Warranties

Warranties and money-back guarantees act as powerful signals about your product’s quality. Imagine that there are two types of cars a buyer could purchase from a used car dealer: lemons and high-quality vehicles. A lemon would require a lot of future repair work while a high-quality car would require little or none. Assume that the dealer, but not the buyer, knows the car’s quality. If the seller knows that his car is of high quality, he should offer a free warranty, promising to pay all repair costs. The seller of a lemon would be reluctant to offer a warranty that would impose expensive obligations upon him. The buyer should thus believe that a free warranty offer signals that the car is no lemon. Note that if the car is of high quality, the warranty will cost the seller nothing and provide no benefit to the buyer once the car is purchased. The warranty would still, however, serve an important function. It would signal the car’s quality.