1

Warranty Design
Under
Buyer
and Seller Risk Aversion
Technical Memorandum 552
by
Peter H. Ritchken
Charles S.
Tapiero
Department
of
Operations
Research
Weatherhead School of
Management
Case Western Reserve
University
Cleveland,
Ohio 44106
December 1984
Abstract
This paper provides a framework in which warranty policies for
non-repairable items can be evaluated according to risk
preferences of both buyers and
sellers.
In particular, a
warranty price schedule is established such that sellers are
indifferent among the policies.
Given this schedule, a buyer's
response is expressed by selecting the price-warranty
combination that minimizes
disutility. Within this framework, a
warranty can be viewed as an instrument of risk management that
can induce more sales and greater profitability. For given
utility functions, analytical results for the development of a
price schedule are developed.
Numerical results illustrate the
substitution effects between warranty terms, prices, and risk
parameters.
B
:
li
Warranty Design Under Buyer and Seller Risk Aversion
1. Introduction
Partial information regarding the bundle of product
attributes such as
reliability, safety, product life and
performance, combined with risk averse purchasing behavior of
consumers, has rendered warranties an important marketing
instrument.
Warranties provide consumers with market signals
concerning product quality and, hence, serve as a substitute to
more complete information regarding product reliability.
As
such, sellers may use warranties as policy instruments to improve
market performance or to alter consumer perceptions on quality
(Spence [13] ) .
The design of a warranty program involves establishing
li
conditions of compensation and the period of coverage.
The
selection of a policy is often determined by competition, sales
effects (signalling) and by
costs. These costs are determined
once the rebate policy, failure function, and demand function
have been
specified. Menke [10] has examined the size of
warranty reserves using linear pro rata rebates and lump sum
I
rebates when failures have exponential times and the item is
non-repairable. Lowerre [8] and Heschel [7] have examined the
problem for repairable
items.
Actual relationships between
warranty parameters and expected profits have also been
investigated (Anderson [1], Glickman and Berger [6], and Thomas
[14]). Blischke and Scheuer [4] use a renewal framework to
compare costs to the consumer and profits of the supplier of
warranteed versus unwarranteed items.
Nguyen and Murthy
-1-
I
I
generalize free replacement and pro rata warranties to more
- applicable policies.
They also obtain bounds for expected total
costs for the case when the failure distribution of the item is
better new than used [11].
This article treats the issue of warranty policy for
non-repairable items that are replaced when a failure occurs
during the warranty period.
Within a risk framework we show how
a schedule of prices and associated warranties can be established
such that sellers are indifferent as to which warranty is sold.
Given this schedule buyers select their price warranty package in
accordance with their
preferences.
The implications of providing
this risk transference warranty schedule are explored.
2.0 Assumptions and Notation
We shall consider a non-repairable item that is deemed
essential and will always be replaced upon
failure. The item is
sold with a warranty that provides pro rated compensation over a
period of time T*. Upon any failure prior to time T*, a new item
is installed and a new warranty
issued. When T* units of time
expire without failure, then the warranty term expires.
We shall adopt the following notation:
$ the warranty policy
PQ the price of the item under no warranty
P the price of the item under warranty
CO the cost of the item
8
W(0) the warranty cost (rebate) incurred by the seller when
an item fails
8 -
Xj the time between failure j-1 and j
-2-
8
.th
S. the time of the
J
failure, S. = E X.
1 Ji
i=1
N(t) the number of failures up to time t
r the riskless rate of return
A "-" above
any
variable denotes a random variable.
Figure 1 characterizes a sequence of warranty related costs
issued by the seller over time.
Figure 1 here
Notice that for this type of policy, the warranty cost
incurred by the supplier when a failure occurs depends only on
the time since the previous failure. That is, the warranty cost
.th
incurred by the seller at the 1
failure is W(0) = W(Xi)
We now proceed to provide an economic analysis of the
warranty policy, first from the viewpoint of the seller and then
from the viewpoint of the buyer.
