Extended Warranties , Adverse Selection , And

This article investigates whether the contractual exclusion of third-party extended warranties should be legally permissible, using a model incorporating consumer heterogeneity. The welfare effects of competition in the market for extended warranties are shown to depend on the degree of competition in the product market. In contrast to the approach typically adopted by the courts, the article argues that manufacturers should not generally be permitted to practice requirements contracting in extended warranties, even when the product market is competitive. INTRODUCTION Competition authorities and economists have recently been wrestling with the question of whether manufacturers should have the right to monopolize aftermarkets for their products. An important class of such aftermarkets, characterized by adverse selection, is extended warranties and service contracts. This paper investigates the problem of whether the contractual exclusion of third-party extended warranties should be legally permissible. Consumer heterogeneity sometimes leads manufacturers to offer a menu of warranty contracts, typically implemented as a base warranty and an optional extended warranty. For most products on which a manufacturer offers an extended warranty, it faces competition from third-party service contracts. Some manufacturers, however, make it a condition of supplying a retailer that she carry only the manufacturer’s extended warranty. A recent case is typical of the legal dilemma. Ford of Canada announced that as a condition for the use of its financing plan, dealers had to commit to exclusive sales of Ford’s extended warranty program. When the Federal Automobile Dealers Association threatened to take it before the Competition Bureau, Ford withdrew the condition, leaving dealers free to continue selling third-party extended service contracts. Should manufacturers generally have the right to impose such exclusivity conditions on retailers? This article argues that competition in extended warranties has an important effect on the base warranty, and therefore on welfare. Aidan Hollis is Assistant Professor, Department of Economics at the University of Calgary. The author is indebted to two anonymous referees, Nancy Gallini, Frank Mathewson, Mike Peters, Ralph Winter, and participants at seminars at the University of Toronto, the University of Western Ontario, l’Universite de Montreal, and the Institut d’Analisi Economica in Barcelona for helpful comments. 322 THE JOURNAL OF RISK AND INSURANCE In both the United States and Canada, the legality of such requirements contracting is still uncertain, despite the magnitude of the extended warranty and service contract markets. Extended warranties are one of the most commonly purchased forms of insurance and marketed along with most large and many small appliances. Sears alone is reported to have sold over $1 billion worth of extended warranties in 1991 in the United States. Ford recorded profits in excess of $100 million from sales of extended warranties in 1988, despite fierce competition from independent insurers.1 Around 40 percent of all automobiles and major appliances are sold with some form of extended warranty, typically with a large profit margin.2 For retailers of products carrying extended warranties, the profits can be significant: Some analysts estimate that around half of operating profits for big consumer electronics chains come from sales of extended warranties.3 Although extended warranties are a form of insurance, they have quite unique features. Unlike most other forms of insurance, warranty contracts do not usually vary by amount of insurance but by duration instead. The reason for variation in the duration could be heterogeneity in consumer risk aversion or heterogeneity in the consumer’s expected intensity of use. I model it as the latter in this article. This suggests that there will be opportunities for third degree price discrimination and the resulting welfare losses that come from distorting contracts for low intensity users to keep high intensity users from buying those contracts. The presence of third party extended warranties complicates the situation and may increase or decrease welfare. What is critical here is that because the warranty contract varies by duration and not by amount of coverage, the standard screening analysis employed in most insurance problems (beginning with Michael Rothschild and Joseph Stiglitz (1976) and Charles Wilson (1977)) does not apply directly to the warranty case. In the next section, the relationship of this article to the previous literature on warranties and extended warranties is explained. The following section develops a model of warranties in which firms choose warranty duration and price. If firms cannot distinguish between heavy and light users, it is shown that they may offer separating or pooling warranties, where the separating warranty is simply characterized by the offer of an optional extended warranty. Sections on the monopolistic product market and the competitive product market examine the effects of competition in extended warranties. If the product market is monopolistic, then the presence of thirdparty insurers will destroy the price discrimination scheme of the manufacturer. This will be welfare enhancing only if “light” users continue to buy the product. Similarly, if the product market is characterized by competition, attempts to impose exclusivity restrictions on extended warranties may often be welfare-decreasing. This result contrasts with current jurisprudence which is lenient to exclusivity restrictions if the product market is competitive. The article concludes with a brief discussion of policy implications, and with suggestions for further research. 