IDEAS home Printed from https://ideas.repec.org/a/inm/ormsom/v17y2015i1p87-100.html
   My bibliography  Save this article

No Claim? Your Gain: Design of Residual Value Extended Warranties Under Risk Aversion and Strategic Claim Behavior

Author

Listed:
  • Guillermo Gallego

    (Department of Industrial Engineering and Operations Research, Columbia University in the City of New York, New York, New York 10027)

  • Ruxian Wang

    (Johns Hopkins Carey Business School, Baltimore, Maryland 21202)

  • Ming Hu

    (Rotman School of Management, University of Toronto, Toronto, Ontario M5S 3E6, Canada)

  • Julie Ward

    (Hewlett-Packard Company, Palo Alto, California 94304)

  • Jose Luis Beltran

    (Hewlett-Packard Company, Palo Alto, California 94304)

Abstract

Traditional one-price-for-all extended warranties do not differentiate customers according to their risk attitudes, usage rates, or operating environment. These warranties are priced to cover the cost of high-usage customers who have more failures and are willing to pay a risk premium for their risk aversion. That makes traditional warranties economically unattractive to low-usage customers and those who are less risk averse. These issues can be addressed by residual value warranties, which refund part of the up-front price to customers who have zero or few claims according to a predetermined refund schedule. Residual value warranties may induce strategic claim behavior, since customers may prefer to pay for small failures out of pocket rather than claim failures now and give up potential refunds later.We design and price residual value warranties to maximize expected profits, taking into account strategic claim behavior and risk attitudes. For the constant absolute risk aversion model, we characterize customers’ optimal claim strategy as well as the net value and support cost for residual value warranties. Surprisingly, the total support cost to the service provider, including repair costs and refunds, is lower for more risk-averse customers under the residual value warranties, whereas their willingness to pay is higher. As contingent contracts, residual value warranties can better price discriminate customers than traditional warranties. We identify conditions under which residual value warranties are strictly more profitable than traditional warranties in a homogeneous market, as well as in heterogeneous markets that differ in various dimensions, such as risk attitude, failure rate, and repair cost.

Suggested Citation

  • Guillermo Gallego & Ruxian Wang & Ming Hu & Julie Ward & Jose Luis Beltran, 2015. "No Claim? Your Gain: Design of Residual Value Extended Warranties Under Risk Aversion and Strategic Claim Behavior," Manufacturing & Service Operations Management, INFORMS, vol. 17(1), pages 87-100, February.
    • Handle: RePEc:inm:ormsom:v:17:y:2015:i:1:p:87-100
    DOI: 10.1287/msom.2014.0501
    as

    Download full text from publisher

    File URL: http://dx.doi.org/10.1287/msom.2014.0501
    Download Restriction: no
    File URL: https://libkey.io/10.1287/msom.2014.0501?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    References listed on IDEAS

