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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
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    References listed on IDEAS

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    Cited by:

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    2. 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.
    3. 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.
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    5. 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.
    6. 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.
    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. Xiao Huang & Dan Zhang, 2020. "Service Product Design and Consumer Refund Policies," Marketing Science, INFORMS, vol. 39(2), pages 366-381, March.
    10. 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.
    11. Yanrong Li & Lai Wei & Wei Jiang, 2021. "A Two-stage Pricing Strategy Considering Learning Effects and Word-of-Mouth," Papers 2110.11581, arXiv.org.

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