Warranty Pricing with Product Failures and Forward Looking Consumers: An Empirical Approach

Abstract

This paper considers warranty pricing for durable goods, taking possible product failures into account. Consumers are forward looking and solve a dynamic program to make purchase decisions. Due to the large number of products and remaining warranty lengths, the consumers’ problem and the corresponding estimation problem are high dimensional. Therefore, we introduce the so-called inclusive value processes to capture the consumers’ “value-to-go”, which reduces the dimension of the estimation problem. We estimate consumers’ preferences using the resulting structural model and individual level transaction data on product and warranty purchases from an electronics retail chain. By conducting counterfactual experiments, we find that extended warranties are generally underpriced in our data set; and the optimal price differs by brand. Specifically, extended warranties are overpriced for high end brand Sony and underpriced for low end brand RCA. Lastly, we explore the impact of changing product reliability on the retailer’s profit.