Question

2. How do warranties and guarantees act as signals? What economic information problem might they address?

Answer 1

Consumers face a situation where they are not convinced about the quality of the product by looking at it. The market for lemons is a concrete example where just observing the car is not sufficient for acknowledging it to be a lemon. In this sense warranties and guarantees are helpful because they act as a signal towards the quality of the product. The address an important economic problem of informational asymmetry. Because parties in transaction especially a manufacturer and a consumer often face asymmetry in information where manufacturer has a greater knowledge of the product then the consumer, providing warranties and guarantees will ensure that the manufacturer is a genuine one and the product is not a lemon.

Consumers will therefore buy the product and will be willing to pay a higher price for the product if warranty or guarantee is compiled with. Because the risk is now shared by the manufacturer and not only borne by the buyer alone.