Simultaneous Signaling and Screening with Warranties

Abstract

It is well known that sellers can use warranties to screen consumers and increase profits. The ability of warranties to signal is also well accepted. The author considers a situation in which a high quality seller needs warranty policy to both screen and signal. Through an analytical model, the objective is to identify the optimal strategy for a high quality seller that offers a base warranty and optional extended warranty for a product whose quality is not observable to buyers. The author finds that signaling can limit a seller's ability to screen, especially when buyers are willing to pay a significant premium for higher quality. To signal, the seller generally lengthens base warranties and shortens optional coverage, making the bundles for each type of buyer more and more similar. The author also provides an empirical application of the model in the Toronto used-car market.