Why Do We Observe Minimal Warranties?

Why is it that some products carry a minimal manufacturer base warranty even though all consumers are risk-averse? Conventional wisdom suggests that it is profitable for the manufacturer to offer a comprehensive warranty in this setting. We provide in this paper an explanation for the provision of minimal warranty in markets where all consumers are risk-averse. Minimal warranties are created by the impact of consumer moral hazard and competition in the insurance after-market for the product. We show that consumers who purchase optional extended warranties from an independent provider of insurance create a significant negative externality on the warranty redemption costs of the manufacturer. This, in turn, creates a significant erosion in the manu- facturer‘s profits from warranty insurance. Consequently, it is in the best interest of the manufacturer to drop the level of warranty coverage provided with the product. This intuition holds for ho- mogeneous as well as heterogeneous markets of consumers.