Warranties as Quality Signal - Essay Example

MACROECONOMIC MACROECONOMIC Introduction Warrant can be as a written ment from a product’s manufacturer that assures the product user real condition of a product. This statement is an implied contract that makes the manufacturer responsible for repair or replacement of a product for a particular period after purchase. The warranties mean that a product is defect-free in terms of material and workmanship hence failure to perform as customary will lead to reimbursement by the manufacturer through repair or replacement. There are different types of warranties which include merchantability and purpose fitness. This academic paper will be focused on the logic behind warranties as signal of quality as well as what limits the attractiveness of warranties as signals for high-quality firms. Warranties as Quality signal Grossman (1981) argued that indicating enhanced efficient functioning of a perfectly competitive market in a situation where there is information deficiency. Warranties offered by most production companies are considered common types of signal sent by high-quality production companies. This is at reducing consumer’s quality doubt and information gaps in the product’s quality. Quality has been used to refer to observable and unobserved product characteristics in terms of product performance and durability. The common assumption is that firms producing low-quality products find it very expensive to offer a warranty. This product assumption makes offering of product warranty a credible signal of unobservable product performance and durability among many other features. In the production industry, product failures are highly linked with product quality and workmanship hence the cost of offering the warrant will be higher for poor quality products. As a result of innovation and technological advancements, the information asymmetry between consumer and manufacturer is great. This comes about due to an increase product modifications and releases on an annual basis. In the situation of new products, consumers have very little information on product information and quality due to the unavailability of past experiences and third party reviews. The injection of costly warranties in asymmetric information implies that warranties serve as pertinent projections of product quality in the production sector. The primary objective of all businesses remains profit-making through cost minimization and revenue maximization. In case the producers manufactured goods with high chances of product failures, they will be forced to incur high costs through repair and replacement which will eventually lead to losses. Most manufacturers, therefore, reduce risks associated with market entry failure through the inclusion of product warranties. The warranties signal product quality. This is a way of communicating the company’s trust in its products. This is through risk aversion by offering warranties. The warranty protection offered by manufacturers in the production industry varies in terms of length, product brands and purpose (Srivastava and Mitra, 1998). The issuance of long-term warranties is as a market entry strategy and will change over time. For our study, we shall take the example of Dell Computer Company. Dell entered the computer market in 1996 and as a method of signalling product quality, it offered longer warranties. At the beginning as compared to its competitors IBM and H.P. IBM and H.P, who had previously been in the market? This implied that there was sufficient information about the products of IBM and HP from past experiences and reviews among many others. When the market share for Dell improved over time, and there was information about its products, but Dell did not change its warranty policy and has maintained it to date. This long term use of its warranty policy is as a result of Dell’s high investment in product quality improvement over time since they were sure of reduced warranty compensations. This, therefore, implies that product reliability is with past warranties (Spence, 1977). On the other hand, a manufacturer offers a warranty as a credible form of commitment to any moral hazards likely to be faced by the consumer. This warranty acts as a bond against possible ex-post actions taken by the manufacturer and might be harmful to the consumer. Other scholars such as Choi and Ishii (2010) argue that warranties act as an insurance provision which works as a risk sharing mechanism between customers and production firms. Furthermore, warranties serve as incentives for manufacturers to improve product quality or cheat consumers on product quality while increasing their market share. This because the manufacturer’s commitment to long term warranties would result in massive warranty costs if the product’s initial quality is below the warranted product level. On the other hand, the warranty costs are systematically related to product quality in terms of durability and reliability. The ability of a warranty to signal quality implies a positive co-relationship between product quality and warranty duration. This is because only high-quality production firms can afford long warranties as a result of their associated high costs of fulfilment (Choi and Ishii, 2010). Limits to the Attractiveness of Warranties as a Signal for High-Quality Firms 1. Differences in the Levels of Product information Based on Purchase Histories Consumers are with different levels of product information based on their purchase histories, word of mouth and third party product reviews. Previous experience with a particular brand makes consumers have more information about brand-specific components of unobserved product quality. This makes the signalling value of a warranty high. On the other hand, consumers with no previous experience of a particular brand tend to have a small signal value of offered warranties (Spence, 1977). 