A Simple Model of Reliability, Warranties, and Price-Capping

The paper presents a model of reliability which captures the process by which reliability is actually determined more accurately than the conventional analysis. In contrast to that conventional analysis, which is based on the characteristics approach, the model of this paper defines reliability as the objective probability of product failure, not as a characteristic of individual goods. Reliability, thus defined, is treated as a choice variable of the firm. The resulting model is applied to a monopolist subject to a price cap. The monopolist can vary reliability and the terms of a warranty or compensation deal in response to price-capping. The monopoly outcome, price-capped monopoly outcome, and Pareto-efficient outcome are compared. The model provides a theoretical explanation of some empirical results in the literature on electricity regulation.