Don’t buy product warranties

by on October 4, 2006 at 7:48 am in Economics | Permalink

If the expected utility calculations don’t convince you, maybe this will:

Neither Circuit City nor Best Buy discloses how much of its bottom line comes from extended warranty sales.  But analysts have estimated that at least 50 percent and in some lean years 100 percent of profits at the electronics retailers come from extended warranty sales.

Here is the full story.  The paper (but not on-line) edition notes that a desktop computer has a 37% chance of needing a repair in the first three years; if you are going to buy one warranty, maybe that should be it.  But you are still best advised to buy insurance only when a) the potential loss is very large, or b) your wife insists.

Gabaix and Laibson have a very good paper on myopia, consumer ignorance, and shrouding.

Brock October 4, 2006 at 9:10 am

To my mind, one of the best values out there is the laptop warranty. Desktop computers can have individual parts replaced fairly easy. Laptops are much less modular, and a busted screen or shorted out motherboard means the whole thing is useless.

Paul McMahon October 4, 2006 at 9:41 am

Dr. Cowen,

My mother insisted on one for the shreader she bought.

She took one look at all of my father’s papers and knew she’d burn out at least one. She’s in the fifth.

Edward Vielmetti October 4, 2006 at 9:45 am

I would never buy an Apple laptop without Applecare – repairs are too expensive without it, and you know you’ll need at least one repair inside of those three years.

Grant Gould October 4, 2006 at 9:52 am

I’m a dedicated free-rider: I’ll let the people who buy the warranty do the hard work of giving the store an incentive to make its products not need a warranty.

If the store is willing to sell a warranty, it means that the product must break rarely enough compared to its price and the price of the warranty that the warranty isn’t itself a money-loser for the store. If that’s the case, I don’t want the warranty. I guess that’s an adverse selection problem for the stores, but it’s tasty savings for me — I can free-ride off of everyone who does buy the warranty.

eriks October 4, 2006 at 10:52 am

I agree that warranties are best for laptops. Laptops are exposed to food, drink, bumps, drops, etc. I wouldn’t buy a laptop without one.

MW October 4, 2006 at 11:19 am

Extended warranties may or may not be worthwhile (I assume most are not). But evidence that they are profitable does not imply that they are a ripoff. (Their quarterly statement indicates that that damn Google ripped me off again.)

I suspect that extended warranties are another form of price discrimination against the “probability theory challenged.”

CMC79 October 4, 2006 at 11:58 am

Most warranties on electronics aren’t worth it, but laptops definitely are (my work Dell has had its screen replaced 3 times in less than a year, and is currently malfunctioning again). Desktops almost never are, unless the manufacturer uses proprietary parts instead of open standards. Dell, in particular, used this tactic (such as reversing the AGP slot on the motherboard so that graphics cards had to be purchased through their online store if you desired an upgrade) in previous years but has thankfully ceased, and at one time or another most PC manufacturers have indulged in this.

It can also be worthwhile to purchase plans on cutting edge technology because the long term failure rates simply aren’t known. I purchased a high definition DLP television several years ago and took an extended warranty because it covered the replacement of the light bulb as well as any other problem. The cost? $400. The cost of a new bulb? About the same. I have one year left on my warranty, and the bulb should be at the end of its life based on usage hours.

Jacqueline October 4, 2006 at 12:30 pm

Every extended warranty I’ve ever bought for a laptop has more than paid for itself over the years. But then again, I’m a total klutz, an a heavy user / frequent traveler so I’m a lot harder on laptops than most people.

Marcus Burrell October 4, 2006 at 12:46 pm

I think the article raises the most important factor in the decision on purchasing extended warranties. How long do you plan on keeping the product? Many electronic products have become so cheap to buy, ie. telephones, printers, and household appliances, it is cheaper to buy a new one than getting the item repaired. The two products I would buy an extended warranty for is an automobile (36,000 miles comes a lot quicker than 3 years) and a computer (even though computers are outdated prior to the 3 yr warranty runs out, many people can’t simply buy a new computer every year). I don’t mind paying an extra $150 for more years of warranty on my computer, just in case I mess something up or $500 for up to 100,000 miles of warranty on my car. I’m going to be keeping both items past the end of the warranty period, so in my opinion, the initial cost is worth the lost opportunity.

