Exended Warranties...WHY do they suck?

[walTer]

I always hear that you sould never get the extended warranty...ok for 20 bucks can get one for an inkjet printer or a TV or a toaster- and for 2 years if it breaks it says they will fix it and in writing it says they will give me a NEW one if they have it back say 3 times....

Even *I* have told people not to get them, but WHY? If you read them, don't they sound like a good deal?

Just wondering why we all hate them and think they are such bad deals.

[Fugitive]

I just can't think back and remember a time when I thought to myself, "Damn, I wish I'd gotten the extended warranty on this!" If something breaks, I'm more likely to just replace it with something newer, cheaper, and better anyway.

[nKoan]

Mainly cause I don't like paying for something I will likely never use.

I also don't like insurance, but I buy it anyway.

[chet]

Depends on the item. For most stuff it isn't worth it, but for digital cameras I get the extended warranty and have always cashed in on it. Just got a nice upgrade when my old canon died. For $80 it let me get a brand new camera 2.5 years later and they let me get a 3 year warranty on that...

For $100 or so I have gotten my laptop fixed twice, so good deal there.

It is annoying on low end items that are essentially disposable or rarely break.

Chet

[Jasper Phillips]

Insurance is only useful for things were catastrophic failure could ruin you (e.g. Mortgage, Life Insurance), not for small purchases, and especially not for small purchases that'll be obsolete in a few years anyway.

[JMR]

I get them for keyboards because I tend to smash them a lot.

[krayzkrok]

Ten years ago I'd never consider extended warranty, but just about every electronic purchase in the last 3-4 years has been a minor or major lemon for me. It's reached the stage where I wished I'd taken out EW on nearly all of them. For really pricey stuff like laptops I think it's essential.

I'm sure it's all a marketing strategy - ensure that all your products are as unreliable as everyone else's, and encourage more people to take out your overpriced extended warranty.

Of course, then you have to try and *claim* your warranty, and that is like pulling teeth from a very pissed off crocodile. That's what I hate most about insurance - so willing to sell it to you, so reluctant to deliver.

[Robert Sharp]

I got one on my latest car purchase. But the general rule is not to, because if the product lasts for the lifetime of an original warranty, it is LIKELY to last much longer. In other words, most problems are worked out in the first year (or whatever period the normal warranty covers). After that damage is almost always caused by normal wear and tear, which many extended warranties do not cover.

[Jeremy Johnsen]

I'd buy one for the 360 and PS3. I don't trust them to work.

[Tim]

I've had relatives say they've gotten screwed when they try to get things serviced or replaced under an extended warranty from Circuit City. I'm sure there are cases where it's a breeze, but the whole idea of paying well in advance for a *possible* product or service seems to invite that kind of problem. If they've already hit their "budget" on replacements that month, they may have corporate orders to fuck with you.

I've never regretted not having one. I can't recall any gadgets malfunctioning after the first time using it. And those I don't even know if there was any warranty at all, it's just gone back to the store for immediate replacement.

[walTer]

Ok, so mostly a money issue....I mean, 20 bucks for a 50 dollar ink jet is silly but say for a DS that when they had dead pixel issues--maybe not so bad.

Oh, and if you buy 1st generation Apple hardware- Applecare FTW- I just got my 3rd motherboard and next up is new internal speakers--best 130 bucks ever spent.

[Rywill]

Echoing some points others have made, but:

The reason not to buy it is because it's worth less than what you pay for it. The companies selling these warranties generally have a very good idea what the warranties will cost them, and they're not in the business of losing money. In fact, according to most folks, most companies price their EWs at much, much more than their real value, using them as a major way to make profits. As an example, I know someone who worked at Enterprise Rent-A-Car, and their business model is heavily dependent on making money by selling you insurance on the car. The impression I got is that the company makes very little on the rental, which is mostly seen as a way to get you to buy their enormously profitable insurance (like the razors/blades business model).

