Homeowner warranties and building codes

A game‐theoretic model of moral hazard associated with unobservable builder effort is postulated to examine the effectiveness of homeowner warranties and building code enforcement by local government in assuring desired builders’ effort. Builders have an incentive to claim and charge for high unobservable effort level in constructing homes, but actually exert low effort to earn higher profits. We find that a homeowner warranty increases the unobservable effort of the builder, but cost minimizing behavior by the builder results in an effort choice less than the most efficient level. On the other hand, building code enforcement essentially converts unobservable builder effort to observable effort and efficient effort is indeed possible if enforcement cost is justifiable. However, an overly strict building code may be detrimental to buyers. The conditions under which a buyer would prefer one alternative over the other and where both measures can co‐exist are also examined. The model provides several interesting implications and testable hypotheses. A survey of builders and building codes provides preliminary evidence to support the proposed model.