Under Cover - Simultaneous Signalling and Screening with Warranties

Why are some warranties long and others short? Why are both base and extended coverage available? What do warranties say about the quality of the products they cover and about the people who buy them? Professor David A. Soberman considers the options when a seller needs a warranty to both signal and screen.

by David Soberman
Last Updated: 23 Jul 2013

You want a DVD player, but the selection is bewildering. More often than not, consumers use warranties to help them choose products: a long warranty may signal the manufacturer’s confidence in its product, while a short one might signal a hope that the warranty fails before the product does.

Once you’ve found your dream machine, there’s still sales staff, often pushing extended warranties. Why? It’s all part of screening, a strategy in which manufacturers offer a price/warranty “menu” and buyers choose their preferred combination. Extra protection might not be necessary, but it is surely profitable—retailers can make as much as 75% of their gross income from extended warranty sales.

In this recent working paper, David A. Soberman, Assistant Professor of Marketing, INSEAD, examines what happens when warranties signal and screen simultaneously. He asks how signalling affects the seller’s ability to screen and how information about quality is conveyed to the buyer. If a warranty both signals and screens, what are the implications for the selling process?

His model focuses on a situation in which a monopolistic seller offers a product and an optional extended warranty to a varied market with two types of buyers. The product’s quality is unobservable by consumers and the different buyer types are unobservable for the sellers. Thus the seller must use warranties to signal quality and also to screen buyers.

The findings indicate that signalling can limit the seller’s ability to screen, particularly when buyers are willing pay significantly more for higher quality products. Thus, to signal the seller generally lengthens base warranties and shortens the optional coverage, making the options for each type of buyer more similar.

For empirical data, this model is applied to the Toronto used car market. Fieldwork suggests that used car sellers are well aware of how warranty policy can be used to simultaneously signal and screen.

The insights provided by the model may well extend beyond warranties. After all, warranties aren’t the only situation in which buyers seek a measurable product whose quality is variable and difficult to evaluate in advance. It would be fruitful, concludes the author, to examine simultaneous signalling and screening in a broader context across several markets, such as service contracts or health insurance.

INSEAD 2002

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