3.0
The Seller's and the Buyer's Problems
-
Let w(T) be a random variable representing the net present
value of profits due to a sequence of sales under no warranty up
to time T. Then
8 - -- - - - - -- -
N(T)-
7TOCT) = (PO - CO) + El Vj (1)
8 - --
where V = (P - CQ)exp(-rS) and V represents the present value
. th
of the
J purchase.
-
Similarly, define by 1*(T) to be the net present value of
profits that accrue from a sequence of sales under warranty 0.
8
T
h
e
n
-3-
il
i -
N(T)1
Trt(T)
(P* - CO) + jEl
Uj
(2)
-
where U = (P - C - W(0) ) exp (-rS) represents the present value
of profit from the
J purchase.
.th
- -
Let EUCT*) and EUCTO) be the expected utility of profit 1$
-
and Tr
0,
respectively. Then, for the seller to be indifferent
between issuing a warranteed item for price P and an
unwarranteed item for price P, we require:
- -
EU(T) =
EU(lrl)
(3)
Let r(0, P4) be the set of all warranties 0 and associated
prices P that satisfy this condition. Given this set r($,P*),
0
the buyer will select that price-warranty combination that best
reflects his/her preferences. Specifically, let LQ(T) represent
the present value of purchase costs incurred up to time T.
Hence:
-
- N(T) _
ZOCT) = Po +jE
Plexp(-rS)
(4)
With warranty, 0, the costs to the buyer are:
--.-- -____N(T_)___-
10(T) = P +jfl(P0 - W(0))exp(-rSj) (5)
Notice that equation (4) can be viewed as a special case of
equation (5), when P =P and W(0) =0. Let Z
()
denote the
loss function for the
buyer.
The buyer's problem is to select
that warranty price schedule from r(P , 0) such that expected
0
disutility is
minimized. The buyer's problem is thus:
I
-4-
i
Minimize EJkI$)
0, Pt
subject
to
(6)
- -
EU(*0) = EU(10)
$ S
where S is the set of all feasible policies, 0.
3.1 Price Warranty Schedules Under Quadratic Risk Aversion
To obtain explicit results, and to investigate the effects of
risk behavior on the price warranty schedule, we shall assume
that both buyer and seller are risk averse and that their utility
functions can be approximated by quadratic functions (Markowitz
'91). Specifically, let
- -
I
EUCT ) = E(w ) -p Var(T
) (7)
0 +S t
- -
and
E (10) = E(10) + FBVar(10)
(8)
where Ps 2 0, 08 2 0 are the risk aversion parameters of the
seller and buyer, respectively.
In order to investigate the set of warranties and prices that
belong to r (0, p*),
we shall assume that failures occur
according
to a Poisson process with parameter
A.
For the Poisson process,
I -i- -- I- I -. -i-I- -- - -I -i- - - -I- -.-- -- -
and for the infinite horizon case, the expected utility of profit
for the no-warranty case can be computed (See Appendix
1).
The
result is
- -
EU(1 ) = E( ) -p Var(w
) (9)
O O S O
with
8 -
E(A0) =(PO - CO) (A +
r)/r (10)
2
li
a
V a r(1 r ) =(P
, - CO) 2 4" h (,1, 'b -1 2)
and 1
1 11 1-a
C-
1
al = A/(A + r)
bl = 1/(1 + 2r)
In order to analyze profits with warranties, we shall
restrict attention to a linear pro rata rebate policy where costs
are given by:
W(0) = W(Xi) = k(T* - xi)/T*
0 < X. < T*
- 1-
(12)
=0 X. > T*
1
The values k and T* are decision variables for this linear
warranty. In special cases, kl may be chosen to be the purchase
price or the cost of production.
We shall assume that it is a
decision variable that is constrained to fall in a specified
interval.
Examples of such policies are provided in Thomas [14].
I 0
As a result, the set r(0, P) = r(k,T,P ).