EWs are tricky to value (which is why companies can get people to pay a lot more than the things are worth). Their true worth is only the amount you can actually collect that you wouldn't have been able to collect otherwise. People probably overestimate what they can collect (because the companies make it hard to collect on the warranties, and sometimes when stuff breaks there's a better model out that you want anyway), and very much underestimate what they would have been able to collect without the warranty -- remember that for some breakdowns, you could just use the manufacturer's warranty, the store's return policy for defective merchandise, or any sort of protection your credit card gives you (if you bought with a card). Also, remember that even "breaking even" on the warranty means you lost. If you buy a $50 EW from Circuit City and eventually use it to get $50 in repairs, that means you just floated Circuit City a $50 loan at no interest.

Ultimately, buying insurance is like gambling in Vegas: the house knows the odds to the nth degree, and they set the rules to make sure that the average person loses money -- maybe a lot of money -- over time. The more you play, the more you lose. Sure, you may remember the $130 you spent on the Apple EW that paid off in spades. I remember the time I put $20 on 16 and it paid off 35-to-1. But the human brain naturally forgets all the unremarkable times that you bought a warranty that never paid out, just like I can't really remember all the times I played roulette and lost. If you were able to add up all the money you spent on various EWs, and all the money you got back from them, I'll bet you'd find the first number is significantly bigger than the second one, even when you include the Apple warranty.

Insurance only makes sense in a couple of situations: (1) when you know your particular risk is much more serious than the insurer realizes; or (2) when you're insuring against a catastrophic loss that could wipe you out (like Jasper says).

[Ben Sones]

Yeah, exactly. It's almost never wise to insure against a possible future expense that you could pay out of pocket. Consider why you are willing to accept a $300 deductable on your car insurance, but still feel that you need to buy a full warranty for your ink jet printer.

[SlyFrog]

Yes, what Rywill and Ben said.

Another way of saying it: if you took the money you would pay for extended warranties and simply put it in a fund that generated interest, from time to time when things did go wrong with a product, you could just buy a new one (or repair it) out of that fund. You would still, statistically, be likely to have considerable money left over in the fund after doing this.

[RickH]

Insurance only makes sense in a couple of situations: (1) when you know your particular risk is much more serious than the insurer realizes; or (2) when you're insuring against a catastrophic loss that could wipe you out (like Jasper says).

If you've ever worked retail sales, EW's are heavily incentivised. That's because the margins are high, and there's plenty of cash to put in the salesman's pocket, the store's pocket, and to actually cover the loss. That, and if it's a small item, chances are the person either won't remember they bought it, will assume it's expired, or can't find the proof that they bought it. It's the gift card principle: money now, delivery maybe never.

The only EW I bought in the last couple of years was for my 60" Sony set. $450 for 4 years of coverage, including a lamp replacement. Those are $250 by themselves, and they don't last 4 years from what I'm seeing on the boards (Sony won't post MTBF for projection TV lamps). Between that and the color block (green blob) problems I'd been hearing about, it was a no-brainer.

[Crater]

Yes, what Rywill and Ben said.

Another way of saying it: if you took the money you would pay for extended warranties and simply put it in a fund that generated interest, from time to time when things did go wrong with a product, you could just buy a new one (or repair it) out of that fund. You would still, statistically, be likely to have considerable money left over in the fund after doing this.

Just like the deductible on your car insurance. If you take a higher deductible, your premiums will be lower. If you save/invest the money that you save by doing that, odds are you still come out ahead if you have to make a claim.

Unless you're Mr. Magoo or something, I've found that the best principle is to pay as little in insurance as you possibly can.

[Phil_Stein]

Rywill's explanation was very good, but I'd add a couple of points to it:

1) To the extent that there is a 'real' underlying cost to the insurance (i.e. people who make the claims), that the retailers are marking up by say 2X, then I'd personally guess that on low-end electronic items in particular, a lot of claims activity (though certainly not all), is driven by fraud or small scale cheating. If you are an honest customer, you are paying for not only the amortized claims of other honest customers, but also those of dishonest customers. I would further guess that on 'big ticket' types of insurance (life, home, car), fraud as a percentage of claims is much, much lower, because the dollar value is high enough that insurers can investigate and filter out the fraud claims. But when Joe teenager breaks his DS, then goes and buys a new DS at Best Buy, gives it to his buddy, and exchanges his broken DS for a new one (i.e. 2 DSs for the price of 1), the Best Buy clerk isn't going to launch a major investigation (sometimes this small scale fraud can be prevented, too, but not always).

