The population clock shows that the world has 7.1 billion people. Let us imagine that this population is divided into families of 4 member each. We will have around 1.77 billion families. How nice it would be if all the families have a own house, a ferrari car, and have their kids study in Ivy league colleges. A novel thought and it will help you to win an election. But in reality it is not possible. Why? These resources are scarce. It means that what everybody wants add up to more than there is.
Economics is the study of the use of scarce resources which have alternative uses.
The headline in a featured article in New York Times read “The American Middle, Just Getting By” Other headlines in the articles included – Wishes Deferred and Plans Unmet, Goals that remain just out of sight, Dogged saving and some luxuries. In the book Basic Economics – Thomas Sowell gives an excellent explanation for this.
In short, middle-class Americans desires exceed what they can comfortably afford, even though what they already have would be considered unbelievable prosperity by people in many other countries around the world – or even by earlier generations of Americans. Yet both they and the reporter regard them as “just getting by” and a Harvard sociologist spoke of “how budget constrained these people really are.” However, it is not something as man made as a budget that constrains them: Reality constrains them. There has never been enough to satisfy everyone completely. That is the real constraint. That is what scarcity means.
Who decides the allocation of scarce resources?
In a market driven economy prices determines the allocation of scarce resources. In certain countries government allocates these resources. But the main point is that resources are scarce and you need some way to ration it. Thomas Sowell writes
If the government were to come up with a “plan” for “universal access” to beach-front homes and put “caps” on the prices that could be charged for such property, that would not change the underlying reality of the high ratio of people, to beach-front land. With a given population and a given amount of beach-front property, rationing without prices would now have to take place by bureaucratic fiat, political favoritism or random chance – but the rationing would still have to take place. Even if the government were to decree that beach-front homes were a “basic right” of all citizens, that would still not change the underlying reality in the slightest.
When resources are scarce, traditional economics assumes that human beings are rational and they will weigh cost and benefits to arrive at an action that maximizes personal advantage. For example if houses are selling at a price which a person cannot afford then he will rent a house. But in reality is this assumption true? Behavioral economics does not think that human beings are always rational. When resources are scarce human brains go crazy.
Scarcity and human brain
When items are scare we assume that it should be of excellent quality. It is a shortcut our brain takes to arrive at quick decisions. But this assumption is not always true.
In one experiment participants were asked to rate chocolate chip cookies according to variety of different attributes. One group of participants took a cookie from a jar in which there were ten cookies. Another group of participants took a cookie from a jar containing only two cookies. Even though the cookies were exactly the same, people considered those they took from the jar with only two cookies to be more desirable.
In the book Influence – Cialdini cites an example from the real estate industry
For example, a realtor who is trying to sell a house to a “fence-sitting” prospect will sometimes call the prospect with news of another potential buyer who has seen the house, liked it, and is scheduled to return the following day to talk about terms. When wholly fabricated, the new bidder is commonly described as an outsider with plenty of money: “an out-of-state investor buying for tax purposes” and “a physician and his wife moving into town” are favorites. The tactic, called in some circles “goosing ’em off the fence,” can work devastatingly well. The thought of losing out to a rival frequently turns a buyer from hesitant to zealous.
In 1973 Barry Diller was the vice president for prime-time programming at the American Broadcasting Company (ABC). He agreed to pay $3.3 million for a single television showing of the movie The Poseidon Adventure. Before this the highest paid amount was $2 million. By doing this deal ABC lost $1 million. Why did Diller do this deal?
It was the first time that a motion picture had been offered to the networks in an open-bid auction. Never before had the three major commercial networks been forced to battle for a scarce resource in quite this way.
This is the reason why Charlie Munger never goes to auctions. He writes
Well the open-outcry auction is just made to turn the brain into mush: you’ve got social proof, the other guy is bidding, you get reciprocation tendency, you get deprival super-reaction syndrome, the thing is going away. I mean it just absolutely is designed to manipulate people into idiotic behavior.