For this warranty policy, the expected utility of net profits
-
EU(4) can be obtained as a function of P, k, and T*. The
derivation, appearing in Appendix 2, yields the following result
1 -
EU(10) hlP02 + h2P0 + h3
8 where
2
hl = -ps(glab - g2b )
:
h =h - 2h C
2 4 10
h =h C -h C +h
2
3 10 40 5
1+r
114 =(-r ) - MS(292bd2 - glbd2 - gladl)
h5 = -ps(gldld2 - d1292) - dl(A + r)/r
91 =(1 +b)/(1 - a)(1 - b)b
92 = 1/(1 - b)
2
a = A/(A + 2r)
-6-
i
b = 1/(A + r)
d = Ak(1 - [jr + A)T]-1(1 - exp( (jr + A)T) )/(jr + A) j = 1,2
Now the feasible set r(k,T,P*) can be expressed as the set of
policies, k and T, together with prices P*, that satisfy the
following condition:
hlp02 +h P+h 3=
EU(10)
(14)
2$
Before we use equation (14) as a constraint in the buyer's
problem (equation (6)), we shall illustrate the seller's price
warranty indifference schedule. Figure 2 shows the set r(k,T,P)
for an item whose failure rate is A = 0.02. The cost of
producing the item is $1.0 and the sales price with no warranty
is $5.0.
Values of k and T are restricted to integer values
between 0 and 5 for k and 0 and 6 for T.
Figure 2 here
Figure 2 clearly illustrates that for the seller to be
indifferent among policies, the price of the item, P*, must
increase as k increases and/or as T*
increases.
To provide
further insight, consider four possible price-warranty policies,
A, B, C, and
D.
The actual composition of these warranties is
I- - - - I- - -I- - - -I- - - - - - - - - - -
shown in Table 1, below.
k T P EUCT )
EZ(0) $$
A 0 0 5 11.6 16.0
B 2 2 7.17 11.6 18.2
C 3 4 8.08 11.6 33.7
D 5 6 9.96 11.6 48.01
Table 1
i
-7-
"
For the risk averse seller to be indifferent between issuing
items with warranties A, B, C, and D, the prices must be set as
indicated in the Table.
Alternatively, the "cost" to the seller
of introducing a warranty without increasing the price above $5.0
can be established.
Given the set r (k,T,P*), defined by equation (14), the
buyer's problem is given by:
Minimize EZ(0)
k,T,P
subject
to
(15)
hlp02 + h2p0 + h3 = EU(0)
(k, T) S
In Appendix 3, the expected disutility for the buyer is shown
to be
EZ< 1 0) = h P + h P + h
2
10 0 11
$
12
where
h = pB (glab - 92b2)
10
A+r
:
hll =BB (292bdl - glbd2 - gladl) - (-r-)
. .A+r.
-- --hl-2 - gB-(gld 1-d-2-- g 2dil) - -9-1-l'-r..., ---- -- - --
Given the expressions the optimal warranty policy, 0*, and
price, P
*
, can be obtained.
0
Example
Figure 3 illustrates the expected disutility for the warranty
policies r (k, t,
P*),
provided
in Figure 2.
Figure 3 here
-8-
"
The expected disutilities for the warranty policies, A, B, C,
and D are provided in Table 1.
The results presented are for the case when both buyer and
seller have the same risk aversion
parameter. Figure 3 clearly
indicates that, for this case, buyers are not prepared to pay the
additional premium to obtain
warranties.
Of course, as the risk
aversion parameter, 98' changes, the optimal warranty policy
changes.
Figures 4 and 5 illustrate how the expected disutility
changes with respect to k and T values for different settings of
buyers' risk aversion.
Figure 4 here
Figure 5 here
Table 2 summarizes the optimal prices and warranties for
different buyer and seller risk aversion parameters.
Table 2
prices P* do not necessarily rise as risk aversion, ps,
increases. This is true because the expected utility, EU(Q)
decreases as
risk
aversion,
ps
increases
(See
equation (9) ) . For
any given PS, the optimal policy is usually, but not always,
provided by an extreme warranty.
(For the example, this is k=1
--- - - --... -- --
i
or k=5 and T=l o r T=5.
