If It Makes Kurgman Happy, It Can't Be That Good

Over at Marginal Revolution today, Tyler Cowen demonstrates that hope springs eternal in the economist's breast, by taking another shot at convincing the common people that extended warranties are highway robbery. He highlights this Washington Post article:

Warranty Week, an industry publication, last year estimated that of the $15 billion in premiums charged consumers in 2004, $7.5 billion went straight into the pockets of the stores that sell warranties as their cut.

Of the remaining $7.5 billion, the publication estimated that $3 billion was paid in claims by the insurance companies that back the plans. On the other hand, according to the Insurance Information Institute in 2004, the U.S. auto insurance industry paid out $66 in claims for every $100 in premiums.

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.

And if that doesn't convince you, maybe this will: Paul KrugmanKurgman thinks extended warranties are the Best Thing Ever:

Insurance protects against all sorts of things, from the catastrophic loss of real estate (assuming you've been paying your taxes) to catastrophic repairs of toasters, paid for by insurance known as "extended warranties". At one time, people had to pay for appliance repairs, or worse, buy replacement space heaters, alarm clocks, and can openers. But now, we can rest assured that our "extended warranty" insurance will pay for repairs, for free, provided you have your receipt and a only a few weeks to wait for service. Yes, a courageous government would require everyone to buy extended warranties for all our purchases. ... In general, mandatory universal insurance for every product and service is one of the most efficient ways of making everything free for everyone. Only the most cold-blooded government would deny it to their people.

Cowen recommends this paper on "myopia, consumer ignorance, and shrouding" for further reading on the theoretical grounding of why people are dumb enough to buy warranties over and over, even for stuff that doesn't break.

UPDATE: The quote is, of course, from Paul Krugman's Red alter ego, Paul Kurgman. My point stands.

Comments

highnumber | October 4, 2006, 7:22pm | #

I never buy the extended warranty, but arguing that I should not buy it because it is profitable to those selling it does not sit well with me.
I do wish I had bought the extended warranty for my iPod. The hard drive failed after 14 months of service. I may get the hard drive replaced or I may wait until the flash memory capacity starts hitting some higher numbers.

sj | October 4, 2006, 7:25pm | #

If you look at that website, you'll notice it was Paul KURGman, not KRUGman. Mayby you were just be very dryly ironic when you posted this, but I doubt it. You lift the quote but you cite as Krugman.

bruce | October 4, 2006, 7:29pm | #

yeah, that's not really a Paul Krugman quote. It's a satire of Krugman ("Kurgman"). It's written so tongue-in-cheeck you can't possibly take that as a serious quote anyway.

Paul | October 4, 2006, 7:31pm | #

highnumber:

Here's how I see extended warranties. I view them across the entire purchase spectrum. If say, over the last ten years I have bought a dozen 'high' priced electronics with the potential for extended warranty, how many dollars would I have spent vs. saved by buying said warranty?

The bottom line, I never buy the extended warranty. The number of devices which have failed where an extended warranty would have kicked in: nearly 0. I'm saving $ overall. Even with the occasional 'uncovered' failure.

anonymous coward | October 4, 2006, 7:36pm | #

It's not that extended warranties are bad because they're profitable for those selling them. It's that their profitability demonstrates something else: that buying said warranties are bad bets on the part of the customer.
I don't want to bore anyone with specifics, but in general a buyer of insurance can always expect to lose money in the bargain, even taking into account all of the times the insurance will pay off big. (Ignoring cases of fraud, of course.) On average, it would cost the customer less to save the warranty money and put that towards the cost of a new iPod than it would to buy the warranty. The only time insurance is a wise bet (though still -EV) is when catastrophic loss would otherwise wipe the individual out entirely, such as in the case of having one's house destroyed.

Paul | October 4, 2006, 7:44pm | #

don't want to bore anyone with specifics, but in general a buyer of insurance can always expect to lose money in the bargain,

This reminds me of a conversation I had with my Dad when I was very young (no, not that one). He essplained to me that insurance was a bet. You're betting the insurance company you'll have an accident, the insurance company's betting you won't. If the insurance company is making money, you're losing the bet.

When you're young and naive, it's one of those things that doesn't seem right. But in the context of extended warranties, it's spot on.

joe | October 4, 2006, 8:01pm | #

Anonymous Coward,

I don't live my life on average. I live it individually.

In actuarial terms, a 100% chance of losing $2000 is the same thing as a 1% chance of losing $200,000 dollars.

In my individual life, losing $2000 means I go on with my life pretty much as before (I have a 100% chance of being ok), but if I lose $200,000, I'm toast (I have a 0% change of being ok).

For me to figure out if I should spend $2000 on $200,000 worth of homeowners insurance, I have to calculate the odds that I'll be ok. If I buy the insurance, I have a 100% chance of being. If I don't buy the insurance, I have a 1% of being toast.

To me, losing $200,000 isn't 100x as bad as losing $2000; it's a billion times as bad. Hence, I have to conclude that insuring my house is good idea.

joe | October 4, 2006, 8:03pm | #

BTW, it takes a special kind of person to read that "Paul Kurgman" quote and not be able to tell the difference between that, and what Krugman really writes.

