Should you buy a warranty?

Dr. Helen regrets not buying the warranty on all the appliances that broke. She shouldn't. Warranties are fantastically profitable for manufacturers, which means they're a fantastically bad deal for you. There's a little bit of truth to those old jokes about appliances breaking immediately after the warranty fails. Most appliances fail either immediately out of the box (due to small faults in the manufacturing not visible to quality control), or work for quite a while before they start breaking. There's usually an inflection point--an age at which the number of breakdowns starts to rise dramatically. Unsurprisingly, your warranty is almost always timed to expire before that age.

The only circumstance under which it would be worth buying a warranty is if you know you are about to be a lot poorer--for example, if you are entering grad school. But even then, you'd possibly do better just saving the price of the warranty.

Of course, we all have regret when it turns out that we would have been better off buying the warranty in this one case--but that's because we don't remember all the times when we bought the warranty and it lay unused in a drawer. Making the right decision doesn't guarantee the best outcome. It just makes it more likely.

Comments

How quickly you've forgotten your old blog! Asymmetrical information can create other opportunities where it is wise to purchase a warranty.

For example, I know I treat headphones particularly roughly, and any headphones I buy will probably break within a year. So the warranty is a good idea for me.

I doubt many people are as harsh with, say, refrigerators. But if you plan on abusing your appliances, then get the warranties. Best of all, you'll get a story of adverse selection in action for no additional charge.

Posted by Nathan | January 16, 2008 8:06 PM

You wrote:

"Warranties are fantastically profitable for manufacturers, which means they're a fantastically bad deal for you."

Oh. My. God.

Pass the beet soup, comrade. The point - the whole entire point - of a free market economy is that there are circumstances in which free exchange creates utility to both parties of a transaction.

Would you ever say "Health insurance is fantastically profitable for insurance companies which means its a fantastically bad deal for you?" Hell no.

Because while the going-in NPV of health insurance is bad for every buyer, the utility of the dollars on the plus side and the minus side of the NPV equation is not symmetrical. If I have a net worth of $100,000, and health insurance costs me $1,000 for an expected payoff of $900, its still a good deal, because losing my entire net worth is a lot more than 100 times as bad as keeping my $1,000 is good.

Its true that replacing a consumer product won't break the bank for most people, and thus fewer people will truly benefit from a product warranty than from other types of insurance. But "fewer" isn't "none".

And some people derive tremendous utility from avoiding lemons. This may not be your preference set, but its no more irrational that deriving tremendous utility from good design or superior quality.

Say a computer costs $1,000. A warranty on it costs $400. The probability of it breaking is 10%. Thus the $400 warranty protects you from an expected loss of $100. In a sense its not NPV-positive to buy the warranty. So you are free to walk away from it. But before you call a person buying the warranty a sucker would you also say that a person willing to buy a $1,400 computer with no chance of breaking is similarly stupid or would you say that they are willing to pay for superior quality?

Posted by sd | January 16, 2008 8:46 PM

When I bought my first new car in the 1980's almost all cars had 12 month/12,000 mile warranties. Today car warranties are much longer, up to 10 years/10,000 miles in some cases. It's curious that similar "warranty growth" hasn't occurred with respect to other types of products.

Posted by Peter | January 16, 2008 8:55 PM

Sad to say, sd stole my line re: buying insurance of any kind. If the insurers make money, the odds are against your doing so. And they wouldn't sell the stuff if they weren't making money off it. (Though the airline industry does arguably put the lie to that truism...)

Which brings us to m' daddy's wisdom: insure against losses that will materially affect your life(style). The utility of preventing meltdown outweighs the immediate dollar loss.

This is rarely true with extended warranties.

Not sure why sd considers that position (as expressed in a different way in Megan's post) to be such a horrendous moral transgression.

Posted by Steve Roth | January 16, 2008 9:20 PM

sd: Would you ever say "Health insurance is fantastically profitable for insurance companies which means its a fantastically bad deal for you?" Hell no.

I wouldn't say "fantastically" profitable, but you shouldn't buy more than you need. Which means choosing the highest deductible you can stand, and self-insuring for the expenses below that.

A while back I bought a computer for $600, and the salesman was pushing the $150 extended warranty — such a deal. I was thinking, "you're claiming there's a 1-in-4 chance this thing's going to die within three years? If I believed that, I wouldn't be buying it at all!

Posted by Bill Woods | January 16, 2008 9:48 PM

The only circumstance under which it would be worth buying a warranty is if you know you are about to be a lot poorer--for example, if you are entering grad school.

I would add the condition of if you use the product much more strenuously than most. I use my laptop about 14 hours a day (I can quit anytime, really I can) and end up sending it back for repairs about once every 3 months (this has held up across a few brands for about 7 years). Needless to say, a warranty is a no-brainer for me as is a back-up laptop.

Posted by Jody | January 16, 2008 9:59 PM

Another problem with Megan's post is that people are risk averse. That isn't rational economic behavior, but insurance (and extended warranties are a form of insurance) allows people to buy peace of mind against future risk, even if they are paying more than the expected value of that risk to get it.

Risk aversion is one of those situations where objective value doesn't correspond with subjective value. And since emotional tranquility and the avoidance of hassle are worth something to many people, it isn't stupid for some people to buy an extended warranty so long as it isn't ridiculously overpriced.

Posted by Dilan Esper | January 17, 2008 1:21 AM

"(due to small faults in the manufacturing not visible to quality control)"

putting the Glib- in Glibertarian, are we?