2) There's another cost involved in insurance - your time and effort - to evaluate and purchase it, to keep track of the paperwork, and, if something actually breaks, to locate the paperwork and pursue the claim.

If you make $50K/year, (say $40K after taxes), then your time is worth about $20 an hour. The time cost of an E/W for something that does NOT break might be 15 minutes (to evaluate E/W, buy, file), and for something that breaks might be 90 minutes (to locate the paperwork, return the item and fight with the clerk). Multiply that time by $20/hour and the E/W is even less attractive.

Again, these transactional/frictional costs are likely to be proportionately less with home or life insurance.

[Phil_Stein]

One other thing - there's lots of little stuff that can go wrong with electronics (say, one dead pixel on a DS), that I would typically shrug off in my normal mode (I do not buy E/Ws). But when an item is under warranty, I'm always fighting a little battle in my head - should I take it back for this?

Life is simpler without E/Ws (for me anyways...)

[Ephraim]

Something worth noting as well:

Most decent credit cards offer extended warranties when you make a purchase using one. My Mastercard, as a basic offering, doubles the manufacturer's warranty. That's enough of a comfort buffer that I've only taken the EW once: the EB one for my PSP, due to fear of dead pixels. And I was glad of it, because it did have plenty of dead pixels, and I swapped it hassle free.

[olaf]

Anything they try so hard to push must be a horrible deal for me, the consumer. That is my rationale and so I enthusiastically decline them all. I will say that one time I paid for that kind of thing on a tire from NTW w/o realizing it and later it helped a ton when the tire went flat from road debris.

[charmtrap]

I always hear that you sould never get the extended warranty...ok for 20 bucks can get one for an inkjet printer or a TV or a toaster- and for 2 years if it breaks it says they will fix it and in writing it says they will give me a NEW one if they have it back say 3 times....

If it was 20 bucks it might be worth it, and I may be more likely to take one. But in my experience they usually bottom out at like, 30. The silliest one was the guy desperately trying to sell me a $49.95 EW on a $50 printer (it must have been EOM and he was below-quota). How dumb would I have to be to take that?

[DennyA]

The only thing I buy them for is laptops. If you buy a three-year warranty for a laptop, you're almost guaranteed to get to take advantage of it.

[chet]

Denny I would say the same with Digital camera's, we are rough on ours and they always seem to break within 3 years. As for the hassle of using the EW? I have had none at bestbuy, walk into the store say the camera is broken, they tell me to go pick out a new one and bring it back up. The only issue ever has been is picking out a slightly more expensive camera ($50) and getting them to eat the cost, which they did after they looked at my purchase history. I would say it was as easy if not easier than buying a new camera.

Chet

[MatthewF]

Expensive things are sometimes worth the extended warranty. The last thing you want is for your $2000 HD set to break after the warranty runs out.

[Shadarr]

Anything they try so hard to push must be a horrible deal for me, the consumer.
Yeah, I've never gotten out the spreadsheets and worked through the math like some people here, I always just figured that if a salesweasle is pushing something that hard, it's putting money in his pocket, not mine. I especially like the two dollar "game guarantee" at EB. If I recall correctly, it covers the game against damage other than actually breaking the disk, which I assume just means scratching. The only way one of my games ever gets scratched is if it was that way when I bought it, which is already covered by the mandatory return policy for defective products.

[Ben Sones]

Expensive things are sometimes worth the extended warranty. The last thing you want is for your $2000 HD set to break after the warranty runs out.

They can be, depending on the cost of the warranty and what it covers. $2000 isn't pocket change for most people, so having to replace a $2000 set out of pocket would represent a real financial hardship. The store is still very probably getting the better end of the deal, but that's true of all insurance.

When you start talking about buying EWs for items that cost less than $500, though, I think the justification gets really iffy.

[Phil_Stein]

When you start talking about buying EWs for items that cost less than $500, though, I think the justification gets really iffy.


Or, to put it another way, if your bank account is so low that a $400 X-Box 360 breaking would cause real financial hardship for you (not annoyance, but genuine hardship), then you probably shouldn't be buying a $400 X-Box 360.

[dannimal]

When I bought GH at EB, I considered that $2 game guarantee because the sales drone said twice that it'd cover the guitar too.

