The Scarcity Effect

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  • A few weeks ago, we talked about the psychology of investing.  Turns out that psychology plays a big role not only in investing, but also in how we spend and save, and most importantly, how we end up in debt.

    Don’t people end up in debt because they spend more than they earn? It’s pretty simple, right?
    Yes and no.  To explain debt in the past, we’ve pointed to poor decision-making and values gone astray in a culture that encourages instant gratification. But what’s interesting is that recent research shows that scarcity by itself is enough to cause financial self-sabotage. It’s called the “scarcity effect”—a basic economic principle that something in low supply becomes higher in demand.

    So you’re saying that having a lower income causes people to go into debt?
    Exactly! And it’s not just because a lower income means it’s harder pay the bills—It’s a poverty trap. When facing financial turmoil, people start to borrow at high interest rates they know will hurt them, taking on loans and making bad financial decisions they avoided before they felt desperate. Being in debt robs us of our sense of security and control, and these less quantifiable psychological effects can cause a very concrete fallout—reckless borrowing and deeper debt.

    But isn’t that counterintuitive—to borrow if you’re already in debt?
    It’s the way we’re wired. A few researchers from the University of Chicago’s school of business published a paper recently that detailed a series of related experiments. Their results showed that scarcity by itself—independent of personality or any other factors—fuels a drive to borrow recklessly.

    In one experiment, participants competed in rounds of the game “Family Feud.” One team was “poor,” allotted only 15 seconds per round, while another was “rich,” with a budget of nearly a minute per round. Both groups could borrow time against future rounds, but the “poor” team borrowed far more, progressively shrinking their future paychecks while the rich mostly avoided debt.

    So this is a common problem?
    Unfortunately, it’s all too common.  I have some pretty grim statistics for you.

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