    as
    1. repec:bla:jemstr:v:4:y:1995:i:1:p:33-53:a is not listed on IDEAS
    2. Lutz, Nancy A. & Padmanabhan, V., 1998. "Warranties, extended warranties, and product quality," International Journal of Industrial Organization, Elsevier, vol. 16(4), pages 463-493, July.
    3. Frank Beichelt, 1993. "A unifying treatment of replacement policies with minimal repair," Naval Research Logistics (NRL), John Wiley & Sons, vol. 40(1), pages 51-67, February.
    4. Boyan Dimitrov & Stefanka Chukova & Zohel Khalil, 2004. "Warranty costs: An age‐dependent failure/repair model," Naval Research Logistics (NRL), John Wiley & Sons, vol. 51(7), pages 959-976, October.
    5. Padmanabhan, V, 1995. "Usage Heterogeneity and Extended Warranties," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 4(1), pages 33-53, Spring.
    6. Joseph C. Hartman & Kamonkan Laksana, 2009. "Designing and pricing menus of extended warranty contracts," Naval Research Logistics (NRL), John Wiley & Sons, vol. 56(3), pages 199-214, April.
    7. Herbert Moskowitz & Young Hak Chun, 1994. "A poisson regression model for two‐attribute warranty policies," Naval Research Logistics (NRL), John Wiley & Sons, vol. 41(3), pages 355-376, April.
    8. V. Padmanabhan & Ram C. Rao, 1993. "Warranty Policy and Extended Service Contracts: Theory and an Application to Automobiles," Marketing Science, INFORMS, vol. 12(3), pages 230-247.
    9. Christoph Haehling von Lanzenauer, 1974. "Optimal Claim Decisions by Policyholders in Automobile Insurance with Merit-Rating Structures," Operations Research, INFORMS, vol. 22(5), pages 979-990, October.
    10. De Pril, Nelson, 1979. "Optimal Claim Decisions for a Bonus-Malus System: a Continuous Approach," ASTIN Bulletin, Cambridge University Press, vol. 10(2), pages 215-222, March.
    11. Stefano DellaVigna & Ulrike Malmendier, 2006. "Paying Not to Go to the Gym," American Economic Review, American Economic Association, vol. 96(3), pages 694-719, June.
    12. N Jack & D N P Murthy, 2007. "A flexible extended warranty and related optimal strategies," Journal of the Operational Research Society, Palgrave Macmillan;The OR Society, vol. 58(12), pages 1612-1620, December.
    13. Kliger, Doron & Levikson, Benny, 2002. "Pricing no claims discount systems," Insurance: Mathematics and Economics, Elsevier, vol. 31(2), pages 191-204, October.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Kaiying Cao & Yunyi Su & Guoxin Han & Jia Wang, 2023. "Optimal maintenance service outsourcing strategy considering extended warranty service," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 44(2), pages 1344-1358, March.
    2. Wang, Haijun & Tan, Jie & Guo, Shuojia & Wang, Shenhao, 2018. "High-value transportation disruption risk management: Shipment insurance with declared value," Transportation Research Part E: Logistics and Transportation Review, Elsevier, vol. 109(C), pages 293-310.
    3. Guo, Shu & Choi, Tsan-Ming & Chung, Sai-Ho, 2022. "Self-design fun: Should 3D printing be employed in mass customization operations?," European Journal of Operational Research, Elsevier, vol. 299(3), pages 883-897.
    4. Choi, Tsan-Ming & Guo, Shu & Liu, Na & Shi, Xiutian, 2020. "Optimal pricing in on-demand-service-platform-operations with hired agents and risk-sensitive customers in the blockchain era," European Journal of Operational Research, Elsevier, vol. 284(3), pages 1031-1042.
    5. Yanrong Li & Lai Wei & Wei Jiang, 2021. "A Two-stage Pricing Strategy Considering Learning Effects and Word-of-Mouth," Papers 2110.11581, arXiv.org.
    6. Bian, Yiwen & Xie, Jiazheng & Archibald, Thomas W. & Sun, Yanhong, 2019. "Optimal extended warranty strategy: Offering trade-in service or not?," European Journal of Operational Research, Elsevier, vol. 278(1), pages 240-254.
    7. Dai, Yue & Chao, Xiuli, 2016. "Price delegation and salesforce contract design with asymmetric risk aversion coefficient of sales agents," International Journal of Production Economics, Elsevier, vol. 172(C), pages 31-42.
    8. Jianhua Ma & Xingzheng Ai & Wen Yang & Yanchun Pan, 2019. "Decentralization versus coordination in competing supply chains under retailers’ extended warranties," Annals of Operations Research, Springer, vol. 275(2), pages 485-510, April.
    9. Lianmin Zhang & Lei Guan & Daniel Zhuoyu Long & Houcai Shen & Huajun Tang, 2023. "Who is better off by selling extended warranties in the supply chain: the manufacturer, the retailer, or both?," Annals of Operations Research, Springer, vol. 328(2), pages 1557-1583, September.
    10. Tong Peng & Liu Chunling, 2020. "Designing differential service strategy for two-dimensional warranty based on warranty claim data under consumer-side modularisation," Journal of Risk and Reliability, , vol. 234(3), pages 550-561, June.
