World Class Faculty & Research / December 22, 2014

Are You a Dolt If You Buy an Extended-Service Contract?

SMITH BRAIN TRUST -- The holiday season is a boom time for the sale of consumer electronics, which means it’s also prime time for retailers to push extended-service contracts onto their customers. The contracts lengthen the terms of manufacturers’ warranties — for a hefty fee. Consider that Best Buy right now is charging $310 to insure a $480 laptop against spills, drops or other damage for three years.

That kind of eye-popping figure explains why Consumer Reports and other buyers’ advocates urge people to decline these warranties, which can carry a profit margin of 50 to 60 percent. Yet despite the markup, the contracts remain popular among consumers. 

Unlike some number-crunchers, Tao Chen, an assistant professor at the University of Maryland’s Robert H. Smith School of Business, is sympathetic to consumers who buy such contracts. “I don't like to describe people as completely irrational,” she says.

Risk-averse consumers buy extended service contracts for the peace of mind. And their choices hinges on whether they believe that peace of mind is worth the “irrational” expense paid in excess of the rational expected repair or replacement cost

Chen is one of the few scholars to have studied the psychology of extended contracts in depth. In 2009, in the Journal of Consumer Research, she and two coauthors explored what makes people more or less likely to buy them. Here are five things to know as you’re standing in line with a new Xbox or tablet:

1. Halo effect. People are more likely to buy service contracts on goods that have high “hedonic” value. Hedonic goods are those that people get excited about, as opposed to products that are merely useful and utilitarian. Consumers treat that halo of excitement as if it had a monetary value: suddenly the perceived cost of having the device break on them seems steeper. So even if a car stereo costs the same as a laser printer, the typical consumer is more likely to buy a service contract for the stereo.

2. Income effect. Low-income consumers are more likely to buy service contracts. The higher their income, the more likely they are to self-insure — to keep enough money in the bank to replace or repair the item if it dies. Lower income consumers, on the other hand, not only hang on to products longer but also realize that they would feel the pain of an item’s breaking more keenly.

3. Bargain effect. Discounts inspire people to buy contracts: Research shows that consumers are inclined to spend some of the money they save during a sale on an extended contract. (Since the profit margins on contracts are higher than for most retail goods, this dynamic works in favor of retailers.) Moreover, there’s a psychological “windfall” effect if the discount is unadvertised. Consumers who stumble on an unannounced sale experience an elevated mood, a consumer’s “high.” Research has shown that people in such a mood are more risk-averse; hence they buy more contracts. The windfall effect disappears when sales are advertised.

4. Gender effect (or lack thereof). Men and women are equally likely to buy contracts. Women tend to be more risk-averse than men, a characteristic that drives the purchase of extended contracts. But men seem more attuned to the financial loss of a failed electronic good. All in all, the gender factor is complicated — and probably a wash.

5. Repeat customer effect. If you’ve ever used a service contract before, you’re more likely to buy another one. If your last camera broke and a service contract helped you replace it, for example, you’re more likely to buy another contract. You might want to pause to consider if the vividness of that experience is outweighing the cost-benefit calculation you’d make otherwise.

The paper on which these insights are based, “Why Do Consumers Buy Extended Service Contracts?", from December 2009, draws on surveys of 604 households, analyzing electronics purchases made in the year ending October 2004. During the study, just under one-third of consumers bought extended contracts. Besides Chen, coauthors are Ajay Kalra, a professor of marketing at Rice University, and Baohong Sun, a professor of marketing at Cheung Kong Graduate School of Business.

Another trend to watch: Retailers are tailoring these contracts ever more specifically to cover different types of worries, from traditional breakdowns to (as the Best Buy example shows) drops and spills. “As retailers get more and more sophisticated in offering menu-based service contracts, covering different level of risks, I would expect consumers to buy more,” Chen says. “On the other hand, consumers need to shop more wisely to find the right service contract that fits the level of protection they want.”

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About the University of Maryland's Robert H. Smith School of Business

The Robert H. Smith School of Business is an internationally recognized leader in management education and research. One of 12 colleges and schools at the University of Maryland, College Park, the Smith School offers undergraduate, full-time and flex MBA, executive MBA, online MBA, business master’s, PhD and executive education programs, as well as outreach services to the corporate community. The school offers its degree, custom and certification programs in learning locations in North America and Asia.

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