Economists Do It With Models

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More On Why I Do What I Do, Extended Warranty Edition…

December 31st, 2009 · 20 Comments
Behavioral Econ · Buyer Beware · Markets

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.)

Tags: Behavioral Econ · Buyer Beware · Markets

20 responses so far ↓

  • 1 Viktor // Dec 31, 2009 at 7:54 pm

    I am not sure about the US, but in Sweden the kind of goods where you are typically offered the insurance are sold at extremely low margins, and with extremely efficient competition.

    My feeling is that if it wasn’t for the fact that OTHER PEOPLE bought the insurance, I wouldn’t be able to buy my electronics as cheaply as I do — so in fact the add ons subsidize the prize of the “main” goods.

  • 2 Don Gooding // Jan 2, 2010 at 11:20 am

    For me, the Nudge authors’ biggest error in this example (I concur with the bulk of their book) is the abandonment of economics’ most fundamental theory of value in their reductionist analysis of the utility from buying extended warranties. It is a slippery slope to argue for some intrinsic value of a warranty independent of that expressed by consumers, and overlooks the possibility that “peace of mind” is one of the features of such insurance.

    And as the Swedish example indicates, the absence of competition *so far* does not prove the difficulty of competition; it may just be an artifact that in the economist’s long run will be resolved.

    This example is not a good application of the authors’ ideas about “choice architects” – it is one instance of “impulse buying” which marketers understand extremely well, and which could not be rectified by libertarian paternalism but instead must be left to competition.

  • 3 John Doe // Jan 3, 2010 at 2:34 pm

    Hmm, haven’t you economists ever thought about the opportunity cost of gathering all the relevant information? I mean, if it takes hours to determine whether a $20 extended warranty is worth $20, then you’re probably making the rational decision of NOT doing the research since the cost of research is so high and the pay off is rather small (maybe save $18?). So, if it’s irrational for you to do the research, then it stands to reason that you’re purchasing the extended warranty based upon how much value YOU perceive you will get out of it. Maybe you value the insurance at a high-premium because you are extremely risk averse. Maybe you have asymmetric information and happen to know that you tend to break things a lot and will need the warranty (maybe the lemon effect is why the warranty is so high!). In any case, I think an economic argument can be made to defend the purchase of an extended warranty. If nothing else, old men seem to just value the “idea” of the warranty…hence they buy the lifetime warranty Craftsman tools.

  • 4 Pablo Garcia // Jan 3, 2010 at 6:41 pm

    I’m not sure if you mentioned this in your article, but I think it also depends on the good.

    If I pay 800 dollars for a computer, I will be more willing to pay for an extended warranty, simply because as time goes by the likelihood that I will drop my computer, is a lot more likely. In my eyes, a 150 investment< a new 800 investment.

    But also, people purchase these warranties for lack of information beyond just the warranty. What about knowing how to install a harddrive? Reinstall windows? I think thats a factor to take into consideration with any product, and even when considering the purchase of a warranty.

  • 5 Alejandro // Jan 5, 2010 at 1:04 pm

    A very interesting article on the issue: http://www.economist.com/businessfinance/displaystory.cfm?story_id=14931591

  • 6 crazynutjob // Jan 12, 2010 at 10:41 am

    I’m a little late to this thread. Catching up on your posts.

    Another firm may be motivated to educate consumers about extended warranties if they do not sell warrantied goods themselves. “Don’t buy an extended warranty, you’re paying 20 dollars for 2 dollars worth of insurance. Buy my cookies instead.”

  • 7 EconomyBeat.org - user-generated content about the economy » Blog Archive » Extended warranties // Feb 26, 2010 at 4:40 pm

    […] post on the concept of extended warranties from late last year on the blog Economists Do It With Models […]

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  • 12 Myself // Jul 2, 2012 at 3:55 pm

    Maybe of interest: The extended warranties decision of the OFT:

    http://www.oft.gov.uk/OFTwork/markets-work/othermarketswork/electrical-goods/

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