Sometimes, I accuse Reason writers of being purveyors of propaganda. I don't think that about you, Ms. Mangu-Ward. You are clearly a victim.

MRW | October 4, 2006, 8:12pm | #

So joe, you opted to spend 5 paragraphs explaining why you agreed with Anonymous Coward?

Amy Alkon | October 4, 2006, 8:15pm | #

How many of you are paying insurance on an old cell phone. I've got an almost four-year-old Sony Ericcson t68i, and I save about $50 a year by killing the insurance on it. What if it breaks? I'll buy a new cell phone for $50! (Don't like those "free" phones tied to a two-year contract with United Shitty Tel.)

Uncle Lumpy | October 4, 2006, 8:17pm | #

Joe -

That's the right approach for homeowner's, life, extended-care, auto liability and a few other forms of insurance against catastrophic risks. But on extended warranties for consumer electronics, you can average, as Paul outlines above.

Don't buy the warranty, but note what you would have paid for it. You'll be way ahead in a short time.

Of course, if you buy Apple stuff, always get the warranty.

highnumber | October 4, 2006, 8:25pm | #

Uncle Lumpy,

Where were you when I was at Best Buy two years ago?

Hence, I have to conclude that insuring my house is good idea.

Moot point if you have any kind of mortgage on your home. Nearly all lenders require homeowner's insurance covering replacement cost of your home. All lenders require homeowner's insurance that will cover paying off the mortgage.

madpad | October 4, 2006, 8:30pm | #

I bought my laptop 2.5 years ago at Best Buy. It was on clearance for $800. I bought the 3-year extended service plan for $250. 6 months later my 2 year old pulled keys off my keyboard and shortly thereafter power connection inside crapped out.

Off it went coming back perfectly 3 weeks later.

One year later, the hard drive crashed. I sent it off and 1 week later I got a 50% bigger hard drive and an extra battery.

Sure wish I hadn't wasted the money on that service plan.

I just bought a $1,000 3-chip video camera - open box display model with NOTHING - for $200. Battery from ebay and I was set.

Salesman asked me if I wanted the 3-year extended service plan. I ask how much. He said if I had bought the camera for full price it would have been $250 but since I was only paying $200 it would be $75. I went for the plan. Do I feel cheated? Nope.

jb | October 4, 2006, 9:51pm | #

Madpad,
Precisely. My Dell laptop has had every single component except the CD drive replaced for free. Now, this illustrates that Dell products are total crap, but also that the extended warranty was an awesome deal.

The higher-end/more expensive/more essential a device is, the better idea a warranty is. For a toaster, not so much. But for a computer/car/house, it's a damn good idea.

Math | October 4, 2006, 10:50pm | #

Personal anecdotes don't count. There are thousands, I'm sure. It all comes down to the math and your ability to absorb the loss.

violent_k | October 4, 2006, 11:02pm | #

Forget the economics. When you find yourself buying a $30 CD player for a nephew you only see at Christmas and the sales droid asks if you want the extended warranty for 10 bucks, don't you just want to poke said droid in they eye?

I do.

I mean I want to poke the droid in the eye. I don't really poke any eyes out. Normally.

Where's my beer?

dead_elvis | October 4, 2006, 11:18pm | #

I've always read, and it makes sense to me, that it's a good idea to get the extra warranty for a laptop.

Pro Libertate | October 4, 2006, 11:18pm | #

I have an idea. Instead of trying to rip me off with some extended warranty program that some consultant suggested you should add to your product mix to increase your returns, how about standing behind your products and fixing them for free when they don't last? Nothing like buying cheap crap and getting charged to fix it the same year you purchased it.

pigwiggle | October 4, 2006, 11:41pm | #

"I've always read, and it makes sense to me, that it's a good idea to get the extra warranty for a laptop."

Agreed, that is if you are buying from a big box retailer that sells the EW based on the item price. If the retailer sells computers exclusively they likely price the high failure rate into the EW. Costco, Samsclub, et al. sell the EW based just on the price; it is a good deal. Laptops break very very easily, and the batteries fail quickly.

madpad | October 4, 2006, 11:46pm | #

For a toaster, not so much.

With ya jb. Anyone who buys a plan for a toaster suffers from a massive lack of understanding about the basics of electricity, resistance and cost-benefit analysis.

But expensive, complex, digital, component-based systems are good candidates for extended warrantees - provided they're priced right.

OBQuiet | October 4, 2006, 11:54pm | #

ESPs do make money for the companies selling them. Why else would they sell them. Butthat does not mean that they are not a good deal sometimes for consumers. I usually skip them but will shell out as circumstances suggest.

I bought one($10) for the CD($30) I got my my daughter. I knew her and accurately predicted that the disk would fail before the warranty expired. Twice.

We bought one on my wife's iPod. This was based on emerging battery issues and reports of some issues with the newer micro drives. This one also paid off.

