Homeowner Warranties and Building Codes: How Effective are They as Incentives in Assuring Desired Builder Effort Levels?

Abstract

Buying a new home involves particularly unique risk because no one knows for sure if everything works. Two sources available to new home buyers to guard against risk are Building Code Enforcement by local government and Homeowner Warranties. Our purpose in this paper is to assess their effectiveness in assuring builders exert the level of effort necessary for optimal workmanship. We contend the answer to this question lies in how effective a Homeowner Warranty or Building Code Enforcement is in overcoming a moral hazard problem associated with unobservable builder effort. Builders have an incentive to claim and charge for high unobservable effort level in constructing homes, but actually exert low effort to earn higher profits. We find that a Homeowner Warranty increases the unobservable effort of the builder, but cost minimizing behavior by the builder results in an effort choice less than the most efficient level. On the other hand, Building Code Enforcement essentially converts unobservable builder effort to observable effort and efficient effort is indeed possible if enforcement cost is justifiable. We then assume the existence of a local Building Code and delineate the optimal provisions of a Homeowner Warranty. The model is generalized to allow for an evaluation of which items in a new home should be covered by a Building Code, a Homeowner Warranty or both. The results of our model are consistent with our findings from a preliminary survey of local builders and hold even if builders are compensated for good reputation.