I
-9-
0
S
-0.02 -0.01 +0.01 +0.02
-0.02 6.21 6.19 6.16 6.14
-0.01 5.19 6.19 6.16 6.14
FB
+001 5.19 5.21 5.67 5.89
+0.02 5.19 5.44 5.67 5.68
D
S
-0.02 -O.01 +O.01 +0.02
T* K* T* K* T* K* T* K*
-0.02 s s s 5 5 5 5 5
-0.01 1 1 5 5 5 5 5 5
P +0.01 1 1 1 1 1 3 1 4
B
+0.02 1 1 1 2 1 3 1 3
Table 2
Price-Warranty and Quality Schedules Under Risk Aversion
Since buyers interpret warranties as signals of quality,
sellers may find it advantageous to provide consumers with false
signals by upgrading the warranty without improving quality.
Although this strategy increases future potential liability, it
may be cheaper than upgrading the quality. Moreover
, the
strategy should lead to increased sales since the consumers have
been provided with an extra
service.
Since sellers can improve
customer service by improving quality and/or warranty, it appears
that warranty policy should not be established independently of
-10-
quality.
In this light, let C(R) be the cost of producing an item of
reliability,
R.
We assume the function to be convex (C'(R) > 0,
C" (R) < 0)
. The seller's problem is to establish a
price-warranty quality indifference set r(k,T,R,P*) in such a way
that all price-warranty-quality settings in this set yield the
same expected utility as that provided by a standard unwarranteed
item of prescribed quality, R*.
The buyer's decision problem is then given by:
Minimize EkI$)
k,T,R
subject to _
r(k,T,R,P ) = EU(#(R*))
$
(k,T,R) G S
As an example, assume the cost of production to the
manufacturer is given by
C(R) =
RYko
q<1
:
where
R = exp(-A)
Furthermore, assume the sales price of an unwarranteed item,
with A= 0.02 is $5. With y=2 and k =1,w e have:
_ _ _ c_(_A) _=_kOexp(-A_Y) =_exp (-2A).___ __ __ __ __ _ __ __
Table 3 illustrates the optimal prices and warranties as the
quality level changes for case parameters ps = 0.2 and pb = 0.2.
A C P T K EUCT ) EZ(t )
O d 0 0
0.05 0.9 9.64 5 3 11.6 13.72
0.10 0.82 8.05 1 2 11.6 14.52
0.15 0.74 6.64 5 1 11.6 15.04
0.20 0.67 5.96 1 1 11.6 15.44
Table 3
- -11-
Note that as A increases, reliability decreases, the unit
cost of production decreases, and the price of the item
decreases. The optimal warranty to purchase is indicated in the
fourth and fifth columns. The seller is indifferent to all these
quality-warranty policies; however, the final column indicates
that the buyer will prefer to pay a premium to receive a high
quality item rather than receive the low quality item at a
discount.
Conclusion
This paper has provided a framework in which warranty
policies for non-repairable items can be evaluated according to
risk preferences of both the buyers and
sellers.
In particular,
we have emphasized the design and the pricing of warranties to
which the sellers are indifferent (in an expected utility sense).
Given the price-warranty schedule, a buyer's response is
expressed by selecting the price-warranty which minimizes
disutility. As a result, a seller can increase sales (and hence
profits) by tailoring price-warranty schedules to specific
buyers'
needs. In this sense, warranties cannot be perceived as
i-
cost inducing only (as is common in the marketing literature) but
as an instrument of buyers' risk management which can induce more
sales and greater profitability. For a particular mean-variance
utility function, we were able to derive analytical results for
the price warranty schedule P4. Furthermore, for a linear pro
rata rebate policy and.Poisson failure, specific results are
obtained'which allow a sensitivity analysis of the warranty
parameters to its price and to seller profitability.
Numerical
-12-
results have emphasized the substitution effects between these
parameters and buyers' and sellers' risk behavior.
To assess the implications and the design of price-warranty
schedules, issues of partial information asymmetry regarding
buyers' and the seller's utility functions should be addressed.
Such asymmetry, combined with a heterogeneous risk behaving
population of buyers, leads to adverse selection and moral
hazard.
