Problem 201 Extended Warranties Your product fails about 2 o

Problem 20-1 Extended Warranties: Your product fails about 2% of the time, on the avarage. Some customers purchase the extended warranty you offer in which you will replace the product if it fails. Would you want to price the extended warranty at 2% of the product price? Discuss both the moral and adverse selection issues.

Solution

Extending warranty at the same rate of normal warranty will give rise to moral hazard problem. Buyers of extended warranty will exercise less caution in using my product and careless handling will increase the risk of the product malfunctioning, which will increase the cost of replacement. So the buyer will gain at my expense.

Again, this extended warranty program will appeal more to the buyers who are likely to make use of the warranty, since they are likely to mishandle the product resulting in damage, and replacement cost would be borne by me. Therefore, lower pricing of extended warranty will result in higher number of careless users (buyers) and lower number of cautious buyers, thus distorting my customer mix favoring the customer segment who are likely to result in higher warranty requirements, thus increasing my cost.

So, pricing the extended warranty is 2% is economically riskier.