Warranty Length, Product Reliability, and Secondary Markets

Abstract

Problem definition: We study how a durable good producer's product warranty length choice depends on its product reliability, and analyze the effect of secondary markets on this choice. Academic / Practical Relevance: This analysis is inspired by particular variations in warranty length specifications in the U.S. automotive industry, and introduces a new angle – secondary market interference – as a compelling explanation for such variations observed in practice and the academic literature. Methodology: Using an analytical model of a finitely durable good producer, we first study the interaction between product reliability and the producer’s warranty length choice in the presence of secondary market interference. We then utilize a generalized least squares random effects estimation approach to empirically validate our analytical results in the context of the U.S. automotive industry. Results: A durable good producer’s warranty length offering is U-shaped in its product reliability. That is, only producers with sufficiently low or high product reliability will benefit from offering longer product warranties. Otherwise, a short warranty offering will be preferred. This result is driven by a dependency between the producer’s warranty length and secondary market interference choices. An empirical analysis based on the U.S. automotive industry also identifies a U-shaped association between warranty offerings and product reliability, and suggests producers’ secondary market interference as a mechanism behind this result. Managerial Implications: We find that producers with sufficiently high product reliability will benefit from longer warranties, as longer warranty coverage has marginal impact on their new product demand cannibalization by used products and warranty fulfillment costs. In contrast, producers with sufficiently low product reliability can leverage secondary market interference to reduce new product demand cannibalization by used products and warranty costs induced by a longer warranty offering. Producers with moderate product reliability, on the other hand, cannot leverage secondary market interference as effectively, and benefit more from shorter warranty offerings.