Question

Problem 7. Suppose that you own a store that sells a particular brand of stove for $1000. You purchase the stoves from a distributor for $800 each. You believe that each stove has a lifetime that is an exponential random variable with rate parameter λ = T, where the unit of time is in years. You would like to offer the following extended warranty on this stove: if the stove breaks within r years, you will replace the stove completely (at a cost of $800 to you). If the stove lasts longer than r years, the extended warranty is void. Let C' be the cost you charge a customer for this extended warranty. Given r, what value of C will help you break even, that is, you will make zero profit from the warranty itself? What do you think is a reasonable choice of r?

Answer 1