DK October 4, 2006 at 1:11 pm

Why don’t stores make having any warrany at all optional?

Why don’t manufacturers drop quality dramatically, assuming that everyone either buys the extended warranty, or doesn’t mind buying a new one every year?

Jacqueline October 4, 2006 at 1:20 pm

“Something else to consider: if you buy a $1500 laptop with an extended warranty and it dies after 2 years, the warranty hasn’t saved you $1500, it’s saved you the replacement cost of the now 2 year old laptop, which is substantially less.”

However, often when they replace the laptop under warranty, since they don’t make the older model that you own any more they send you a newer model. My brother got a brand new laptop that way when his old one was irrepairable and still under warranty.

AH October 4, 2006 at 2:27 pm

I cannot say conclusively that buying a warranty on a product is a good or bad idea. All I know is that a warranty, in most cases, gives peace of mind to the consumer. With a somewhat worry free outlook, it might just be worth the extra money for the warranty.

What Mike Huben Would Say If He Didn't Suck October 4, 2006 at 3:19 pm

Thank you, Tyler Cowen, for being so intellectually honest and constantly challenging, rather than confirming, libertarian biases. I really could learn about intellectual honesty from you. I really need to get over my irrational hated of libertarians. I’m working on that as we speak.

Tony October 4, 2006 at 4:23 pm

Another thought… warranties don’t just buy you the cost of repairs, they buy you bargaining power. A party (manufacturer, store, or otherwise) has tremendous bargaining power with those that actually perform the repair, more power than an individual consumer could possibly have. The likely result is lower maintenance costs for warrantyholders.

Health insurance is a good example of this. Individual payers at hospitals can get royally soaked because there is no published price data for services. Insurers pay much less for the same things.

Brian Simmons October 4, 2006 at 5:35 pm

I find it very interesting that electronics stores, such as Circuit City and Best Buy, make
50-100% of profits from extended warranty sales. I never really have thought about the excessive amounts of money that can tied up in warranties. I am guilty to an extent for contributing to the profits of these electronic stores in the form of warranties. I always try and consider the chances of actually needing to use the warranty and the monetary value that is attached to the repair of the item. For example, I recently purchased a Sirius radio and chose to purchase the two-year warranty from Best Buy. The warranty covers every piece that came with initial purchase (antenna, receiver, remote, and mount). The two most prominent reasons that I chose to purchase the warranty were the replacement costs of the receiver and antenna combined with the probability of having to replace either . The receiver is exposed to both extreme heat and cold while being in a vehicle which could easily cause a malfunction in the display and the antenna could be pulled out without much effort. The cost of a replacement receiver is about $120 and the cost of a replacement antenna is around $40. I only had to pay around $25 for a two-year warranty which I thought was a pretty fair deal.

The warranty I chose to purchase is relatively cheap in comparison with the purchase of other electronic goods from these stores. The article referred to the purchase of an LCD TV costing around $1700 and an extended 5-year warranty which was an additional $450. There is a considerable difference in that purchase and the one I referred to earlier. From that example it is not hard to believe that a huge majority of profits come from the purchases of warranties. I think that the cost of the TV warranty is rather excessive, but on the other hand so is the cost of a replacement. In the end it is the responsibility of the consumer to weigh the chances of using the warranty with the costs involved. These warranties are impulse purchases for many buyers which is not considered an informed purchase by any stretch of the imagination. If the consumer does the research and makes an informed decision then I think that the purchase of these warranties can be a smart purchase.