[RickH]

I will say that one time I paid for that kind of thing on a tire from NTW w/o realizing it and later it helped a ton when the tire went flat from road debris.

Those are almost a different animal, kind of like the prorated tread and brake pad warranties. It's a way to generate a bit of reveue, but it's also a way to make sure the customer comes back to them when they need a fix. And they often don't cover labor.

[Balasarius]

When I worked at CompUSA many years ago, the profit margin on the EW was 84%.

[Ben Sones]

When I bought GH at EB, I considered that $2 game guarantee because the sales drone said twice that it'd cover the guitar too.

See, now this actually makes sense to me, but only if you are covering songs by The Who.

[Tnylr]

Another way to look at the business model - In the warrenty period say something has a 10% chance of breaking, and you are paying 20% of its cost (or more) in Extended Warrenty. That margin is a big money maker for the retailers.

I never get the extended warrenty on electronics. I use Consumer Reports a lot, so have a good idea of what the reliable stuff is. They also tell you where extended warrenties are a good idea (pretty well never for less than high price stuff.)

Another factor to keep in mind is, if it breaks in 2 years, would you rather just buy the newest, latest model instead of getting the old one fixed or replaced? That's especially relevant for electronics.

[shift6]

I think I've said it before, but I'll say it again. When I worked at Fry's, clever customers frequently got a pretty good deal with EWs on expensive electronics.

Let's say you buy a $3000 HDTV and there's a $400 EW. Many times, the customer would have the sales rep "throw in" the warranty. What the rep would do is knock $400 off the TV and then the customer would pay the full EW price. The total balanced out for the customer (think: free EW) and the sales rep got a chunk o'change on selling the EW. This may not always work, but if you want an EW, shmooze the guy that it's outside of your budget unless he can "throw it in" or something. Maybe you can get the $400 EW for an equivalent $200. Then comparing the cost to the potential you will use it ain't so bad.

Same reasoning may apply to laptops, video game consoles, appliances, dig cameras/video, and other things. It doesn't hurt to try.

[SlyFrog]

I think I've said it before, but I'll say it again. When I worked at Fry's, clever customers frequently got a pretty good deal with EWs on expensive electronics.

Let's say you buy a $3000 HDTV and there's a $400 EW. Many times, the customer would have the sales rep "throw in" the warranty. What the rep would do is knock $400 off the TV and then the customer would pay the full EW price. The total balanced out for the customer (think: free EW) and the sales rep got a chunk o'change on selling the EW. This may not always work, but if you want an EW, shmooze the guy that it's outside of your budget unless he can "throw it in" or something. Maybe you can get the $400 EW for an equivalent $200. Then comparing the cost to the potential you will use it ain't so bad.

Same reasoning may apply to laptops, video game consoles, appliances, dig cameras/video, and other things. It doesn't hurt to try.


Yes, and another thing to do with extended warranties is to wait until near the end of the warranty period, and then fry something out on the electronics intentionally. Voila, brand new piece of electronics for free (or a refund of full price if they no longer make it), and the equivalent of getting another X years of life for the product.

No, I have never done this. Yes, I have been tempted to because I fucking hate extended warranty pushers.

[Shadarr]

I am not a lawyer, but I'm pretty sure intentionally destroying the product will void the warranty. Everything else does.

[charmtrap]

I am not a lawyer, but I'm pretty sure intentionally destroying the product will void the warranty. Everything else does.

I'm pretty sure he meant, y'know, to destroy it in a non-obvious way so as to not void the warranty...

If you were being sarcastic, then ha ha, good one.

[Lunch of Kong]

The extended warranty I got for my laptop covers me if I accidently spill a glass of water into it, but not if I drop it into a swimming pool.

Somehow, they can tell the difference.

[Coca Cola Zero]

I'd buy one for the 360 and PS3. I don't trust them to work.

Just buy them at costco or some other place that has super good return policies. That's what I did. And my 360 has never given me a problem yet. Probably because costco treats their 360s so well! A happy 360 is a productive 360.

[Lunch of Kong]

Dude.

Buddy at work brought his 360 in to show us Gear of War in the meeting room, realized the projector was blowing hot exhaust onto the 360, and out of the corner of my eye, I saw him pick up the 360 and start to change its orientation from horizontal to vertical with the disc still spinning in the drive.

