Warranties, Extended Warranties, and Product Quality

By Nancy LutzV. Padmanabhan
1994| Working Paper No. 1311

We analyze the effect of extended warranties on manufacturer’s warranty policy under conditions of producer moral hazard. When all consumers in the market are identical, the manufacturer offers a full warranty, blockading entry into the insurance market. If consumers differ in their valuations of working unit, then the manufacturer offers partial warranties (and low quality) to low valuation consumers, and full warranties (and high quality) to high valuation consumers. This creates an opportunity for entry into the insurance market. The entering insurer sells extended warranties to low valuation consumers. In response, the manufacturers changes the menu if offers to consumers. It sells high valuation consumers a high quality product with a full warranty, at a lower price. The manufacturer may increase or decrease the warranty, price and quality that it offers low valuation consumers.