question archive Two used car dealerships compete side by side on a main road
Two used car dealerships compete side by side on a main road
Subject:MarketingPrice:8.88 Bought15
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 dealerships' 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 he sells. He knows that a warranty lasting Y years will cost $500Y on average, and he also knows that if Lew tries to offer the same warranty, it will cost Lew $1000Y 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 one-year warranty? If he does offer a one-year warranty?
ii. What is Harry's profit if Lew's 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 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.
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In the given context, the decision to extend warranty services or not would be a product differentiation strategy which would depend upon the rationale of profit maximization. Without product differentiation, the customers do not have information on car quality and hence, each economic agent (Harry and Lew) would on an average receive $8500 for a car. While, if the car is differentiated, Harry can sell the car at $10,000 and Lew would sell it at $7000.
- One-Year Warranty Scheme
If Harry and Lew both offer the warranty, the cars do not get differentiated:
| Harry | Lew | |
|---|---|---|
| Cost of the car (i) | $8000 | $5000 |
| Warranty (for 1 year) (ii) | $500 | $1000 |
| Total Cost (A=i+ii) | $8500 | $6000 |
| Sale Price (B) | $8500 | $8500 |
| Profit (B-A) | $0 | $2500 |
If Harry offers the warranty and Lew does not, the car gets differentiated.
| Harry | Lew | |
|---|---|---|
| Cost of the car (i) | $8000 | $5000 |
| Warranty (for 1 year) (ii) | $500 | $0 |
| Total Cost (A=i+ii) | $8500 | $5000 |
| Sale Price (B) | $10,000 | $7000 |
| Profit (B-A) | $1500 | $2000 |
A (i): If Lew does not match the one-year warranty offer his profit would be $2000. If he matches the offer his profit would be $2500.
A(ii): If Lew does not match Harry's warranty service offer, Harry's profit would be $1500. If Lew matches the offer, Harry's profit would be $0.
A(iii). Yes, Lew would match Harry's one-year warranty service offer as he would earn $500 more by matching the offer.
A(iv). No, Harry should not offer a one-year warranty service. His competitor, Lew, has incentive to match his offer and if Lew matches his offer, Harry would earn $0. Without the offer, Harry on an average earns $500 per car ($8500-$8000).
- Two-Year Warranty Offer
If Harry offers the two-year warranty and Lew matches it, then there will be no product differentiation:
| Harry | Lew | |
|---|---|---|
| Cost of the car (i) | $8000 | $5000 |
| Warranty (for 2 year) (ii) | $1000 | $2000 |
| Total Cost (A=i+ii) | $9000 | $7000 |
| Sale Price (B) | $8500 | $8500 |
| Profit (B-A) | ($500) | $1500 |
If Harry offers a two-year warranty and Lew does not match it, then there will be product differentiation:
| Harry | Lew | |
|---|---|---|
| Cost of the car (i) | $8000 | $5000 |
| Warranty cost (ii) | $1000 | $0 |
| Total Cost (A=i+ii) | $9000 | $7000 |
| Sale Price (B) | $10,000 | $7000 |
| Profit (B-A) | $1000 | $2000 |
b. Two-year warranty offer by Harry is not a credible signal as Lew would match it to retain his market share. Though Lew may earn more per car by not matching the offer, his, market share may fall to 0. In such a scenario, he may not earn anything. Thus, it is in Lew's interest to match the offer.
- Three-Year Warranty Offer
If Harry offers a three-year warranty and Lew matches, then there will be no product differentiation:
| Harry | Lew | |
|---|---|---|
| Cost of the car (i) | $8000 | $5000 |
| Warranty (for 3 year) (ii) | $1500 | $3000 |
| Total Cost (A=i+ii) | $9500 | $8000 |
| Sale Price (B) | $8500 | $8500 |
| Profit (B-A) | ($1000) | $500 |
If Harry offers a three-year warranty and Lew does not match it, then there would be product differentiation:
| Harry | Lew | |
|---|---|---|
| Cost of the car (i) | $8000 | $5000 |
| Warranty (for 3 year) (ii) | $1500 | $0 |
| Total Cost (A=i+ii) | $9500 | $5000 |
| Sale Price (B) | $10,000 | $7000 |
| Profit (B-A) | $500 | $2000 |
Harry's three-year warranty offer if matched by Lew, then Harry would be losing $1000 while Lew would be earning $500. Though by not matching Harry's offer he may earn $2000, Lew might lose the market share and end up selling 0 cars. Thus, it is in Lew's interest to match the offer.
C. The advice would be not to offer any warranty service. In such a case, Harry would be earning $500 per car on an average. The offer of four-year warranty service would earn him $0 profits even if the cars are differentiated. As already explained, other offers would be matched by Lew and Harry would be making losses on his car sales.
