Try this quote on for size:
On our assumptions, the extended warranty is a product that simply should not exist. If Humans realized that they we paying twenty dollars for two dollars’ worth of insurance, they would not buy the insurance. But if they do not realize this, markets cannot and will not unravel the situation. Competition will not drive the price down, in part because it takes the salesperson a while to persuade someone to pay twenty dollars for two dollars’ worth of insurance, and in part because it is difficult for third parties to enter this market efficiently. You might think that firms could educate people not to buy the warranty, and indeed they might. But why should firms do that? If you are buying something that you shouldn’t, how do I make any money persuading you not to buy it?
The above quote is from Nudge: Improving Decisions About Health, Wealth, and Happiness by Richard Thaler and Cass Sunstein. They have a very good point, to a degree- one of the conditions under which free markets are efficient (read, better than the alternatives) is that both the buyer and seller have all the information they need in order to make the “right” (read, utility-maximizing) choices. In the extended warranty example, at least at the point of purchase, this condition isn’t likely to hold- I don’t know about you, but I don’t go around googling extended warranty statistics for fun. (Okay, maybe I do, but don’t tell anyone, k?) Therefore, since the consumer doesn’t have full information, he could be convinced to purchase something that isn’t actually worth the price to him, since he doesn’t know better at the time.
Thaler and Sunstein argue that competition in the extended warranty market is limited by the fact that sales are usually made as add-ons to the item under warranty, and therefore it’s hard for other companies to get access to these customers. (It is competition that would drive down the price of insurance to a point where it would be worthwhile for the average customer.) They go on in the text to describe a situation where a company could set up a kiosk outside the store (or in the airport, since they use the example of flight insurance) that sells information about whether or not to buy the extended warranty. Given their rhetorical question of “how do I make any money persuading you not to buy it?”, it seems like the authors don’t see much of a viable business model here. But are they right?
For the sake of my career, I can’t help but hope that they aren’t. On a more serious point, however, there are companies that are in exactly this advice business, albeit not in kiosk form. Consumer Reports is the first thing that springs to mind, at least for me, or perhaps web sites such as The Consumerist. In the former case, people pay for subscriptions to the hard copy magazine and books and whatnot, so to some degree consumers are in fact willing to pay for objective information when that data is not easy for them to acquire on their own. It’s interesting to note, however, that Consumer Reports is a nonprofit organization, and The Consumerist is supported by ad revenue and donations. That said, Thaler and Sunstein are in a similar business with their book, and I would imagine that they’ve turned a tidy profit.
I point out over and over that it’s super helpful to know economics in order to be better at life, and this is a perfect example of that principle. If nothing else, economics teaches us to think about incentives- why is the company so eager to offer me this extended warranty? Is it possible that this is a mutually beneficial transaction? What does the company know that I don’t know? Analyzing the underlying motivations certainly provides some insight into whether or not you’re getting a good deal. That said, I think that the best foray into the extended warranty business is via this business model:
(See cartoonstock.com for a few more extended warranty cartoons.)