hence, warranty is advantageous if and only if py > ky2 + λp 2 σ 2. This results in the condition k ≤ 1/4λσ 2.
- 15.
The consumer may decide to reduce his voluntary level of caution since preventive maintenance can substitute for this. Similar results can be developed in this case as well.
- 16.
It was generally pointed out that the output from household durables is not measurable. It cannot be objectively verified either. In such contexts, the only possible warranty is over a duration less than the expected life of the durable.
- 17.
Issues pertaining to warranty duration in such contexts have been examined in Emons (1989b).
- 18.
Some alternative specifications appear equally plausible. However, the qualitative results will not change materially.
- 19.
There is no clear a priori economic basis on which these costs can be defined. As such, this specification can be contested. The point of the following analysis is that at least one plausible cost structure that can sustain the observed empirical regularities can be traced.
- 20.
Cooper and Ross (1985) pointed out that the firm will be at a disadvantage when they have too many diffused and heterogeneous customers.
- 21.
Emons (1988) also examined such a possibility. The argument was that an increase in warranty reduces the motivation of the consumer in maintaining the product properly. The economics underlying the argument in this section is quite different.
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Rao, T.V.S.R. (2016). Warranties and Risk Sharing. In: Risk Sharing, Risk Spreading and Efficient Regulation. Springer, New Delhi. https://doi.org/10.1007/978-81-322-2562-1_8
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