Homeowner warranties and building codes
| Published date | 01 August 2000 |
| Date | 01 August 2000 |
| Pages | 456-472 |
| DOI | https://doi.org/10.1108/14635780010345409 |
| Author | Carl R. Gwin,Seow‐Eng Ong |
| Subject Matter | Property management & built environment |
JPIF
18,4
456
Journal of Property Investment &
Finance, Vol. 18 No. 4, 2000,
pp. 456-472. #MCB University
Press, 1463-578X
Received 9 April 1999
Revised 21 July 1999
ACADEMIC PAPERS
Homeowner warranties and
building codes
Carl R. Gwin
Babson College, Massachusetts, USA, and
Seow-Eng Ong
National University of Singapore, Singapore
Keywords Warranties, House building, Codes of practice
Abstract 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.
1. Introduction
Defective workmanship is a unique risk in the purchase of new homes. No
information is available from the experience of a previous owner as there would
be for an existing home. Additionally, a new home buyer cannot be sure that
the builder has actually constructed the home to promised specifications. In
fact, new home buyers have been known to experience serious building defects
after purchase (Razzi, 1995; Ong, 1996). A new home buyer must be careful to
consider every resource available that helps in understanding the
characteristics of new home construction that determine possible risk.
The purchase of a new home can be viewed as a ``game'' that involves the
home buyer (principal) and the builder (agent). This is a game of moral hazard,
which arises when the home buyer cannot observe the actions of the builder,
and when the actions affect the home buyer's payoff. Because effort is costly,
builders have an aversion to unobservable effort. However, low unobservable
effort leads to a higher probability of building defects. In the absence of any
monitoring device, any claim to superior unobservable effort by the builder is
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We wish to thank Gerald Brown, Eric Rasmusen, Jeff Fisher, Susan Wachter, discussants and
participants at the 1997 AREUEA Mid-year Meeting, Washington DC and at the 1997
International AREUEA Meeting, Berkeley, for their comments, suggestions and insights. Any
errors are the sole responsibility of the authors.
Academic papers:
Homeowner
warranties
457
not credible to the buyer. This results in a second best and inefficient
equilibrium.
Two sources available to new home buyers to guard against the risk of
defective workmanship are building code enforcement by local government
and homeowner warranties. A homeowner warranty ``offers to repair or replace
certain items in the home if they are found to be defective within a certain time
frame'' (Molloy, 1996). A building code ``is a legal document that sets forth
requirements to protect public health, safety, and general welfare as they relate
to construction and the occupancy of a building. These codes include specific
requirements for building materials, fire protection, structural design, light and
ventilation, heating and cooling, sanitary facilities, and energy conservation''
(NAHB, 1997). Building codes do not specifically address the quality of builder
workmanship, but they do specify minimum standards that require
appropriate levels of builder performance. Many states in the USA supplement
building codes with implied warranty laws that determine the quality of
builder workmanship. Therefore, the definition of building code in this paper
includes the implied warranty law.
The purpose in this paper is to assess the effectiveness with which
homeowner warranties and building code enforcement can achieve a more
efficient outcome for the both the home buyer and the builder, in terms of the
optimal workmanship. We view optimal workmanship as the construction
performance level that maximizes buyer value for the home with an acceptable
degree of risk. The risk of defect cannot be eliminated in practice, but it can be
controlled.
We address three important questions. First, how effective are homeowner
warranties and building code enforcement in assuring desired builder effort
levels? Second, which items in a new home should be covered by a building
code, homeowner warranty, or both? Finally, given the existence of a building
code, what provisions should be made in a homeowner warranty?
The next section explains the moral hazard problem and scope of study. The
following section describes the game-theoretic model. Details and proofs are
available on request from the authors. A comparison is then made of the
relative effectiveness of homeowner warranty and building code enforcement
in assuring desired builder effort. Several interesting implications are
examined and a survey is conducted to provide preliminary evidence in
support of the proposed model.
2. Moral hazard in the building of new homes
Buyers value features of a new home they can see. They also value the
workmanship of items they cannot see, such as quality of roofing, plumbing or
electrical wiring. New home buyers do not necessarily observe builder effort
devoted to the workmanship of home items that are concealed after
construction. We posit a simple game theoretic model of builder effort aversion
under asymmetric information in which builders have an incentive to claim
high unobservable effort but actually exert zero effort. Builders want to charge
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