For example, the mere unequal distributions of
information between a particular buyer and the seller can lead to
adverse selection, as pointed out by Arrow [3] (See also
Arkerloff [2], Pauly [12].).
For this reason, a principle of
expected utility equivalence we borrowed from
insurance
(e.g.,
see Borch [5]) was used to obtain the price-warranty schedule
offered by the
seller.
Further study leading to the seller's
optimization of utility will lead to arguments regarding the
distribution of buyers' risk and the propensity of buyers to buy
the product in the first place. These issues provide a fertile
ground for further research to be addressed in subsequent papers.
-13-
REFERENCES
1. Anderson, E.
E.
"Product Price and Warranty
Terms: An
Optimization Model," Operations Research Quarterly, vol. 28,
no. 3, 1977, pp. 739-741.
2. Arkerloff,
G. "The Market for 'Lemmons': Qualitative
Uncertainty and the Market Mechanism," Quarterly Journal of
Economics, August 1970, pp. 488-500.
3. Arrow, K. "Political and Economic Evaluation of Social
Effects and Externalities," in The Analysis of Public Output,
J. Margolis,
ed. New York: Columbia
University Press,
1970.
4. Blischke, W. R. and E. M.
Scheuer. "Calculation of the Cost
of Warranty Policies as a Function of Estimated Life
Distribution," Naval Research Logistics Quarterly, vol. 22,
Dec. 1975, pp. 681-696.
5. Borch,
K.
"The Theory of Risk," Journal of the Royal
Statistical Society, vol. 29, no. 3, 1967, pp. 432-452.
6. Glickman, T.S. and P.D. Berger. "Optimal
Price and
Protection Period for a Product Under Warranty," Management
Science, vol. 22, August 1976, pp. 1381-1390.
7. Heschel, M.
S.
"How Much is a Warranty Worth," Industrial
Engineering, vol. 3, May 1971, pp. 14-15.
8. Lowerre, J.
M.
"On Warranties," Journal of Industrial
Engineering, vol. 19, July 1968, pp. 359-360.
9. Markowitz, H. Portfolio
Selection.
Yale University Press:
New Haven, 1959.
10. Menke, W.
W.
"Determination of Warranty Reserves,"
Management Science, vol. 15, June 1969, pp. 542-549.
-14-
t
11. Nguyen, D. G. and D. N. P. Murthy. "Cost Analysis of
Warranty Policies," Naval Research Logistics Quarterly. vp;/
31, 1984, pp. 525-541.
12. Pauly, M.
V. "Overinsurance and Public Provision of
Insurance:
The Roles of Moral Hazard and Adverse Selection,"
Quarterly Journal of Economics, vol. 88, 1974, pp. 44-55.
13. Spence, M.
"Consumer Misperceptions, Product Failure and
Producer Liability," Review of Economic Studies, vol. 44,
1977, pp. 561-572.
14. Thomas, M.
U. "Optimum Warranty Policies for Nonrepairable
Items," IEEE Transactions on Reliability, vol. R-32, no. 3,
Aug. 1983, pp. 282-288.
1 - - - -- - - - - -f j - --
-15-
APPENDIX 1
For the no warranty case, the expected utility of profit is
given by
- - A.
EUCT ) = ECT )
-Fs Var(10) 00
with
-
E(w0) =(PO - CO) (A +r)/r
2
-
2 (1-al)(11 -a l )
ab
Var(w ) = (P -C)
0 0 0 1+a 1-a b 2
1 1 1 1-a
1
1 and al
= A/(A+r)
bl = 1/(A+2r)
proof
The net present profit of a sequence of sales under no
I -
warranty V is given by
-- -
VO = E Vj + (PO
-CO)
(Al)
J=1
where
V. = (PO - CO)exp(-rSj)
- -
J
Hence the expected utility is:
- -
EU(VO) = E(VO) - PSVar(VO)
00
-
00 00
--
=
(P -C) +E E(V.)