TimM October 4, 2006 at 6:30 pm

I’ve always been under the firm belief that places such as Circuit City, Best Buy, etc all are able to sell their products for close to wholesale price due to their rediculous customer service plans (CSPs). I have had many friends who have worked for the companies listed above and they have told me that the companies continually push people to sell these CSPs, especially in cell phone departments. I find most of the replacement or repair plans rediculous, seeing how most of the companies that produce the product you are buying normally include a 1-3 year warrantee anyways. The only real thing I can see a use for buying a CSP for, would have to be for a computer, as was stated above. Many unexpected and troublesome things happen to a computer when a person gets a hold of it online and having a warrantee or CSP to be able to take the computer somewhere and have it fixed for free is a magnificent thing. I would figure that most people only get CSPs on items that are expensive in price or include a high amount of new technology, which is more prone to breaking.

BillWallace October 4, 2006 at 7:50 pm

sd I’m a little confused. Why would you allocate any of the $75 product cost as cost of the warranty? I would say that the COGS of the warranty is the $10 underwriting only, making the profit $25, as you said. Then the 50-50 claim holds. I don’t see your point unless you can explain how the product cost is COGS for the warranty.

Chris Meisenzahl October 4, 2006 at 8:14 pm

I often get a pitch for extended warranties on sub-$15 items.

Michael October 4, 2006 at 9:30 pm

It doesn’t surprise me that a store could make as much money on warranties as they do on other sales. If you lower your profit on each sale enough you could sale enough products to make up for the loss. However for the consumer sake I think that it is still a wise idea to purchase the warranty. Not just because the idea of not purchasing it just to screw the store is pretty stupid, but also because of random probablity. Just because your computer or TV hasn’t compt out on you in the time that you’ve had it doesn’t mean you’re going to get that lucky next time.

BLAKE October 4, 2006 at 11:26 pm

i think that these warranties are a good deal. I happen to work at one of the mentioned stores that these warranties are offered. From the amount of product that goes out of my store and the amount of returns i see com in on a regular basis, if you are an economist i dont see how you are saying they are not worth it.The guys that say that things arnt going to break and they dont need warranties, are the same people that when their product does break comes in to the store throwing a temper tantrim and want something for free when all they had to do was buy the warrnty that they were offered in the first place.

Foobarista October 5, 2006 at 3:56 am

Many on this thread should wander over to a personal finance blog and learn about emergency funds, and how if you have money saved, you don’t need to spend money on over-insurance – in addition to many other benefits. And if you have to have “peace of mind” beyond money in your bank account instead of Best Buy’s, do what the guy above suggested and pay with a credit card that warrants purchases.

And pay off that credit card when the bill shows up…

BillWallace October 5, 2006 at 1:15 pm

sd:
If anything your argument goes in the other direction. If the warranty is driving TV sales, then really you’d allocate costs away from the warranty.

But I still disagree with your argument. It’s makes perfect sense to look at the product in a marginal way. The marginal cost of the warranty is still $10, and the profit is still $25. The fact that the warranty is still desirable enough to drive TV sales at that price means that it could be priced higher to meet demand. But that’s somewhat irrelevant in analysing its current profitability.

sd October 5, 2006 at 4:59 pm

BillWallace:

Yes, the marginal cost of the warranty for Best Buy is $10. But we have no way of definitively knowing the marginal revenue of the warranty, and thus the profit, because the warranty is always purchased along with the TV. In the case of an item like a a DVD player, which is often purchased along with a TV but is also purchased by itself, we can confidently say that the price of the DVD player is the marginal revenue of the item when its bought alongside a TV. But for the warranty, there is literally not a single transaction in which we can observe the revenue of the warranty separately from the revenue of the TV. Whenever a warranty is purchased it is purchased by a consumer spending $135 and getting two things. The fact that some consumers buy one of the two things on its own is suggestive but by no means conclusive proof that the marginal revenue of the warranty is $35.

Brandon October 10, 2006 at 5:29 pm

I think warranty purchases soley depend on the electronic device you purchase. Buying a warranty for a labtop computer or desktop would be worth it because what is the consumers total benefit from that warranty purchase a few thousand dollars? On the other hand like ipods or dvd players what is the consumers total benefit from the warranty purchase less than a hundred dollars? There is a reason for avaible warranties on almost every device you buy and that is to increase the bottom line of the company. Companies fully have an estimated count of how many devices should malfunction and what expense to them it will be and with that information they set their extended warranty prices.

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