Question

Your product fails about 2% of the time, on average. Some customers purchase the extended warranty you offer in which you will replace the product if it fails. Suppose that you have currently set the price of the extended warranty at 2% of the product price.

An analyst at your company argues that after purchasing the extended warranty, customers are less likely to exercise caution when using the product because they will know that they can get their product replaced.

The analyst is claiming that ______ (adverse selection/ moral hazard) will cause the claim rate to be ______(lower/higher) than 2%.

True or False: You should set the price of the extended warranty at less than 2% of the product pri

Answer 1

The analyst is claiming that "Moral hazard" will cause the claim rate to be "higher" than 2%.

Adverse selection occurs when there is some information which is known by the seller and not the buyer, which is not the case here. The seller is not hiding any information here.

Moral hazard occurs when the person uses the product recklessly because the risks are covered. Because of moral hazard, the product will be damaged more i.e. more indemnity to cover.

The statement is "False".

If the extended warranty is less more people will take warranty and the damaged goods will increase even more.