-p(2 E
E Cov (V. ,V- ) + E Var (V. ) ) (A
0 0 j=l J S j=l
t=j+1
Jz J
-
Now E(V) = (PO - C0)E(exp(-rS))
=(PO - CO) (x/(A +r))

(A3)
8


H
e
n
"
e
CO
-
A 'j
E(V)=(PO -CO) +(PO -C)E(TTE' 0 0
j=1
=CP - C ) Clir (A4)
0 O r
-16-
The covariance terms are computed by first evaluating
E(VVt).
--
E(VVt) = (PO - Co)2E(exp[-r(S + St)] where 1 2 j
, 1-j
2 A
=(P- c ) (-) J(A) (A5)
0 0 1+2r X+r
Now, substituting (AS) and (A4) into the following equation
- - --
Cov(V.,V)=E(VVt) - E(V)E(Vt) 1 1
we obtain:
Cov(Vj,Vt) = (Po - Co)2aZ(b-a)
where
a = 1/(A + r), b = 1/(A + 2 r)
Inserting the expectation and covariance terms into equation
(A2), and simplifying, yields the final result.
B
8
-17-
APPENDIX 2
For the warranty case, where warranty costs per failure are
given by C(Xi), the expected utility of profit is given by:
l
2
1 = -BS (glab -g b )
2
h =h - 2h C
2 4 1 0
h=h(0 -h C+h
2
3 1 40 5
A+r
h4 =(-r) - BS (292bd2 - glbd2 - gladl)
h5 = -ps(gldld2 - dl 92) - dl(A + r)/r
2
91 =(1 +b)/(1 - a)(1 - b)b
92 = 1/(1 - b)2
a = A/(1 + 2r)
b = 1/(A + r)
d. =Ak(1 - [jr +A)T]
(1 - exp( (jr + A)T))/(jr + 1) j = 1,2
-1
J
li Proof
-
Let V represent the present value of total profits. Then we have
Co
-. -- -- -1.1 -3- - -- -
Vt = E W. + (P t -C O)
- -
where Wj = (P* - CO - C(X))exp(-rS)
- - -
= (P0 - CO)exp(-rSj) - C(X)exp(-rS)
and C(Xj) represents the warranty cost of a failure.
-18-
Hence
-
xi
-
- A j-1
E(W.) =(P - C )(-)- - E(C(X.)exp(-X.))(-)
1 0 0 1+r J J X+r
= (p - p \ c A )j - (-1-) j
-ld
(A7)
0 0'
'TTE A+r 1
l
]
j
- -
where d
= E(C(X.)exp(-rX.))
The expression dl is computed later.
8
H
e
n
c
e
-
CO
E(V*) =.EIP$_CO) (T.r) j- CAr)-ldll +CP$ 0
-C)
A+r
=
[P -C) -d] [ -1 (A8)
0 0 l r
: -0
-
- - -
00 00 CO 00
Var(V ) Var C E W. ) = 2
E
E Cov(W,Wl) + E Var(W)
(A9)
j=l
j
j=l t=j+1
J=1
To compute the variance requires expressions for the
--
covariance terms. To the end, we first compute E(WWt) for 2j.
-- - - - -
E(WWt) = E(exp[-r(Sj+St)](k - C(Xj))(k4 - C(Xt))
where k =P-C 0 0 0.
Hence
E(W.W.) = k*2E(exp[-r(S+St)] - k4((C(X)exp[-r(S+St)]
--
-
1%
- --
.
- --- -k-0-E-(-c(Xi-)-e-x-p[-r-(ST+Sl)-1 +- -- - -- -- =- -- -- --- -- -
I ---
E(exp[-r(S+St)((x)c(Xg))
The expectations of these four expressions are simply derived
as in Appendix 1 to yield the following:
-
E(W1Wt)=k*2ajbz-j-kaj-lbt-jd2-k*abt-j-ldl+aj-lbz-j-ldld2
where a = 1/(1+2r); b = A/(A+r) and d2 = E(exp(-2rX)C(X))
which will be computed later.