1 Cited in Lutz and Padmanabhan (1995). 2 Plotkin (1985) and Therrien (1991). 3 Therrien (1991). EXTENDED WARRANTIES, ADVERSE SELECTION, AND AFTERMARKETS 323 RELATED LITERATURE Economic analysis of warranties is divided by the principal function attributed to warranties: Some studies are premised on the notion that the function of warranties is to shift risk-bearing from risk-averse consumers to risk-neutral warrantors; while in others, warranties serve to provide a signal of product quality.4 The seminal paper on warranties as a form of insurance is by Geoffrey Heal (1977), and it is this function of warranties which is of interest in the present article. Warranties typically seem to provide at best partial insurance,5 which as will be seen may be the result of consumer heterogeneity, as observed by Winand Emons (1989) and V. Padmanabhan (1995), or of consumer moral hazard. Michael Spence (1977) was the first to show that warranties could be an informative signal for consumers if it is more costly for low quality manufacturers to provide long warranties than for manufacturers of highquality products in a competitive market. Sandy Grossman (1981) extended the analysis to monopolistic markets and found that monopolists would always offer full warranties because not to do so would be a bad signal to consumers. Esther Gal-Or (1989), Linda Welling (1989), and Nancy Lutz (1989) derived conditions limiting the effectiveness of such signals in various environments. A series of related papers on two-sided moral hazard considered the problems of using warranties to minimize producer moral hazard in the presence of consumer moral hazard.6 Steven Matthews and John Moore (1987) consider the problem of a monopolist who chooses both quality and warranty and explore the sensitivity of their results to different restrictions on the usual single crossing property which is employed in this article. The focus of this article is the market for extended warranties, which, despite its importance, has attracted very little economic study. The two exceptions are work by Lutz and Padmanabhan. Their 1995 article considers a puzzle in the market for contact lenses, where, although warranties may be purchased as an option, the standard base warranty is zero. They attribute this to the presence of third-party insurers, whose extended warranties cause a negative externality on base warranties, since consumers with more coverage will be less careful in handling their lenses. They conclude that where consumer moral hazard is a problem and average product durability can be predicted with reasonable accuracy by an independent insurer, this externality will push base warranties to zero. This result applies to a particular type of product, since on the vast majority of products for which third-party extended warranties are available, base warranties are far from zero. Evidently some other paradigm is required to explain the variety of warranties and extended warranties available on different types of products. This article is based on the idea that warranties are heterogeneous because consumers are heterogeneous in their intensity of use and presents a model that helps to explain the variety of warranties which we observe. In contrast to Lutz and Padmanabhan’s contact lens article, it relies on adverse selection rather than on moral hazard. 4 Two other explanations of the function of warranties are provided by Salop (1977), who observed that with imperfect consumer information on product quality, the warranty may be used as a tool of price discrimination; and by Braverman, Guasch, and Salop (1983) who noted that a warranty may be used as part of a two-part tariff to extract consumer surplus. 5 See, e.g., Bryant and Gerner (1982), Gerner and Bryant (1981), and Priest (1981). 6 Cooper and Ross (1985), Emons (1988), Dybvig and Lutz (1993), Soberman (1995), and Lutz and Padmanabhan (1998). 324 THE JOURNAL OF RISK AND INSURANCE Lutz and Padmanabhan (1998), building on Matthews and Moore (1987), examine the effect of competition in extended warranty markets when the manufacturer is a monopolist in the product market and offers products of two different qualities to consumers with heterogeneous valuations. Warranties are modeled as a cash payment. They show that the presence of competitive extended warranties may cause manufacturers to change the quality of the product offered. This paper is closest in spirit to the model presented below, but differs in key results because warranties are modeled as a cash payment rather than as repair or replacement; and because product quality is determined endogenously. The model used in this article differs from most other models in the literature because it focuses on the duration of the warranty. This follows from Philip Dybvig and Nancy Lutz (1993), who model warranties as a time-variable payment in case of breakdown. They show that the “block” form of warranties typically seen, with high coverage initially and zero coverage later, is optimal when there is double-sided moral hazard. The focus on duration is useful because it more closely resembles the choices that warrantors actually make, and because these choices are not isomorphic to models where warranties are a payment which varies by amount rather than duration of coverage.