    11. Xiao Huang & Dan Zhang, 2020. "Service Product Design and Consumer Refund Policies," Marketing Science, INFORMS, vol. 39(2), pages 366-381, March.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Wang, Xiaolin & Zhao, Xiujie & Liu, Bin, 2020. "Design and pricing of extended warranty menus based on the multinomial logit choice model," European Journal of Operational Research, Elsevier, vol. 287(1), pages 237-250.
    2. Bian, Yiwen & Xie, Jiazheng & Archibald, Thomas W. & Sun, Yanhong, 2019. "Optimal extended warranty strategy: Offering trade-in service or not?," European Journal of Operational Research, Elsevier, vol. 278(1), pages 240-254.
    3. Kunpeng Li & Suman Mallik & Dilip Chhajed, 2012. "Design of Extended Warranties in Supply Chains under Additive Demand," Production and Operations Management, Production and Operations Management Society, vol. 21(4), pages 730-746, July.
    4. Joseph C. Hartman & Kamonkan Laksana, 2009. "Designing and pricing menus of extended warranty contracts," Naval Research Logistics (NRL), John Wiley & Sons, vol. 56(3), pages 199-214, April.
    5. Murthy, D. N. P. & Djamaludin, I., 2002. "New product warranty: A literature review," International Journal of Production Economics, Elsevier, vol. 79(3), pages 231-260, October.
    6. Lei, Yong & Liu, Qian & Shum, Stephen, 2017. "Warranty pricing with consumer learning," European Journal of Operational Research, Elsevier, vol. 263(2), pages 596-610.
    7. Lianmin Zhang & Lei Guan & Daniel Zhuoyu Long & Houcai Shen & Huajun Tang, 2023. "Who is better off by selling extended warranties in the supply chain: the manufacturer, the retailer, or both?," Annals of Operations Research, Springer, vol. 328(2), pages 1557-1583, September.
    8. Li, Kunpeng & Chhajed, Dilip & Mallik, Suman, 2005. "Design of Extended Warranties in Supply Chains," Working Papers 05-0128, University of Illinois at Urbana-Champaign, College of Business.
    9. Joaquín Coleff, 2020. "Can consumer complaints reduce product reliability? Should we worry?," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 29(1), pages 74-96, January.
    10. Wang, Yukun & Liu, Zixian & Liu, Yiliu, 2015. "Optimal preventive maintenance strategy for repairable items under two-dimensional warranty," Reliability Engineering and System Safety, Elsevier, vol. 142(C), pages 326-333.
    11. Mitra, Amitava, 2021. "Warranty parameters for extended two-dimensional warranties incorporating consumer preferences," European Journal of Operational Research, Elsevier, vol. 291(2), pages 525-535.
    12. Jianhua Ma & Xingzheng Ai & Wen Yang & Yanchun Pan, 2019. "Decentralization versus coordination in competing supply chains under retailers’ extended warranties," Annals of Operations Research, Springer, vol. 275(2), pages 485-510, April.
    13. Arthur Charpentier & Arthur David & Romuald Elie, 2016. "Optimal Claiming Strategies in Bonus Malus Systems and Implied Markov Chains," Working Papers hal-01326798, HAL.
    14. Pranav Jindal, 2015. "Risk Preferences and Demand Drivers of Extended Warranties," Marketing Science, INFORMS, vol. 34(1), pages 39-58, January.
    15. Laksana, Kamonkan & Hartman, Joseph C., 2010. "Planning product design refreshes with service contract and competition considerations," International Journal of Production Economics, Elsevier, vol. 126(2), pages 189-203, August.
    16. Desai Preyas S & Padmanabhan Paddy, 2004. "Durable Good, Extended Warranty and Channel Coordination," Review of Marketing Science, De Gruyter, vol. 2(1), pages 1-25, January.
    17. Michael Braun & Peter S. Fader & Eric T. Bradlow & Howard Kunreuther, 2006. "Modeling the "Pseudodeductible" in Insurance Claims Decisions," Management Science, INFORMS, vol. 52(8), pages 1258-1272, August.
    18. N Jack & D N P Murthy, 2007. "A flexible extended warranty and related optimal strategies," Journal of the Operational Research Society, Palgrave Macmillan;The OR Society, vol. 58(12), pages 1612-1620, December.
    19. Bo Jiang & Xubing Zhang, 2011. "How Does a Retailer's Service Plan Affect a Manufacturer's Warranty?," Management Science, INFORMS, vol. 57(4), pages 727-740, April.
    20. Arthur Charpentier & Arthur David & Romuald Elie, 2017. "Optimal Claiming Strategies in Bonus Malus Systems and Implied Markov Chains," Risks, MDPI, vol. 5(4), pages 1-17, November.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:inm:ormsom:v:17:y:2015:i:1:p:87-100. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Chris Asher (email available below). General contact details of provider: https://edirc.repec.org/data/inforea.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.