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Loss aversion drives consumers to purchase high-priced extended warranties

January 23, 2015

Editor's note: This story originally appeared in the Jan. 11 edition of the Centre Daily Times as part of the paper's Focus on Research series.

It’s a decision fraught with uncertainty for many consumers: Should I dig even deeper into the wallet to pay for an extended warranty to go along with that new dishwasher, refrigerator, television or other product purchase?

“Consumers feel cheated because often they are not very familiar with what the extended warranty covers, and what it doesn’t,” said Pranav Jindal, assistant professor of marketing at the Penn State Smeal College of Business.

In his paper “Risk Preferences and Demand Drivers of Extended Warranties,” which is forthcoming in the journal Marketing Science, Jindal took a closer look at this aspect of the retail world.

"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 three to four times more to pay for repairs than paying the price of the product itself. This hurt drives consumers to buy extended warranties."

This phenomena is called loss aversion.

Through an online survey, Jindal collected data on consumer choices for washing machines and extended warranties. His research revealed that loss aversion and peace of mind are among the key reasons why consumers buy extended warranties for products.

“When considering an extended warranty purchase decision, the consumers should understand why retailers are able to charge such a high mark-up for extended warranties,” Jindal said.

Retailers selling home appliances and electronics typically make 15-20 percent profit on the products they sell. By contrast, they make more than 200 percent in profit from selling extended warranties for these products. A key finding of the study is that retailers rely on high premiums from extended warranties to subsidize the home appliances and electronic products; thus, selling them at prices lower than they would charge otherwise.

If these retailers are not allowed to sell extended warranties, then they will not subsidize the home appliances and electronic goods, and the price of these products will rise.

“Conventional wisdom says that extended warranties should be sold through independent firms such as Squaretrade, which sell only warranties, thus, making the extended warranties more competitive and cheap, and making consumers better off. While extended warranties through independent firms will be cheaper, they will not necessarily make those consumers now paying more at retail any happier," Jindal said.

Based on the study, Jindal concludes that on average, consumers lose more due to the increased product prices than they gain from the lower warranty prices.

While Jindal’s study focused on the role of loss aversion, it also acknowledged that other factors such as over-predicting failure rates, lack of information about repair and replacement policies and financial constraints may also result in consumers purchasing extended warranties.

“Consumers may buy a warranty for a variety of reasons. Controlling for others, this study shows that consumers’ perception of potential losses and peace of mind are important factors, and have important implications for how extended warranties should be sold,” Jindal said.

Individual consumers may be better served if just like products, they also search for the best warranty prices online, or through firms selling only warranties.

“Moving forward, it would be really interesting to get into the consumer’s mind and understand when they think a product will fail and how much they believe it will cost them to repair or replace the product.”

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