PhotoAny time you buy electronics or appliances, chances are the sales clerk will offer you an extended warranty, which in truth is usually just a service contract. A large percentage of consumers say yes.

When they do, the retailer reaps a handsome profit. A business professor at Penn State University says the typical profit margin on these products is 15% to 20% but businesses realize a more than 200% profit on the extended warranty.

Prof. Pranav Jindal wondered why so many consumers buy extended warranties and conducted a study to find out. His work has turned up some interesting observations.

Combining conjoint analysis, one of the most widely used market research tools, with economic models, Jindal analyzed the choices made by more than 550 consumers drawn from an online panel.

Two key questions

Specifically, he posed 2 key questions -- "Why do consumers buy extended warranties?" and "Why do consumers pay such a high premium for extended warranties?"

The answer to the first question has to do with how consumers look at risk and their fear of loss.

"Paying $500 for a new laptop is not the same as paying $500 for repairing or replacing a laptop you already own," Jindal said. "Consumers view paying for repairs as a loss. Consumers feel it hurts 3-4 times worse than paying the price of the product itself.”

Loss aversion

Fear of suffering this hurt, says Jindal, is what influences you to buy the extended warranty. This behavior is called “loss aversion.”

Jindal's research uncovered another interesting nugget. While consumers may work very hard researching their purchase, to get the lowest price possible, they tend to blindly pay whatever the retailer charges for the extended warranty, no questions asked.

"So, they are locked in by retailers selling appliances and electronic goods,” Jindal said. “Conventional wisdom says that extended warranties should be sold through independent firms selling only warranties, which will make extended warranties cheaper and consumers better off. But according to this new research, obtaining extended warranties through independent firms may be cheaper but it does not make consumers happier."

Influence on price

And that led Jindal to another discovery. He found that retailers tend to offer a lower price on a home appliance – in an effort to beat competitors – but regain some of that margin by getting a premium price for the extended warranty.

So that means if you always buy the extended warranty, you are subsidizing the discount being offered to your fellow consumers who decline the extended warranty.

If appliance and electronics retailers are not allowed to sell extended warranties, Jindal says the prices of home appliances and electronic goods will go up, while the cost of extended warranties will go down.

Perversely perhaps, the status quo tends to benefit consumers – at least the savvy ones who pass on the extended warranty – as well as the retailers who are selling them.

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