My wife took one on our first digital camera since we knew we wold use it lot and expected it to at least need cleaning which would be covered. Three years into the 4 year warranty, when we took it in to be cleaned, they told us it was "not repairable" and we got credit for a new model at the original purchase price.

I did not get one for my laptop. I do not travel that much so it does not get the abuse that some folks would and I expect it to hold up fine. So far, it has.

I am not saying that the warranties are a good investment IN GENERAL. But each of us knows our own usage patterns better than the insurer and can judge for ourselves the value. When is it bad to have extra options?

anon2 | October 4, 2006, 11:55pm | #

That a company makes money selling extended warranties doesn't inherently mean that consumers can save money by not buying them. Consumers are not necessarily able to buy replacement products at the same cost that the company offering the extended warranty does.

For an oversimplified example, ignore the middle man and assume that you are buying a product at the manufacturer's outlet:

Consider a product that costs $1 to make, but is sold for $10. Normally it comes with a 1 year warranty, but for an additional $2 you can get a five year warranty. To make the math easy, let's say we know the product will break after exactly two and a half years. If you pay $12, you get 5 years of use, and the company still got you to pay $2 for a product that cost them $1 to make. Your alternative would be to pay $20 by buying the product twice.

You might think the company would make more money if they didn't sell the warranty at all, but there could be other reasons (e.g., competition). Or perhaps the company might know that a bunch of their customers buy new versions of their products every year anyway, so the extended warranty is sold to a different class of customer.

The above is all hypothetical, but it illustrates that you can't look at the profit from one option made available and automatically determine that customers would be better off without that option. If a company makes 75% of their profit on sales of widgets by the case, it doesn't inherently mean that you'll save money by buying widgets individually.

I read the Washington Post article and it really contains more emotion than numbers. By the fourth page, they admit that Consumer Reports believes in some cases that extended warranties are worthwhile in a few limited cases. I can believe that Consumer Reports has sufficient statistics that their recommendation to almost never buy an extended warranty is valid, but the whole "If all these stores are pushing them so hard, it means they're only making a lot of money off them and repairing very little" is bogus reasoning. You could apply the same reasoning to all products and services sold and then come to the conclusion that everybody would be better off buying no products and no services, but trade isn't a zero-sum activity.

OBQuiet | October 5, 2006, 12:09am | #

"For a toaster, not so much."

Not quite the same but for a while in my youth, I worked for Radio Shack. It was about the same time the the phone companies were over-charging to rent phones. RS had a really cheap phone($8) but it didn't seem to last very long. Standard Warranty was 90Days. They offered an EW on it for $10.Now understand that it made NO sense to even have a tech look at an item that cheap. Warranty service was to check that it didn't work and give them a new phone.

I sold a lot of them. Not as a $8 phone with a $10 warranty. I pointed out that for $18 they were getting a phone with a 3 year, same day replacement warranty. That put the price just over the next cheapest phone($15 I think) but it would save them a bundle over what renting the phone cost and they would not have to worry about it breaking.

And they did break. And I happily replaced them.

Value varies with product, person and purpose.

pigwiggle | October 5, 2006, 12:17am | #

I also think EWs end up like a lot of rebates. Lost, forgotten, ignored. If you keep all the EW info for the one, two, or three+ years you benefit from the disorganized fool that does not.

Timothy | October 5, 2006, 9:48am | #

Wait wait...Paul Krugman's alter-ego is red? And I always thought Krugman was the evil twin.

Pro Libertate | October 5, 2006, 10:08am | #

I just bought an extended protection warranty on my Dell. By paying Dell an additional $250, they agree not to send a goon to smash my monitor. It's a good program--profitable for Dell and good for me, too!

jb | October 5, 2006, 10:41am | #

Timothy: Remember, the Republican/Democrat split in this country is just one of many socially constructed dichotomies. The opposite of Liberal could just as easily be Communist as it could be Conservative.

Timothy | October 5, 2006, 10:42am | #

Seriously, though, resist the temptation to buy an OEM machine. Any desktop you can build better, cheaper through a local shop which will probably not use shitty proprietary parts that break. Any laptop from an OEM is likely to also have a bad motherboard in it, and probably substandard drives of all sorts. You can usually do better in the laptop market with a local shop too.

NathanB | October 5, 2006, 3:28pm | #

I buy electronics with my American Express card to automatically add an extra year to the manufacturer's warranty. If your machine doesn't crap out in 2 years, it probably won't crap out for a long time (though you should always behave as if your hard drive is going to die tomorrow).

With warranties or any upsell, just do your research. I just helped my brother buy a MacBook at an Apple store. They tried to sell us: A more expensive model, the $300 3 year warranty, a $99 annual "tune-up", and a RAM upgrade with a 100% mark up. Apple is picky about what counts in their warranty, they like to claim that consumers misuse products. The "tune up" as far as I can tell is just garbage that preys on Windows switchers' fears that their computer will be full of spyware and cruft in 3 months. The overpriced RAM is just part of Apple's business model of making most of their money from $40 iPod docs and $99 iPod cases. Bastards.