Monopoly Provision of Product Warranties

Abstract

This article considers the problem of monopoly provision of product warranties when consumers are heterogeneous and when the probability of product malfunction depends on both the quality of the product and on the consumers' care. The optimal warranty contract is characterized to maximize the expected profit for the monopolistic seller. The properties of the optimal contract depend on the nature of the product. If the quality of the product is more important as a determinant of reliability than consumer care then standard results are obtained; that is, a positive correlation between warranties and reliability and between price and reliability are observed, and higher type buyers buy more expensive versions of the product with higher warranties. On the other hand, if consumer care is more important in increasing reliability, the results are exactly opposite; for example, there is a negative correlation between warranty coverage and reliability. Also, when consumer care is important, higher type buyers buy versions of the product with lower warranty and lower quality. Other features of the optimal warranty contract are also characterized in this paper.