The Effect of Product Misperception on Economic Outcomes: Evidence from the Extended Warranty Market

Panel and experimental data are used to analyze the economic outcomes in the extended warranty market. We establish that the strong demand and high profits in this market are driven by consumers distorting the failure probability of the insured product, rather than standard risk aversion or sellers' market power. Providing information to consumers about failure probabilities significantly reduces their willingness to pay for warranties, indicating the important role of information, or lack of, in driving consumers' purchase behavior. Such information provision is shown to be more effective in enhancing consumer welfare than additional market competition.