The Psychology of Scarcity: Part 1 of 2

The Psychology of Scarcity: Part 1 of 2

January 2, 2014 Behavioral Finance
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(Last Updated On: December 15, 2014)

“…The inconveniences of a real scarcity cannot be remedied; they can only be palliated.”

– Adam Smith, Chapter V, The Wealth of Nations

As Adam Smith pointed out back in 1776, scarcity is fundamental aspect of the human condition which, while often impossible to remove entirely, can sometimes be managed. In Scarcity: Why Having Too Little Means So Much, Sendhil Mullainathan and Eldar Shafir discuss the notion of scarcity, how it can affect our decision making, and steps we can take to manage it.

Scarcity often drive our interactions with the world, sometimes positively and sometimes negatively, and the authors provide a highly useful framework for thinking about this dynamic. In this post, Part 1 of our 2 part series, we will present the framework itself. Within the context of the framework, however, there are a number of strategies that can be implemented for addressing and offsetting these powerful behavioral forces. We will cover some applications of the framework and specific strategies in Part 2 of our series.

The Focus Dividend and Tunneling

Anyone who has procrastinated and begun work on a paper the day before it is due can appreciate the concept of a focus dividend. As a result of time pressure – literally the scarcity of time – the student goes into overdrive, churning out text a a furious pace.  It is the opposite of writer’s block. The authors describe how the impending deadline focuses the mind tremendously, to the extent that it literally shuts out everything else. Every time the urge arises to, say, turn on the TV or pick up the phone, the mind relentlessly refocuses on the urgent task at hand, driving sustained productive thought. This high degree of focus enhances the ability to work productively, and is thus a “dividend” that can accompany the scarcity of time.

Sometimes, while in this highly focused state one can begin to exclude more and more considerations. This is described as “tunneling.” The mind becomes oblivious to everything external to the tunnel of concentration, where all focus resides. If you are writing a term paper, tunneling may be a good thing, but in some cases, where important tasks lie outside the tunnel and require some level of attention, it can be dangerous.

Neglect and Tunneling/Bandwidth Tax

Consider a skydiver whose parachute has malfunctioned. The skydiver is singularly focused on pulling the rip cord, but it may be that the cord is caught on a piece of clothing, requiring that it be untangled first. In this case, tunneling has turned counterproductive, resulting in the skydiver neglecting a critical consideration.

The focus dividend is now working against us. When our extreme focus results in neglect of important issues, we suffer a “tunneling tax,” whereby we end up worse off, as with the hapless skydiver who mindlessly pulls at the rip cord.

The concept of a tunneling tax can be extrapolated to general life conditions. When we tunnel, we neglect important considerations; likewise, in life, when we are stressed or preoccupied with something, we can be simply unable to process effectively. We literally lose IQ points, since the full capacity, or bandwidth, of our thinking is unavailable. We become impulsive and lack self-control. What can preoccupy our thoughts? Various conditions related to scarcity can do so. A noisy environment (scarcity of quiet). Hunger (scarcity of food). Exhaustion (scarcity of sleep). Even worry (scarcity of resolution). These types of scarcity-based stress consume cognitive bandwidth, and lead to an overall scarcity of cognitive resources. 

Slack

The opposite of scarcity is slack, and slack provides us with the luxury of not having to make difficult choices involving tradeoffs. The self-storage industry is based on the principle that people are willing to pay a small amount to store their belongings, thus deferring the choice of what to throw away.

Hyperbolic Discounting or Present Bias

Is time more precious today than tomorrow? Sometimes it is. Scarcity can drive us to tunnel on the present, to value the present more highly than the future, leading to poor decision making. We opt for the shortsighted, inexpensive, quick fix solutions, which result in higher time and resource costs in the future.

hyperbolicdiscounting

We tunnel on what’s immediate such as answering an email, and postpone important tasks that don’t seem as urgent, such as going to the dentist. This can result in cascading outcomes driving more scarcity – a scarcity trap – as with someone who takes a high interest payday loan that sends them spiraling into debt. In these cases, scarcity has captured our attention today, at the expense of appropriate planning for tomorrow. 

Shocks and Liquidity

Without slack, may not be able to escape these scarcity traps. Liquidity, for example, acts as a buffer against balance sheet shocks. The financial crisis was exacerbated by banks’ insufficient availability of financial slack to accommodate defaults, which was driven by risk managers’ tunneling on extending resources to drive profitability.

Choking

So too, the perception of scarcity can cause us to “choke” in a sports event. When we tunnel on the importance of that free throw, our performance suffers and we are more likely to miss.

As with payday loans and the financial crisis: scarcity begets more scarcity. The danger occurs when scarcity drives our arousal level higher, and available cognitive resources lower, impacting performance, as per the graph below:
scarcitygraph

Designing for Scarcity

The trick to managing scarcity then, might be to create slack, and think tactically about ways to avoid pernicious tunneling, to keep ourselves from moving too far out along the curve above. We should try to manage down our individual bandwidth taxes and cognitive load so that they don’t cause too great a burden on our performance. In our next post, Part 2, we will explore some ways we might be able to accomplish this in different contexts.


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Definitions of common statistics used in our analysis are available here (towards the bottom)




About the Author

David Foulke

Mr. Foulke is currently an owner/manager at Tradingfront, Inc., a white-label robo advisor platform. Previously he was a Managing Member of Alpha Architect, a quantitative asset manager. Prior to joining Alpha Architect, he was a Senior Vice President at Pardee Resources Company, a manager of natural resource assets, including investments in mineral rights, timber and renewables. He has also worked in investment banking and capital markets roles within the financial services industry, including at Houlihan Lokey, GE Capital, and Burnham Financial. He also founded two technology companies: E-lingo.com, an internet-based provider of automated translation services, and Stonelocator.com, an online wholesaler of stone and tile. Mr. Foulke received an M.B.A. from The Wharton School of the University of Pennsylvania, and an A.B. from Dartmouth College.