CHUNK-CHUKN-CHUNK-CHUNK. My head snapped back. I could see my puzzled friend holding this ticking timebomb in his hands, oblivious to the danger he now faced.

"NOOOOooooooo!" I screamed out, as my bionic muscles sprung into action and I supermanned across the table to yank the power cord out of the 360.

Don't know if the warranty would have covered that one.

[Xaroc]

It is pretty simple math. To figure out if an extended warranty is worth it multiply what you think the failure rate is against the price of the item then compare that with what you pay for the insurance. If it is less then you buy the warranty. If it is more you don't.

So the question is: Why spend $50 to protect yourself from losing a $300 product with a 1% failure rate? The math is:

$300 * .01 = $3
vs.
$50

You can't know exactly how reliable some things are but the companies that make them do so it is easy for them to rake in the cash with extended warranties.

Just as an aside, even with the unreliability of the Xbox 360 you are paying $50 to avoid a chance of paying $130 to have it repaired. The failure rate on Xbox 360s would have to be over 38% before buying the warranty makes sense.

[Lloyd Heilbrunn]

Echoing some points others have made, but:

The reason not to buy it is because it's worth less than what you pay for it. The companies selling these warranties generally have a very good idea what the warranties will cost them, and they're not in the business of losing money. In fact, according to most folks, most companies price their EWs at much, much more than their real value, using them as a major way to make profits. As an example, I know someone who worked at Enterprise Rent-A-Car, and their business model is heavily dependent on making money by selling you insurance on the car. The impression I got is that the company makes very little on the rental, which is mostly seen as a way to get you to buy their enormously profitable insurance (like the razors/blades business model).



I had a lot of fun a few years back litigating a case under the creative theory of holding a car dealership to the standard of care of an insurance agent who did not properly inform and educate his "insured". :)

[Qenan]

Expensive things are sometimes worth the extended warranty. The last thing you want is for your $2000 HD set to break after the warranty runs out.

We elected to self-insure. Sure, it wouldn't be fun to have to buy a new one, but:
we can definitely afford it
odds are, by the time it breaks, there will be a much better model available

At one time in my life I underwrote insurance. Things like life insurance or medical insurance are sold at about cost (in fact, at times below cost, made up for by the interest on premiums). Extended warranties are not sold anywhere near cost -- at least 50% is typically profit. The only way they make sense is if you absolutely can't cover the loss -- in which case, you are paying the premium for a real service. (But I would say: don't buy luxury items you cannot cover the loss on.)

[walTer]

Since I got a new "fancy phone" with my new wireless agreement- I opted for the 5/month total warranty- broken, lost, destroyed...i get a new phone- WITH a 50.00 deductible.

Meh, at some point the economics will probably warrant cancelling it, but with the stupid "retail" prices-- mine is like 349.00, it is worth it to lose it a couple of times during my contract.... figure i pay 60 dollars a year- for a 349 dollar phone- ok say 110 if i USE the warranty in a year, and I do get a brand new phone....

Money-wise it is close but frankly the cost of replacing a cell phone without a contract is excessive at best.

I just found this- Consumer Reports on EW's:
http://www.consumerreports.org/cro/personal-finance/news/november-2006/why-you-dont-need-an-extended-warranty-11-06/overview/extended-warranty-11-06.htm

[Stroker Ace]

I paid $1400 on an extended warranty for my 2000 impala (40k miles) in summer 04. So far I've had to get two new transmissions (blame chevy i guess, i dont drive too crazily) and today I'm getting some $600 filtery things replaced, all on the warranty company's tickent. This is going to push my warranty payout close to the $3000 range at this point. I'm glad I got it, and I should really think about selling this car before it runs out.

[skedastic]

It is pretty simple math. To figure out if an extended warranty is worth it multiply what you think the failure rate is against the price of the item then compare that with what you pay for the insurance. If it is less then you buy the warranty. If it is more you don't.


That's the correct comparison if you're "risk neutral," that is, you make decisions based on the expected value of the outcomes. If that's you, then you never need to do any math at all: you should just never, ever buy any sort of insurance. Insurance always costs more than the actuarially fair price (the expected payout on the contract) because any firm selling insurance at the actuarially fair price would necessarily be losing money.

