Economists Do It With Models

Warning: “graphic” content…

Bookmark and Share
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 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:

  • 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 - 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 […]

  • 8 dating // Oct 13, 2011 at 9:26 am

    Thanks for the information… appreciated… been reading for awhile, and simply wanted to tell you I continue to appreciate your writing.

  • 9 Rui1732 // Dec 2, 2011 at 11:51 pm

    I needed to put you one very little observation to finally say thank you once again for these striking tricks you’ve featured on this page. It is open-handed of people like you to convey openly exactly what a lot of people could have offered as an electronic book to end up making some profit for their own end, and in particular now that you might have tried it in the event you wanted. The concepts also worked as the fantastic way to recognize that many people have the identical passion similar to my personal own to know more and more with reference to this problem. I believe there are many more fun instances up front for many who take a look at your site.

  • 10 sell mobile phones // Dec 28, 2011 at 11:08 am

    I wanted to visit and let you know how much I loved discovering this blog today. I might consider it a honor to work at my workplace and be able to utilize the tips contributed on your web site and also participate in visitors’ remarks like this. Should a position involving guest author become offered at your end, make sure you let me know.

  • 11 cool chandeliers // Jun 1, 2012 at 10:05 pm

    Hello, i just planned to drop which you a line to say that we thoroughly enjoyed this particular post from yours, I have subscribed for your RSS feed and have completely skimmed several of your articles or blog posts before but this weblog actually endured out in my situation.

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

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

  • 13 contact details for UKBA // Jul 7, 2014 at 12:15 pm

    Hi there! I could have sworn I’ve visited your blog
    before but after browsing through some of the articles I rrealized it’s new too me.
    Anyhow, I’m certainly delighted I discovered itt and I’ll be book-marking it aand
    checking back regularly!

    my site :: contact details for UKBA

  • 14 phone number for Dsa // Jul 9, 2014 at 9:50 am

    We stumbled over here from a different web page and thought I
    should chec things out. I like what I see so i am just following you.
    Look forward to looking over your web page for a second time.

    Also visiot my homepage: phone number for Dsa

  • 15 contact John Lewis // Jul 9, 2014 at 11:36 am

    Iall the time emailed this weblog post page tto all my friends, because if like to read itt afterward my contacts will too.

    my bloog post :: contact John Lewis

  • 16 Sports Direct Phone Number // Jul 18, 2014 at 11:00 am

    Hey I know this is off topic but I was wondering if you knew of any widgets I could add to my blog that automatically tweet my newest twitter
    updates. I’ve been looking for a plug-in like this forr quite some time and was hoping aybe you would have some experience with something like this.
    Please let me know if you run into anything. I truly enjoy reading
    your blog and I look forward to your new updates.

    my website … Sports Direct Phone Number

  • 17 Melina // Jul 18, 2014 at 1:01 pm

    Hello there! This is kind of off topic but I need some advoce from an established blog.
    Is it harrd to set up your ownn blog? I’m
    nnot very techincal but I ccan figure things out pretty fast.
    I’m thinking about making my own but I’m not sure where
    to begin. Do you have any ideas or suggestions? With thanks

    Feeel free to surf to my site; click, Melina,

  • 18 the best spinner discount // Oct 1, 2014 at 11:57 pm

    I do not even know how I ended up here, but I thought this post was good.
    I do not know who you are but definitely you are going to a
    famous blogger if you aren’t already 😉 Cheers!

  • 19 Arthharis@Warrantech // May 14, 2015 at 3:28 am

    I am perplexing about extended warranty which is about shown here. Why should be much bother, I think you must check up the creative blog or website which is really giving extended warranty. Then take a breath of relaxation. Solve your all illusion easily then.

  • 20 AsaHGutiennez // Jul 18, 2015 at 11:32 am

    I feel this is among the such a lot significant information for me.
    And i am glad studying your article. However want to statement on few general issues, The
    web site taste is ideal, the articles is really great
    : D. Good activity, cheers

Leave a Comment