In an ideal economic world, supply and demand are balanced. Low demand and high supply cause prices to decrease to reach market equilibrium, where supply is equal to demand. This means all the products and services are distributed to consumers and there is not an over- or under-supply of those goods. However, this is not always the case. The scarcity principle comes into play when there is a high demand and low supply, meaning prices need to increase to compensate, resulting in a lower demand with the goal of reaching equilibrium.
What is the Scarcity Principle?
The scarcity principle relies on two basic economic principles: the law of supply and the law of demand. Plotted on a graph, a supply curve is most commonly upward-sloping, representing a higher quantity of the item produced when the item can be sold at a higher price. Inversely, the demand curve is most commonly downward-sloping, representing the willingness of consumers to purchase more items at a lower price, or fewer items at a higher price. The point at which the two curves intersect represents the equilibrium price, where supply and demand are equal. The relationship between supply and demand curves can be seen on the graph below.
In essence, the scarcity principle claims that the more difficult it is to obtain a product, the more valuable the product becomes. The scarcity principle assumes that supply and demand are at a disequilibrium, with a higher demand for a product than supply. Prices tend to increase to compensate for the lower supply, ideally achieving a lower demand to reach the equilibrium point where supply and demand are equal. At higher prices, fewer people are willing to purchase a product as they do their own cost benefit analysis. If the perceived benefit of purchasing the product is less than the price, the consumer tends to not make the purchase. This relationship can be seen on the graph below.
This also plays into basic human desire. People tend to place a higher value on a scarce object and are willing to pay more for a scarce object. Inversely, more abundant objects tend to hold less value, and are able to be sold for lower prices. The scarcity principle relies on these basic human desires as prices increase to facilitate demand.
Example of the Scarcity Principle
The scarcity principle also can allow for businesses to artificially inflate demand to keep higher prices. One example of this is the diamond industry. In 1902, 90% of the world’s production and distribution of rough diamonds was owned by one company: De Beers. The company utilized a strategic marketing campaign paired with the choice to only release a certain number of diamonds into the market to help artificially inflate the demand while keeping supply low. The choice to limit the supply of diamonds led to the opportunity to increase the price of diamonds. Consumers still demanded diamonds, and some were willing to pay the higher associated price.
The Scarcity Principle and Investments
This principle tends to translate well to investments such as luxury products – like art, classic cars, fine wines, and jewelry. These products rely on the scarcity principle to help drive sales, generating a high demand for a product, with a limited supply available to purchase. In return, this can increase the resale value as a consumer’s willingness to purchase the product at a higher price can increase. For example, long term investments in a popular watch brand like Rolex have consistently outperformed real estate and gold, and even has outperformed the Dow Jones at times over the past 10 years 2011-2021. However, this historical trend is not guaranteed to continue in the future. Investments, even in luxury products, can be subject to many risks.
The scarcity principle plays off basic human desires and assumptions to claim that the more scarce a product is, the more valuable it may become in the eyes of a consumer. Many brands have utilized this economic theory to manually control supply, artificially inflate demand, and therefore increase prices – sometimes to a point where resale value is greater than original sale value.
The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.