Question

Two used car dealerships compete side by side on a main road. The first, Harry's Cars, always sells high quality cars that it carefully inspects and, if necessary, services. On average, it costs Harry's \(\$ 8000\) to buy and service each car that it sells. The second dealership, Lew's Motors, always sells lower-quality cars. On average, it costs Lew's only \(\$ 5000\) for each car that it sells. If consumers knew the quality of the used cars they were buying, they would pay \(\$ 10,000\) on average for Harry's cars and only \(\$ 7000\) on average for Lew's cars. Without more information, consumers do not know the quality of each dealership's cars. In this case, they would figure that they have a \(50-50\) chance of ending up with a high-quality car and are thus willing to pay \(\$ 8500\) for a car. Harry has an idea: He will offer a bumper-to bumper warranty for all cars that he sells. He knows that a warranty lasting \(Y\) years will cost \(\$ 500 Y\) on average, and he also knows that if Lew tries to offer the same warranty, it will cost Lew \(\$ 1000 Y\) on average. a. Suppose Harry offers a one-year warranty on all of the cars he sells. i. What is Lew's profit if he does not offer a oneyear warranty? If he does offer a one-year warranty? ii. What is Harry's profit if Lew does not offer a one-year warranty? If he does offer a one-year warranty? iii. Will Lew's match Harry's one-year warranty? iv. Is it a good idea for Harry to offer a one-year warranty? b. What if Harry offers a two-year warranty? Will this offer generate a credible signal of quality? What about a three-year warranty? c. If you were advising Harry, how long a warranty would you urge him to offer? Explain why.

Short answer

i. Lew's profit without warranty is $3500, while it is $2500 if he offers a one-year warranty. ii. Harry's profit is $0 whether or not Lew offers a one-year warranty. iii. Lew will not match Harry's one-year warranty because it reduces his profit. iv. It is a good idea for Harry to offer a one-year warranty as it reduces Lew's profit if he tries to match. v. Offering a two or a three-year warranty gives a stronger signal, with Lew less likely to match the warranty length. vi. Advisably, Harry should offer a two-year warranty, providing a credible signal without significantly reducing his profit.

Step-by-step solution

Answer to Question a.i

Firstly, let's calculate Lew's profit. If Lew does not offer a warranty, his revenue will be $8500 (the price consumers are willing to pay without knowing the quality of the cars), and his cost will be $5000. Therefore, his profit will be $8500 - $5000 = $3500. If Lew offers a one-year warranty, his cost increases by $1000, leading to a profit of $8500 - ($5000 + $1000) = $2500.

Answer to Question a.ii

When considering Harry, if Lew does not offer a warranty, Harry's revenue will be $8500, and his total costs will be $8000 + $500 (Cost of the warranty), resulting in a profit of $8500 - ($8000 + $500) = $0. If Lew offers a warranty, Harry's profit will still remain the same.

Answer to Question a.iii

Lew will not match Harry's one-year warranty. Offering the warranty reduces Lew's profit from $3500 to $2500. Hence, it is not a profitable move for him.

Answer to Question a.iv

For Harry, offering a one-year warranty did not increase his profit. But this step allows him to break even (Profit = $0) while Lew's profit decreases if he tries matching the warranty offer.

Answer to Question b

When Harry offers a two-year warranty, his costs increase by $1000, however for Lew, costs rise by $2000. If Lew does not match, Harry's profit is negative ($-500). But if Lew tries to match, his profit will be significantly negative ($-3500) which he cannot afford. So, this strategy provides a credible signal of quality. Similarly, a three-year warranty will increase costs even further and continues to provide a credible signal of quality.

Answer to Question c

Advising Harry, it would be strategic to offer a two-year warranty. This is long enough to deter Lew from offering a similar warranty (due to the high costs involved) but not too long to push Harry's profit too low. This simultaneously gives Harry's Cars a competitive advantage via credibility of signal and minimizes profit loss.

Key concepts

Signaling in Economics

In microeconomics, when dealing with markets characterized by information asymmetry—where one party possesses more or better information than the other—'signaling' is one of the strategies used to resolve this imbalance. Signaling involves one party, typically the more informed one, sending a credible signal to the less informed party to indirectly convey information about the product or service being offered.

For instance, in the case of Harry's Cars and Lew's Motors, offering a warranty is a form of signaling. By providing a guarantee, Harry signals to customers that he is confident in the quality of his cars. This form of signaling is powerful because it is more costly for low-quality car dealerships like Lew's Motors to imitate, ensuring that the signal is credible and that only high-quality dealerships like Harry's Cars will choose to offer such warranties.

Competitive Strategy

A competitive strategy involves actions that a business takes to attract customers, withstand competitive pressures, and strengthen its market position. Harry's Cars employs a competitive strategy by offering a bumper-to-bumper warranty. This strategy is designed not just to attract consumers who understand the value-added from this warranty, but also as a deterrent to competition. By imposing a cost structure that Lew's Motors cannot match due to his lower-quality cars, Harry effectively uses the warranty as a competitive weapon.

Incorporating a warranty into the competitive strategy allows a business to potentially increase its market share and set a threshold that competitors may find too costly to cross, thereby influencing the overall dynamics of the market.

Information Asymmetry

Information asymmetry is present in many economic transactions where one party has more or better information than the other party. This often leads to an inefficient market because the party with less information is at a disadvantage. In the exercise, customers are unaware of the quality differences between Harry's and Lew's vehicles and are only willing to pay an average price without additional information.

To combat the issues arising from information asymmetry, businesses can take steps to reduce the uncertainty faced by consumers. By offering a warranty, Harry provides additional information that helps consumers make a more informed decision, reducing the asymmetry and increasing the efficiency of the market.

Market Signaling

Market signaling refers to the way in which a market participant communicates its attributes or intentions to another participant within the market. It is related to signaling in economics, but it specifically deals with the actual mechanisms by which businesses can send these signals.

In our example, offering different lengths of warranties is a direct signal of quality that can be observed in the market. A one-year warranty, while not profitable for Harry, may function as a signal that his cars are of higher quality. Extending to a two-year warranty enhances this signal, making it more credible, because it further separates high-quality dealers like Harry from lower-quality ones like Lew. The advice to Harry to offer a two-year warranty is based on this market signaling theory; a warranty of this length is substantial enough to signal higher quality and differentiate his cars from his competitor's.