Money-Back Warranties

Abstract

We present a model of monopoly provision of money-back warranties. A buyer values an object more than its seller. They are both risk neutral and initially have no private information. The buyer can, however, acquire information and learn his true valuation for the object. Information acquisition is wasteful because it is costly, and because it reduces the gains from trade. The seller uses a warranty to prevent wasteful information acquisition, by offering the buyer some of the benefit that the information would have given him, namely, the ability not to purchase useless objects. We compare the optimal contracts when a warranty can be offered and when it cannot. We find that when the cost of information is lower than a threshold, allowing the seller to offer a warranty is welfare improving. However, when the cost of information is higher than the threshold, it is socially optimal to forbid money-back warranties.