Academic journal article Contemporary Economic Policy

Quality-Assuring Price and Breach of Express or Implied Warranty

Academic journal article Contemporary Economic Policy

Quality-Assuring Price and Breach of Express or Implied Warranty

Article excerpt

DONALD VANDEGRIFT [*]

If consumers cannot discern quality prior to purchase, firms may use both court enforcement and the market mechanism to assure quality. But the level of warranty protection that firms choose to offer depends on the efficiency of the market. As the ability of consumers to communicate information concerning quality among themselves (market efficiency) increases, the level of warranty protection that maximizes consumer surplus falls. In highly efficient markets, producers do not offer a warranty. Thus, courts should not imply a warranty if producers do not specify one. In addition, the level of warranty protection depends on the courts' ability to distinguish between producer and consumer moral hazard. (JEL L15)

1. INTRODUCTION

When a producer provides a warranty, he or she makes a promise. Because the producer may renege on that promise, we must consider the mechanism by which the promise is enforced. To enforce the promise, consumers must rely on either markets or courts. Neither mechanism is perfect. Despite this, the economic literature assumes that warranties are perfectly enforceable (Spence, 1977; Grossman, 1981; Cooper and Ross, 1985; Matthews and Moore, 1987; Lutz, 1989; Dybvig and Lutz, 1993; Padmanabhan, 1995; Lutz and Padmanabhan, 1998). There is no consideration of the mechanism that enforces the warranty. None of the articles on product warranty consider the ability of markets to discipline producers. As a result, the literature on product warranty evinces a rather coarse understanding of the legal attributes of warranties. The literature combines the notion of warranty as a promise about product characteristics with the notion of a warranty for a breach of promise (Chapman and Meurer, 1989).

To consider the effects of the legal and market mechanisms that enforce warranties, this article builds on the literature on quality-assuring price. Although warranties may provide for pure insurance when even the producer cannot observe quality, this article considers only the role of warranties in enforcing the producer's promises of product quality. I model a competitive market to consider the way that courts and markets enforce promises of product quality. The legal and market mechanisms ought to be considered in the same framework because they are substitutes as well as complements (Coase, 1988).

The legal and market mechanisms are substitutes because promises of product quality may be enforced with court sanctions or lost sales. The model shows that the level of warranty protection (and expected court sanctions) falls with increases in the ability of consumers to communicate to other consumers information about product quality. This is consistent with the empirical studies that show that most warranties offer only partial coverage and that there is no necessary relation between warranty coverage and quality (see Bryant and Gerner [1978]; Priest [1981]; Gerner and Bryant [1981]). [1]

The legal and market mechanisms are complements because an efficient legal system supports market exchange. The model shows that the level of warranty protection (and the value of the good) depends on the courts' ability to distinguish between producer and consumer moral hazard. Most of the models in the product warranty literature assume that the producer is a monopolist, but the major results here do not depend on market power.

Even in the absence of a legal requirement, producers often have an incentive to fulfill both explicit and implicit contractual promises. If consumers are uncertain of quality prior to purchase, it is possible for producers to make opportunistic representations of product quality. However, the threat of punishment makes cheating a costly strategy. Consumers collectively impose costs on cheaters when they refuse to buy from them. These costs constitute a punishment. If the punishment is sufficient, no producer will elect to cheat. …

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