Product reliability and extended warranty in supply chains

Abstract We study firms' product reliability and extended warranty (EW) pricing decisions in different supply chains. Using a game‐theoretic model, we analyze three supply chains: a centralized supply chain in which the manufacturer sells products and optional EWs directly to consumers (Model C), and two decentralized models in which products and EWs are sold through a retailer with the EW offered by the manufacturer (Model M) or a third‐party insurer (Model I). We also study cases where consumers cannot observe product reliability and investigate the impact of unobservable quality. We find that the manufacturer generates most profits by directly selling both products and EWs, irrespective of whether reliability is observable or not; whereas the retailer prefers selling EWs offered by an insurer when consumers can observe product reliability but prefers sourcing EWs from the manufacturer when product reliability is unobservable. In addition, when the reliability is unobservable to consumers, the manufacturer always chooses a lower reliability than that when consumers can observe the reliability. Such information advantage (over consumers) on product reliability hurts the manufacturer and consumers, and the retailer. With the existence of a third‐party insurer, the manufacturer may be indifferent or prefer to provide EWs. But having the manufacturer competing with the insurer benefits consumers and the retailer under certain conditions. This study offers guidelines on how firms should determine product reliability and EW prices in different supply chains, and sheds light on where a retailer should source EWs based on whether reliability is observable to consumers or not. Finally, our results highlight the importance of establishing a mechanism to credibly disclose product reliability information to consumers.