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Simultaneous signalling and screening with warranties

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It is well known that sellers can use warranties to screen consumers and increase profits. The ability of warranties to signal is also well accepted. This paper considers a situation where a high quality seller needs warranty policy to do both. Using an analytical model, the author's objective is to identify the optimal strategy for a high quality seller who offers a base warranty and optional extended warranty for a product where product quality is not observable to buyers. He finds that signalling can limit the ability of a seller to screen especially when buyers are willing to pay a significant premium for higher quality. To signal, the seller generally lengthens base warranties and shortens optional coverage making the bundles for each type of buyer more and more similar. He also provides an empirical application of the model in the Toronto used car market.

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