The Effect of Product Misperception on Economic Outcomes: Evidence from the Extended Warranty Market
We use panel data on extended warranty purchases to investigate three potential drivers of the economic outcomes in this market: (1) pricing power due to consumers' search costs and the add-on feature of the warranty, (2) standard risk aversion, and (3) consumers' misperception of the insured product's failure probability. We estimate a model that incorporates these drivers, and perform counterfactual experiments to quantify their significance. We find that ``shutting down'' probability distortions leads to a decrease of more than 80\% in market volume and profit, and to a dramatic increase in consumer welfare. We also find that probability distortions are reduced with information and experience.
Salant, Yuval. 2016. The Effect of Product Misperception on Economic Outcomes: Evidence from the Extended Warranty Market.