Why Do We Observe Minimal Warranties?

Nancy A. Lutz and V. Padmanabhan

Why is it that some products carry a minimal manufacturer base warranty even though all consumers are risk-averse? Conventional wisdom suggests that it is profitable for the manufacturer to offer a comprehensive warranty in this setting. We provide in this paper an explanation for the provision of minimal warranty in markets where all consumers are risk-averse. Minimal warranties are created by the impact of consumer moral hazard and competition in the insurance after-market for the product. We show that consumers who purchase optional extended warranties from an independent provider of insurance create a significant negative externality on the warranty redemption costs of the manufacturer. This, in turn, creates significant erosion in the manufacturer's profits from warranty insurance. Consequently, it is in the best interest of the manufacturer to drop the level of warranty coverage provided with the product. This intuition holds for homogeneous as well as heterogeneous markets of consumers.

(Game Theory; Pricing Research; Warranties; Risk Aversion; Service Contracts; Moral Hazard)