The Effect of Product Misperception on Economic Outcomes: Evidence from the Extended Warranty Market

Abstract

Panel and experimental data are used to analyse the economic outcomes in the extended warranty market. We establish that the strong demand and high profits in this market are driven by consumers distorting the failure probability of the insured product, rather than standard risk aversion or sellers’ market power. Providing information to consumers about failure probabilities significantly reduces their willingness to pay for warranties, indicating the important role of information, or lack of, in driving consumers’ purchase behaviour. Such information provision is shown to be more effective in enhancing consumer welfare than additional market competition.

Mental Accounting, Access Motives, and Overinsurance*

“…Finally, applying Propositions 2 and 3 as well as Corollary 2 to the model with beliefF instead of F reveals how the model can accommodate seemingly contradictory evidence on the effect of income on warranty purchase. While Chen et al (2009) and Abito and Salant (2018) find a negative effect, Padmanabhan and Rao (1993) find a positive effect. Chu and Chintagunta (2011) find a concave relationship between income and warranty purchase.…”

“…Hence, people with a higher perceived budget risk are predicted to have a larger willingness to pay for warranties that fully cover the replacement cost of a broken product. This is consistent with poorer people showing a stronger inclination to purchase a warranty (Chen et al ., ; Abito and Salant, ). It is also consistent with the results of Cicchetti and Dubin (), who find a negative relationship between income and insurance against damages of telephone wiring.…”

“…Nevertheless, there is a notable difference between these studies. Chen et al (2009) and Abito and Salant (2018) consider warranties for consumer electronics that typically offer full insurance through repair or replacement of a broken device. In contrast, the other two studies consider car warranties that typically prescribe a deductible.…”

“…3 While partial insurance does not cover the entire loss, but pays benefits in all loss states, probabilistic insurance does not pay benefits in all loss states. 4 A negative effect of income is often found for insurance against modest risks such as warranties (Chen et al, 2009;Abito and Salant, 2018) and telephone wire insurance (Cicchetti and Dubin, the deductible, or by reimbursement. This can explain conflicting evidence on insurance behavior across different insurance contexts, 5 and it suggests a straightforward way to test the model.…”

“… A negative effect of income is often found for insurance against modest risks such as warranties (Chen et al ., ; Abito and Salant, ) and telephone wire insurance (Cicchetti and Dubin, ), while a positive effect of income is consistently found for insurance involving higher stakes, such as health insurance (Smith and Medalia, ), long‐term care insurance (Brown and Finkelstein, ), and flood insurance (Brown and Hoyt, ; Michel‐Kerjan and Kousky, ). …”