Extended Warranties, Adverse Selection, and Aftermarkets

Abstract

ABSTRACT 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 exc lusive 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. 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)) doe s not apply directly to the warranty case. …