Warranty policy and extended service contracts: Theory and an application to automobiles

This paper characterizes the manufacturer warranty policy and its effect on consumer behavior under the following conditions: consumers are heterogeneous in risk-preferences, consumer actions affecting the probability of warranty redemption are unobservable to the manufacturer, and the product reliability is known. The authors obtain the ‘menu’ of warranty contracts, and then make connections with its institutional counterpart: the extended service contract. The model’s implications for consumer behavior are examined using data obtained from a sample of recent buyers of new cars. The role of risk in consumer behavior with respect to choice of extended service contracts, and the allocation of effort for maintenance are found to be consistent with the model’s predictions. The empirical analysis permits quantifying the demand for extended service contracts as a function of the extent of manufacturer warranty. The estimates show that for the present sample of buyers a manufacturer warranty of three years is optimal in the sense of overcoming the role of risk-aversion in the choice of extended service contracts.