Insurance works because people are generally risk averse, which implies they're willing to pay more than the actuarially fair price for an insurance contract. Insurers in turn take risk on individual contracts but that risk is reduced or (all but) eliminated by selling to many thousands of people. Everyone wins, on average.

Extended warranties on electronics are a bit of a puzzle, though. Not because the consumer gets on average less back than they paid for the insurance: that's true of all insurance. Rather because the price is much higher than the actuarially fair price, which makes it a generally bad deal even for us risk-averse consumers. I don't know why that's the case.

[Phil_Stein]

...Things like life insurance or medical insurance are sold at about cost (in fact, at times below cost, made up for by the interest on premiums). Extended warranties are not sold anywhere near cost -- at least 50% is typically profit...

Medical and Life insurance differ from things like E/W in some other, significant ways too:

1) Due to economies of scale and more direct competition between insurers, the markup as a percentage of the policy is likely to be much less (as Qenan indicates)

2) Medical (and I think Life, too) insurance receives tax breaks in various ways. If your employer provides it, it is generally not taxed. So, if your marginal tax rate is 30%, you get a significant price break there, subsidized by the government. Life insurance also has certain tax benefits, I think, but I know less about that...

3) Medical insurance effectively means you pay for most medical costs, whether fully insured or involving co-pays, at the rate negotiated by the insurer, which is often substantially less than the 'rack rate'. In some cases, an uninsured patient can also ask for comparable discounts, but receiving them is not guaranteed, is a hassle, and they still not be equal to what an aggressive insurer can negotiate.

[Phil_Stein]

That's the correct comparison if you're "risk neutral," that is, you make decisions based on the expected value of the outcomes. If that's you, then you never need to do any math at all: you should just never, ever buy any sort of insurance. Insurance always costs more than the actuarially fair price (the expected payout on the contract) because any firm selling insurance at the actuarially fair price would necessarily be losing money.
Your mention of a risk premium is appropriate and something I and others should have explicitly mentioned above.

However, your second statement is incomplete - in a completely laissez-faire marketplace, then it would generally be true that insurance is always overpriced (in actuarial terms). But, as I mention in the post above, various government subsidies and large-company price negotiation aspects make it possible that certain insurance policies are actually underpriced to the consumer, in actuarial terms, even though they may still be at a level that's profitable to the insurer.


Extended warranties on electronics are a bit of a puzzle, though. Not because the consumer gets on average less back than they paid for the insurance: that's true of all insurance. Rather because the price is much higher than the actuarially fair price, which makes it a generally bad deal even for us risk-averse consumers. I don't know why that's the case.
Among other reasons why E/Ws may be particularly overpriced:
1) Non-competitive marketplace. Whereas a consumer or business can normally choose easily amongst many competing carriers for car/life/home/medical insurance, when choosing to buy or not buy an E/W, you can generally only choose to buy it directly from the retailer you're buying the product from. A monopoly seller has more pricing power than one who has to compete. (Yes, I think there are certain after-market sellers of E/W, but if so, they are a small enough market presence not to affect things).

2) Lack of consumer information. The consumer has generally not considered the E/W choice until time of purchase, and I'd imagine does little research or comparison shopping (perhaps one retailer has a lower price for E/W, even if the item itself is priced identically across retailers). An uninformed consumer is a business's best friend - ripe for overcharging.

[skedastic]

But, as I mention in the post above, various government subsidies and large-company price negotiation aspects


I agree.




1) Non-competitive marketplace. Whereas a consumer or business can normally choose easily amongst many


I don't agree with this one because it doesn't explain why the firm doesn't charge more for the product and less for the warranty, which would generally result in higher profits. This is basically the same situation as the old "why is movie popcorn so expensive" puzzle -- the answer "because the theatre has a monopoly on popcorn sales" doesn't fly (see, for example, this bit (http://www.daviddfriedman.com/Academic/Price_Theory/PThy_Chapter_4/PThy_Chapter_4.html) from David Friedman's micro textbook, skip down to towards the end of the page).




2) Lack of consumer information.


Yeah, I think this one makes a lot of sense. It's very difficult to get pricing on warranties, which leaves the door open for monopolistic pricing.