Hence
-19-
--
j-1 1-j-1 2
E(W.W.) =a
b
(k ab - k
bd - k ad
+d d)
Substituting this expression into the covariance equation and
Jt 0 02 0 1 1 2
simplifying yields
Cov(., * ) =
aj-lbl-j-lfl-f2bj+1-2
(A10)
J 1
wheref =k 2ab-k (bd
+a d) +d d_ (All)
1 0 0 2 1 1 2
f =k 2b+d2- 2kbd
(A12)
Now, the variance terms can be calculated by substituting
2 $ 1 0 1
(A12) into (A9) and
simplifying.
The result is
Var(V*) = glfl -
92f2
(A13)
(1+b) 1
where gl =(1-a) (1-b)b ' 92 = 2
1 (1-b)
Substituting in the expressions for fl and f2 and rearranging, we
1 obtain:
2
Var(00) =
k02(glab-92b2)+k0(292bdl-glbd2-gladl)+gldld2-92dl (A14)
Given the expected value and variance, the expected utility
can be
computed.
The final result is given by equation (A6).
Computation of dl and d
2
- - - -
The expectation-and-var-iance terms -for-the-utility-equation -- -- -
(equations (A8) and (A13)) hold true for any rebate policy.
In
order to obtain specific results, we have assumed a linear rebate
scheme. That is:
C(Xi) = k (T-Xi)/T
0 < X. < T
- 1-
otherwise
For this policy, dl and d2 can now be computed.
dj=E(C(Xi)exp(-rjX)) j = 1, 2
-20-
Hence
T T
xk
dj=A k /exp((-jr+A)x)dx- T I xexp((-jr+A)x)dx 0 0
Integration by parts yields the final solution:
Ak -1
d.
=
[l-[(jr+A)T] (1-exp((jr+A)T))] j = 1, 2
J (jr+1)
I
-21-
l
APPENDIX 3
The expected disutility for the buyer is given by
2
EZ(t* ) = h P + h P + h
10 0 11 0 12
where
hlo = FB (glab - 92b2)
A+r
hll = FB (292bdl - glbd2 - gladl) - (r-)
2 A.r
h12 = BB (gldld2 - 92dl ) - dl (-r-)
Proof
Since the proof follows that of Appendix 2, the results of
the expected value and variance are stated without proof.
A+r
E(1) =C P b -d)(-)
$ $r
Var(10) = P02(glab-92b2)+P$(292bd-glbd2-gladl)
+gldld2-92dl
2
'
:
-22-
.
N(t)
i (xi)
.
X3 1
T.
1 W'*4, F G..i, 1
xl . (2 1, ( *2)
Lt j
Sl S2 53 S# SS
Figure 1: warranty Costs Over M
j
i*
..
4
9
1
:
: -
0
10 D
T=6
9
- T.2
i

1
7 1
:
3. 6
:
1
1.5 i
A 1 2 3 4 5
k
Figure
2: Sensitivity of Prices With Respect
to k
Values and Time.
,
:
I
- 1
4 i
J
4 4 1
N
. '
,.
..
..4
1
R et
$
50
T=6
T=4
T==2
40
20
il
01234 5
10
'k
1 Figure 3: Sensitivity of Expected Disutility
3 Versus k Values.
:
"
4 I
I
31
:;
t
' 1
4 ..
4 P
'
.
ot(p (0))
25
20
15 98 = +003
10
5 98 = -0.03
k
1 2 3 4 5
/ CASE PARAMETERS
p = 0.02
S
cl=l
PO = 5
i = 0.02
T =2
Figure 4:
Sensitivity of Disutility as a Function of
Buyer Risk Aversion Versus k Values.
.
S.
12 1
k
:
98 = +003 1
11 I
10
1
t
98 = -0.03
8
12,45
T
CASE PARAMETERS
K =3
p = 0.02
S
1 = 0.2
.0 = 5
cO = 1
Figure
5: Sensitivity of Disutility as a Function.of '
Buyer Risk Aversion versus Time of Warranty.
i
i
4 .,
li
'

,
:
1
d
1
1
1