MM,

have you, really, never heard of Six Sigma(?)
or, concepts of MTBF ?

though, the idea that today's QC relies on human sight is truly amazing..this art:

http://www.advancedimagingpro.com/article/article.jsp?siteSection=10&id=378

is a start, and this:
http://www.advancedimagingpro.com/directory/?cat=85

should make it clearer that there are whole industry segments devoted to sub-micron QC inspection..

"The hardest thing for economists, when writing for a popular audience, is remembering all the things they didn't know before they were economists."--MM 15 Jan 2008 04:33 pm

past that,
"But if you plan on abusing your appliances, then get the warranties. Best of all, you'll get a story of adverse selection in action for no additional charge."

Posted by Nathan | January 16, 2008 8:06 PM

Nathan gets it right, there's no 'on-size-fits-all' answer such as the CW that you're attempting to pass off...

Cobb county, Here we come!~ ;)

Posted by MEH | January 17, 2008 1:22 AM

Warranties also may make sense as "time insurance", if getting something fixed quickly is crucial.

Several jobs back, my husband needed to have a pickup truck for work. We bought one, new, and we purchased the extended warranty because if he didn't have the truck, he wasn't going to be able to do his job.

Turned out to be an excellent decision: the truck was a lemon, and ate the engine and three---count 'em, three---transmissions, as well as several other ancillary parts, in four years. (We deduce, based on some cosmetic body work we discovered shortly after purchase, that the truck was dropped hard off the delivery trailer. We think it twisted the frame slightly. The dealership refused to do anything about it then, so they saw quite a bit of us after that.)

At the time, we were of fairly modest means. While New York State does have a lemon law, and we could have eventually gotten our money back, it would have been a slow and painful process. We would have had to get another truck in the meantime, or my husband would have had to give up his job. With the warranty, we were easily able to demand a loaner vehicle and timely repairs to the truck. It was worth far more than we paid.

Posted by Dictyranger | January 17, 2008 6:32 AM

And some people derive tremendous utility from avoiding lemons. This may not be your preference set, but its no more irrational that deriving tremendous utility from good design or superior quality.

As long as the people buying warranties are the ones who derive tremendous utility from avoiding lemons. In my experience, my husband wanted to buy warranties because he thought it was a good idea to buy insurance as a general rule of thumb. It is a good idea to buy insurance against potential costs that could financially wipe us out, such as needing an operation that costs $100,000. But if the iPod or the toaster breaks we can afford to just buy another one.

Dr Helen now says she is happier due to Megan's explanation, so Megan has just increased utility. (Okay, the future utility of the warranty seller has gone down, but Dr Helen will either spend that money on something else or save it so it can be invested in something else, making that seller or borrower's future utility rise).

Posted by Tracy W | January 17, 2008 6:33 AM

While risk aversion would be a plausible explanation, most people's behavior indicates that this is an instance where people just don't understand insurance. If it were really risk aversion, people should be buying both extended warranties AND insurance against a host of truly catastrophic but low probability events -- such as earthquake insurance in the Midwest. It is economically rational for a risk-averse homeowner to buy both kinds of insurance. But any consistent model would indicate that it is the home earthquake insurance (rare event, high potential loss, low premium) which should be preferred. But we observe the reverse: many families buy the extended warranty on their $600 washing machines for $59 but NOT the earthquake insurance for their $600,000 homes [my guess is it would run at most $100-$150 per year]. There are known psychological reasons for this "quirk" and companies exploit this fully.

Posted by jjww | January 17, 2008 10:50 AM

I'm a computer programmer, and I once spent some time working on an application to sell extended warranties for automobiles. One of the things I did was to calculate how the purchase price paid by the consumer got allocated to various accounting categories.

One of these categories was the "reserve", which is the account that they paid claims out of. Less than 50% of the purchase price of the policy went into the reserve. The majority of the purchase price went into overhead, commissions, and profit.

In plain English, the company expected that they would have to pay you back out less than half of the cost of the policy.

If you value having warranty protection, you're saying that it's worth it to spend twice as much as averages suggest repairs will cost you, and to be more restricted in your choice of service provider. Most people, when it's phrased like that, find that they don't derive as much utility from it as they'd thought.

Posted by Emma B | January 17, 2008 11:28 AM

I may be naive, but do regularly purchase extended warranties through Sam's Club for much of the electronics I buy there. I am hard on electronics and the like, and seem to save money this way. So, when buying an external hard drive recently, I spent an extra $5 for an extra year, combined with the year I get as a Plus member and the manufacturers warranty, I was beyond what I would expect to get out of the product. I expect that I have a 50/50 chance of utilizing the warranty, for the $5 plus a pro rata portion of my Plus membership. Already, over the last couple of yeas, I have easily made up my cost of extended warranties several times over for electronics I bought there in replacements.

I used to routinely get extended warranties through Sears for microwave ovens, and was quite happy that I had done so. Back then, they were almost guaranteed to break soon after the store warranty expired, and I collected several times, paying off the extended warranty cost many times over.

On the other hand, I had several extended car warranties, and they were invariably losers.

Posted by Bruce E. Hayden | January 18, 2008 10:42 AM

There is no warranty so useful as the $5 warranty for the $7 universal remote at Best Buy. The clerk ringing my purchase up said, "Do you want to buy a $5 warranty on this? Oh, wait, no, you don't."

Posted by Psychohistorian | January 18, 2008 2:26 PM