It may also be the case that consumers with higher wilingness to pay for the product are also the ones who want to insure the most, which implies that a high price for the warranty may be a form of price discrimination (this is the analog of the most common resolution of the popcorn pricing puzzle).

A policy implication is that we consumers would probably be better off if retailers were required to make EW pricing information readily available.

[Phil_Stein]

I don't agree with this one because it doesn't explain why the firm doesn't charge more for the product and less for the warranty, which would generally result in higher profits. This is basically the same situation as the old "why is movie popcorn so expensive" puzzle -- the answer "because the theatre has a monopoly on popcorn sales" doesn't fly (see, for example, this bit (http://www.daviddfriedman.com/Academic/Price_Theory/PThy_Chapter_4/PThy_Chapter_4.html) from David Friedman's micro textbook, skip down to towards the end of the page).

Consumers price shop more on certain items than on others. No firm data on this, but my instinct tells me that at the grocery story, the price shop milk more than, say, gourmet candies. So the store keeps a low margin on milk (perhaps even cost or less), and advertises that prominently, and then marks up other items to keep their overall margins to what they need to be.

As a poster above states, rental car companies may rent cars at break-even or a small loss, but make up for it with insurance charges, overpriced gas, etc.

I suspect electronics/appliance retailers are similar. Even aside from E/W, if you look at the prices of purchases often made alongside of electronics purchases, the margins are extreme. Cabling seems to be marked up 5X from what it costs online. Simple USB cables ~$10-15, versus $2 online.

As for movie theater popcorn, I believe all of the above applies, plus one more thing. Theaters have to split out a large percentage of ticket prices to the studios. AFAIK, they do not do this for concessions. So a theater selling a popcorn for $3 may clear $2.50 in profit, even though they only cleared $1 in profit on a $7 ticket to a hot new release. I believe the same principle may be in effect at ballparks, where ticket revenue is shared with other teams/the league, but concession revenue may not be.

[Phil_Stein]

A policy implication is that we consumers would probably be better off if retailers were required to make EW pricing information readily available.

This would be nice, but since the E/W is not required, I'm not sure there's basis for the government requiring it.

What I hate, and WOULD like to see solved by government policy, are charges that are required, but not disclosed. Cell phones are terrible for this. The advertised price versus your actual bill are substantially different, due to layers of fees and such.

I'm fine with sales tax not being included in published prices - that's understood by consumers. But pretty much anything else that you MUST pay to use the item/service should be included in the advertised price.

[skedastic]

Consumers price shop...

Yes, but notice that this is your second explanation, not your first. It's information costs and not the monopoly power per se which drives the result.



As for movie theater popcorn, I believe all of the above applies, plus one more thing. Theaters have to split out a large percentage of ticket prices to the studios. AFAIK, they do not do this for concessions.

Yes, but if it were the case that the total profits to be made by the studio and theatre could be higher by a different ticket-popcorn pricing scheme, we would expect to see the theatres and firms arranging contracts in such a way to implement that scheme. If not, they're just leaving money on the table. So we would expect to see similar pricing for tickets/popcorn even if theatres didn't have to split ticket proceeds with the theatre. And I think we do: the concession at events such as music concerts or plays seems to be just as overpriced as at movies, for example. So, I don't think that the observation that the ticket price is split with the studio helps explain popcorn pricing.

[Phil_Stein]

Re ticket/concession prices:

The revenue split (with studios, other teams, etc) may not be the entire explanation, but it's part of it.

Additionally:

1) I think consumers don't take 'full event price' into account. (i.e. all costs, not just the readily displayed ticket price).

2) Consumers underestimate how much additional stuff they'll buy at an event (i.e. concessions, parking, souveneirs, etc.)

I would suggest that the number of people who go to a ballgame and PLAN to spend $20 on random trinkets is far less than the number who actually do so (either caught up in the moment, or pestered by their kids/girlfriends, etc...)

[Phil_Stein]

Also, while it might be possible for movie theaters and studios to construct agreements that have a more balanced revenue share that reflects both tickets and concessions, constructing and enforcing such agreements (and amortizing the cost of cheating), would be difficult. Sometimes easy solutions win out over solutions that, purely on the economics and ignoring contract/enforcement costs, look better.