2. Product Brand Choice and Preference When choosing a new product to purchase, product brand or choice plays a very significant role in signalling quality more strongly than the offered warranty. Product consumers are risk averse while buying products thus tend to stick to long term used products. Brand preference tends to make warranties as a quality signal irrelevant since warranties do not easily lure consumers but rather brand (Srivastava and Mitra, 1998). 3. Identifiable Characteristics Product characteristics most likely those observable to the consumer are likely to affect the attractiveness of warranties as a signal for high quality. Features such as colour, material used and product pricing are more liable to be more appealing to consumers as quality indicators in comparison to warranties. In the automobile industry, car class fixed effects make the model control other indirect characteristics that are not. Consumers believe that car brand and its fixed effects primarily control pricing and are as signal quality indicator (Srivastava and Mitra, 1998). 4. Insurance Theory The warranty insurance theory states that the level of consumer risk aversion is with the duration of warranties purchased. This implies that the majority of consumers who buy products with long term do so as a way of reducing risks rather than as a signal for quality (Choi and Ishii, 2010). 5. Other Promotional Tools used The other promotional tools such as advertising, sales promotions and corporate sponsorship changes the consumer’s perceptions about different products hence affecting the attractiveness of warranties as quality signals. Advertising tends to create brand images alongside celebrity endorsements which go along in creating a psychological image in the consumer’s minds. These established brands make warranties unattractive as consumers compare celebrities’ success to a particular brand thus ignoring the significance of warranties as signals of high quality. In the situation of sales promotions, consumers are offered more for less thus tend to find high pricing associated with long term warranties as rather unattractive. Other promotional tools such as corporate sponsorship and personal selling are more appealing to consumers. This is because products are excellent third party reviews from both the media and individual basis hence making warranties rather unattractive. Similarly, warranties contain very limited quality information to consumers who make consumers focus more on manufacturer reputation and promotional tools as quality signals. This makes buyers de-emphasize the signalling role of warranties (Choi and Ishii, 2010). 6. Heterogeneous Nature of Buyers The nature of buyers is heterogeneous in their valuation of warranty coverage. The market contains a spectrum of buyers from gamblers to hedgers. Gamblers place very little value on warranty coverage while hedgers place very high value on warranty coverage. Similarly, high-quality goods sellers have a problem trying to get a fair price since the quality is variable and difficult for buyers to evaluate. This makes the use of warranties unattractive as many people have different perceptions about the quality and the nature of buyers. This variation limits the attractiveness of warranties as signals for quality (Emons, 1989). Conclusion This paper argues that warranties play a very vital role in the signalling of a firm’s quality production. The logic behind warranties as signals for quality is based on companies’ confidence to avert associated risks through the provision of quality products in materials and workmanship. Since the products have been manufactured using high-quality material and workmanship, the company can take costs associated with repair and replacement since it is on a slight scale. As a result of the information insufficiency, consumers tend to rely on the companies’ confidence to reimburse them for costs associated with functionality breakdowns as a way of communicating quality. The product warranties signal product quality through minimization of risks on the consumer’s part. Warranties vary in form of length, brand and purpose. Other factors that limit the attractiveness of product quality as signals for high-quality firms include brand preference and different levels of product information to mention just but a few. Reference List Choi, B., & Ishii, J. (2010). Consumer perception of warranty as signal of quality: An empirical study of power train warranties. Working Paper, Amherst College. Emons, W. (1989).On the limitation of warranty duration. The Journal of Industrial Economics, 287-301. Grossman, S. J. (1981). The informational role of warranties and private disclosure about product quality. Journal of law and economics, 461-483. Srivastava, J., and Mitra, A. (1998).Warranty as a signal of quality: The moderating effect of consumer knowledge on quality evaluations. Marketing Letters, 9(4), 327-336. Read More