Mutaism Abdur Rahman

User ID: 596594

Microeconomics

Course code: 153400130

Tutor: Francesco Ruggerio

Word Count: 1988

What is the simple logic of warranties as signal of quality? What limits the attractiveness of
warranties as a signal for high-quality firms?

It is a common ethos amongst firms to adhere to the idea; ‘success is built on quality’ (Belleflamme
and Peitz, 2010, p284). For consumers the notion of high quality products is one which is
experienced only after purchase. Manufactures therefore conciliate consumers through
implementing warranties and therefore guaranteeing a level of assurance. While warranties vary in
length and type, the usual surety is that the good in question is replaced or repaired (Balachaner,
2001). While warranties are acclaimed to indicate high product quality, they also incentivise
competing manufacturers to invest in products and therefore solve ‘moral hazards’. These hazards
are actions which take place under the umbrella of asymmetric information, whereby any action
which is undertaken is hidden and therefore harms the unaware group (Belleflamme and Peitz,
2013). Moral hazards remain a pressing concern when discussing warranties, however before this
essay tackles it, one must lay out the purposes of warranties as a signal of product and consequently
what limits their attractiveness. To do so my essay will be split into two subsections; the first being I)
the logic of warranties in signalling quality. Accordingly I will discuss how warranties lead to the
creation of high quality goods, as an incentive of investment and through the juxtaposition of
‘lemons’ with better quality goods. The second subsection; II) Limitations of warranties, will delve
into the use of branding, double moral hazards and other limitations of warranties as signals for
high-quality firms, followed by respective counter arguments.

Warranties signalling quality

Due to the fact that markets are plagued by asymmetric information, there remains an issue with
regards to consumer awareness in terms of product quality. Therefore firms attempt to encourage
cliental that products are of a high calibre. By establishing a level of accountability between both
firm and consumer, warranties serve as resolutions for manufacturing faults. Warranties in general
are less costly to a firms if the product in question is reliable, therefore one can assume that
warranties can act as a signal as to whether there product is of high quality or not. However there
remains contention as to whether there is quantitative proof of warranties implying product quality
(Balachaner, 2001).

The reasoning behind using warranties to signal quality can be further analysed once we interpret
the two types of production qualities; goods and lemons (Emons, 1987). As an example we refer to
the used car industry, asymmetric information plays its part between firms and consumers, whereby
the consumer cannot differentiate between a car of high or low quality (Belleflamme and Peitz,
2010). Intuitively, the ‘lemon’ is the produce of low production costs and thus comparable price.
Mathematically we can display this through the following equation:

E ( X ) =Ƥ λ1 +(1−Ƥ) λ 2 ¿ r −Ƥ

The expected utility of consumers can be seen from the formula above. Where λ 1> λ2 as λ 1
represent a good which is less likely to have a breakdown than λ 1, therefore representing a good
and a lemon respectively. λ 1 has a breakdown probability of Ƥ λ 2 has (1−Ƥ) and the willingness to
pay for the product is described as r >0 . Due to the concept of asymmetric information the
consumer does not know whether to opt for products λ 1∨λ2, the differentiating factor is that of r , if
it is lower for λ 1 then it will preferred over λ 2and vice versa. ‘Lemons’ will therefore be purchased in
abundance due to lower pricing causing displacement of λ 1regardless of superiority. From the
perspective of the supplier of λ 2 complacency arises, due largely to the fact that there is no need to
invest in higher quality λ 1, thus arises the phenomenon known as ‘a producers moral hazard’
(Belleflamme and Peitz, 2010, p310). Following on from this model, we can factor in the use of
warranties. Evidently good λ 2 would be more in need of a warranty due to the fact that it is an
inferior product and therefore is more likely to breakdown. However it is less likely to be offered due
to the potential deficit of adding a warranty for a poor quality good. In comparison the high-quality
good λ 1 is deserving of a warranty, and therefore there is a differentiation between goods signals
λ 1∧λ2 to consumers that the good is of a high-quality. Asymmetric information is therefore
challenged by the introduction of the warranty, from a consumers point of view there is manifest
quality differences, while for producers there is added incentive to produce high quality goods,
thereby combatting the moral hazard through investment. The introduction of warranties can be
inputted by altering the prior original slightly to attain:

E ( X ) =λr + ( 1−λ ) wr− p

From the equation above, we can infer that utility is contingent upon quality, which will therefore
effect consumer decisions.

Warranties and high quality firms

As discussed previously, warranties signal quality. In the case of high quality firms this remains as a
point of contention for varying reasons, namely because of; product significance, branding, double
moral hazards. This next section of my essay will focus on factors which affect the usefulness of
warranties for high quality firms.

On the subject of warranties and high-quality firms is that of ‘product significance’ essentially
breakdown warranty must be worth claiming on certain products. Warranties have a high
significance amidst products where there is asymmetric information between customer and firm.
However for this to hold true, consumers must be dedicated enough to retain warranty proof.
Regardless of the prestige of the firm, if the product being offered is inferior, one may not even
bother to keep track of warranty records, as put simply it is not worth the hassle. An example being
that of high quality light bulbs which are supplemented with 10 year warranties. Regardless of
whether warranty compensation is w ε [0,1], the practically of keeping proof of purchase for 10
years is rather slim, therefore diluting the practical use of the warranty. In this respect, the
attractiveness of warranties is limited, while theoretically the extended warranty may signal higher
quality, it remains insignificant in respect to the significance of the product itself. Conversely, if the
product was for e.g. a £30,000 Mercedes, a 10 year warranty is relatively applicable.