[skedastic]

The revenue split (with studios, other teams, etc) may not be the entire explanation, but it's part of it.


Well, now I'm convinced.

[Phil_Stein]

An interesting counter-example.

In general, when purchasing a ticket to an event, extra services/concessions offered at that event appear over-priced relative to what they cost when independently purchased (i.e. ballpark beers, movie theater popcorn).

But, there are certain classes of event where the opposite is true.

Notably, a large portion of the Caribbean/Mexican/Cruise vacation market now offers all-in-one pricing. Pay a flat fee for the trip, and everything is bundled - airfare, hotel accomodations, and food and drinks.

I think in this case, consumers know that they would prefer to consume a large amount of good food and drinks on vacation, but the pricing uncertainty of a traditional resort market scares them - they know they would be at the mercy of the resort, which might significantly overcharge for these items (and prevent them from having as much as they would purchase if they were more normally priced). So they pay a premium for the all-inclusive resort. The premium presumably approximates not only the cost to the hotel to provide the food and drinks, but also the foregone profit on those items' markup. But because the consumer consumes more of these at the all-inclusive, the per-item markup can be less and still allow the resort to make the same profit per consumer.

[unbongwah]

You need to look at several factors, including the terms of service (many include major exclusions or make you wait weeks for replacements), the predicted reliability of the product, the cost of full replacement on your own (i.e., guarding against "catastrophic failure"), and the impact of downtime while something is being serviced or replaced (your iPod dies, you're out of tunes; your work laptop dies, you're SOL). It's all about calculated risk.

As a general rule, extended warranties are not worth buying on relatively inexpensive electronic items, though even here there are exceptions. [Need I even mention all those Xbox 360s which died early deaths?] E.g., recently the CD player in my car died. I had an extended warranty, so I took it in for repair. After a few weeks (they mailed it back to their service center to work on it), they decided it couldn't be fixed and gave me a pro-rated store credit so I could pick out a new one: out of the $200 I originally spent on the CD player and warranty (excluding labor), I got back $160. Still, I lucked out, so to speak: if I had a shorter extended warranty, it would've ended up being wasted money.

[skedastic]

That's a good example of why popcorn pricing is considered a puzzle. For both cruise ships and movies, the consumer pays to get in, and then is confronted with the options of buying more goods and services. The firm, in effect, has a monopoly on those goods and services: you can't choose to buy food from a cruise ship other than the one you're on, and you can't choose to buy popcorn from some theatre other than the one you're in. If we ignore heterogeneity across consumers and other such complications, the firm would makes the most profits by charging marginal cost for the goods and services and a high price for the ticket, as David Friedman explains in the textbook chapter cited above.

Cruise ships take an extreme version of that sort of pricing: food is pretty cheap, so they just charge nothing for it, and charge a high price for the ticket. This sort of pricing is not surprising. Another common example is nightclubs which charge a high price at the door and then price drinks near cost. Observing the opposite sort of prcing -- low prices at the door and high prices for the goods and services you can buy once you get in -- is surprising. Hence, the popcorn pricing puzzle.

[Phil_Stein]

Heh - I just got in the mail a postcard from 'Motor Vehicle Protection Corp.' urging me to call them (FINAL REMINDER).

So there are some after-market E/W providers. Unfortunately for them, I understand economics, and also can deal with car repair costs out of pocket. And even if I didn't my car is a Hyundai with a standard 10 year, 100,000 mile warranty (IIRC).

[Nick Walter]

Heh - I just got in the mail a postcard from 'Motor Vehicle Protection Corp.' urging me to call them (FINAL REMINDER).

So there are some after-market E/W providers. Unfortunately for them, I understand economics, and also can deal with car repair costs out of pocket. And even if I didn't my car is a Hyundai with a standard 10 year, 100,000 mile warranty (IIRC).

I got something similar yesterday and had a good laugh over it. It was clearly a very scummy company trying to mislead people, because it was a letter full of dire warning about how my warranty was about to expire and I had to ACT NOW to get an extended warranty through these people. I don't have a car with a warranty. Never have had one.

I was curious if something that misleading might be illegal, but I was too lazy to follow up on it so I just circular filed it.