Warranties as a device to extract rent from low-risk users of a product

David Hakes and Dongsoo Shin
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David Hakes: Department of Economics, University of Northern Iowa, Cedar Falls, IA 50614, USA, Postal: Department of Economics, University of Northern Iowa, Cedar Falls, IA 50614, USA
Dongsoo Shin: Department of Economics, Santa Clara University, Santa Clara, CA 95053, USA, Postal: Department of Economics, Santa Clara University, Santa Clara, CA 95053, USA

Managerial and Decision Economics, 2008, vol. 29, issue 1, pages 1-7

Abstract: We develop a simple model that provides a new rationale for why a monopolist should bundle its product with a warranty even when all parties are risk neutral. In our model, a risk-neutral monopolist faces two types of risk-neutral consumers-low-risk users that are unlikely to cause product failure and high-risk users that are more likely to cause product failure. We find that when the firm fails to provide a warranty, a low-risk user acquires a strictly positive rent by pretending to be a high-risk user and receiving a price discount. By imposing a warranty, however, the monopolist can increase the price to high-risk users, which in turn removes the incentive for a low-risk user to pretend to be a high-risk user, and the firm successfully extracts rent from the low-risk user. Copyright © 2007 John Wiley & Sons, Ltd.

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