In tandem with warranties, firm use the element of branding to placate product quality to
consumers. In the case of high quality firms, branding can effect warranties in a multifaceted
manner. The most prevalent case of branding is whereby it negatively affects the attractiveness of
warranties. As most famously mentioned by Spence (1977), the reason for this limitation on
warranties is due to the substitution effect that can a strong brand can have on warranties. It can be
argued that stronger brands are correlated with higher quality goods and therefore are not in need
of warranties due to the reliability, Bar-Isaac and Tadelis (2008) compliment the argument by adding
that an eminent brand is linked with a less likely chance of manufacture breakdown. The second
case is a rarer one where we initially discuss the brand of those who carry out warranty resolutions,
as opposed to the firm issuing out the good. This scenario relates to the firm dealing with warranty
has a strong brand and therefore warranties are held in high esteem as they are trusted to resolve
any breakdowns. An example of which is that of the ‘Carphone Warehouse’, while products may be
bought through them, all breakdowns relating to warranty issues are carried out by a third party
company known as ‘Geek squad’. The more credible the third party company repair, the more
attractive the ‘Geek squad’ warranty. Therefore warranties are not necessarily a signal of quality.
One can conclude that from a branding perspective, warranties can be limited as well as
supplemented, however the latter is the rarer case.

The last case to be analysed is that of the double moral hazard. The double moral hazard
concentrates on hazards on both the consumer and suppliers side, theoretically it remains a severe
limit on warranty attractiveness. As iterated previously one must consider how the consumer is
unaware of product quality at point of purchase. Contrasted to this is the position of the firm, where
the seller does not know the true characteristics of the consumer. Both parties attempt to effect the
breakdown rate of the product in question, bearing in mind that they will equally seek to minimize
any possible costs in the process. While the firm seeks to reduce costs via the production of
‘lemons’, the consumer reduces costs by abstaining from product maintenance. When factoring in
warranties, one can infer that consumers who have product warranties are less incentivised to invest
time into precautionary use of their products, increasing the probability of breakage. Therefore
there is an additional moral hazard from the consumer’s standpoint, coupled with the producers
moral hazard leads to the theory known as the double moral hazard (Coricelli and Luini 2002). By
looking at a third equation similar to the first two, it can be mathematically demonstrated how the
double moral hazard limits the effectiveness of warranties.

π= p−( 1−P ) λ ¿ wr
The expected profit π of a firm can be stated as consisting of the price of a product, minus the
warranty-product quality function ( 1−P ) λ ¿ wr . The warranty-product quality function infers that
the good λ is unknown to be a ‘lemon’ or high-quality good due to asymmetric information.
Whereas (1−P) acts as the probability of breakdown, the smaller the better. The double moral
hazard, causes P (probability of a breakdown) to increase because of customer carelessness due to
the safety of warranty,w . This leads to a decrease in profits from the firm side due to an increase
repairs or replacement. In such a respect warranties can be viewed as a limit on attractiveness for
high-quality firms.

The theory of double moral hazards presents a tough case as a limit on warranty attractiveness.
However when considering block warranties in economic literature, there are differing opinions with
regards to whether or not the hazards can be solved. If we assume that the warranty in question is a
blocking one, there is an apt resolution to hazards on both the firm and the consumer’s sides. Block
warranties act in a manner whereby the warranty which is supplied are shorter than the predicted
life of the product (Coricelli and Luini 2002). This level of cover over a limited period is known as a
‘block warranty’, it combats the double moral hazard as consumers will become increasingly
cautious as the warranty gets close to expiry. From the firm’s perspective, as warranties continue to
act as additional costs, investment into products must rise, due to the fact that losses associated
with lemons could be extensive during the limited warranty.

In summary, this essay has demonstrated the logic of warranties as a signal before exploring aspects
which effect their attractiveness. By first contrasting high-quality goods with ‘lemons’, theory
dictated that the implementation of warranties acted as a signal to differentiate between higher and
lower quality goods. While there was an evident moral hazard inferred by the producers restrict
supply to ‘lemons’, the inclusion of warranties led to either an investment in quality or a strict high-
quality product supply. Following on from this logic, was the limits to warranties in terms of
attractiveness. Limits to warranties was somewhat circumvented when we considered the type of
good in question, i.e. light bulbs, and whether warranty is in fact practical to claim under.
Nevertheless for the majority of goods, limits still applied when we deliberate on branding. Explicitly
because of the fact that if a brand is strong enough it signals quality in of itself, thereby foregoing
the need for warranties altogether. The last and most predominant limitation was that of the double
moral hazard, whereby due to a consumers complacency products are not treated with care. The
counter argument here being that, the nature of a warranty could in effect combat the hazards,
more so through block warranty than the prescribed government ones. This solution to double
moral hazards, has led me to conclude that warranties as a signal of quality is an accurate
hypothesis.
Bibliography

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Bar-Isaac, Heski, and Steven Tadelis. Seller Reputation. Microeconomics, (2008). 4(4), pp 273-351.

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Belleflamme, Paul, and Martin Peitz. Asymmetric Information and Overinvestment in Quality.
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Coricelli, Giorgio, and Luigi Luini. Double Moral Hazard: An Experiment On Warranties. University of
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Emons, Winand. Warranties, moral hazard, and the lemon problem. Journal of economic theory,
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