Market Regulation of Voluntary Add-on Contracts

This paper analyzes contract choices and the effectiveness of consumer protection policies when firms can offer voluntary add-on insurance for their products at the point of sale. We develop a model in which a base product can be sold together with a voluntary extended warranty contract that insures consumers against the risk of product breakdown. Some consumers do not pay attention to extended warranties before making a base product choice, but they overestimate the value of such warranties at the point of sale. Under retail competition, if the resulting extended warranty profits are sufficiently high, a no-arbitrage condition prevents the full profits from being redistributed to consumers via a lower base product price. Inducing competition in the extended warranty market weakly increases consumer welfare and weakly outperforms a minimum warranty standard, which can even reduce consumer surplus. The results of the paper are consistent with the effects of recent changes regarding extended warranty regulation by UK legislators.