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Why Do Consumers Buy Extended Service Contracts?

Buy a $14 TV remote control and the retailer will ask if you want to purchase an extended service contract (ESC) in the event it breaks. “Although most consumer magazines and experts advocate that consumers do not invest in ESCs because they provide little value, it is intriguing that consumers’ demand for them remains high,” says Baohong Sun, Carnegie Bosch Professor of Marketing. “Thus ESCs now provide a substantial and increasing amount of the profits of electronics retailers.”

Sun and her colleagues used data from the electronics department for one retailer that tracked 604 households for one year, analyzing their 1,676 product and 553 ESC purchases. “To the best of our knowledge, our study is the first to examine consumers’ purchases of ESCs in a retail environment using field data, rather than controlled studies. The use of real purchase data enables us to expand our inquiry into factors such as the retailers’ marketing actions, ESC pricing by price-tiers, product types, and different consumer characteristics such as gender and income.

“Results indeed show that consumers are more likely to purchase ESCs for products that have higher hedonic than utilitarian value because the value of these products and the guilt associated with spending for them increases the pain of loss and heighten risk aversion,” says Sun. She adds that the data also show that consumers are more likely to purchase an ESC if there are unadvertised, in-store promotions: “the unexpected gains from these promotions appears to evoke positive moods in consumers as well as heighten their risk aversion—they are more inclined to buy product insurance.”

The resulting paper, “Why Do Consumers Buy Extended Service Contracts?,” to appear in theJournal of Consumer Research, provides valuable insight into consumer behavior. Sun confirmed earlier empirical findings that product price serves as a cue of quality; consumers assign a lower chance of product failure if it has a higher price. Consumers who have purchased ESCs in the past are also more likely to do so again for other product categories in the future. Finally, the results show that low income consumers are more likely to purchase ESCs because they are more sensitive to the replacement costs in the event of failure. “If the extended service contracts, do, in fact, offer little value, the results imply a perverse impact on consumer welfare,” Sun notes. “The inability of low income consumers to replace products induces them to pay a potentially unnecessary and overpriced insurance premium.

“20 years ago, service contracts were offered principally by manufacturers on big-ticket items; now retailers offer them on many small-ticket products. Our research shows that the retailer’s current pricing strategy of ESCs is not optimal at all—after all, customers are smart. Retailers can learn to price ESCs better and offer them in conjunction with in-store promotions. This, combined with good service, can promote customer loyalty to the store.”

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