Today we bring you a story about the flaw inherent to traditional economic theory, and an inherent human attitude about scarcity that gives the lie to this thinking. We asked Gamification expert and occasional Stanford University lecturer Yu-kai Chou to write a blog post about how scarcity can drive demand.  You may remember our conversation with Yu-kai during The BizSpark Show (see video embedded below this post).

About the Author: Yu-kai Chou is an Entrepreneur, a Partner at the Enterprise Gamification Consultancy(EGC) and a Gamification Pioneer who has been working in gamification since 2003. Yu-kai is the original creator of the Gamification Framework Octalysis, and is a regular speaker/lecturer at organizations like Stanford University and Google Inc.

The Flaw of Traditional Economics Theory

When I was studying economics in school, the one fundamental lesson that the professors always talked about was the supply and demand curve. It basically says that if the price of an item drops, the demand will increase (moving forward on the demand curve).

If the item becomes completely free, the curve will indicate the maximum number of buyers that will acquire it. Supply Demand Gamification But if you have studied behavioral psychology, gamification, and/or human focused design, you will find that there's another side to the story. It turns out, being one of the 8 Core Drives of Gamification, Scarcityis another beast that drives consumer behavior. Scarcity is the limitation of something (an item, a resource, a service) towards meeting the corresponding demand. In economics theory, scarcity is well understood, but only in the sense of objective limits matched against the consumer's utility derived from a purchase. The issue here is that, almost all economics theory starts off with two key assumptions:

  1. Consumers have perfect information
  2. Consumers always behave rationally

But in the real world, these two assumptions almost never hold true - people are often irrational and never really have perfect information. Often they react to pricing in another, more surprising way: the more expensive something is, the higher the value (utility) is placed on it. This leads to increased demand. As a result, sales may actually increase with pricing. Normally, if an item were free (the extreme right of the demand curve), everyone who would want this product would obtain it. Say hypothetically, 100 people would do this. But sometimes, if the product is unusually expensive, people who previously didn't care might suddenly want it. Now sales may exceed 150 items! Because of this scarcity effect, a real demand curve in some products might produce a C-Shape instead of a diagonal line moving down to the right. Economics Demand Curve Scarcity   Scarcity works because people perceive that something is more valuable if it is more expensive or less attainable. Because people don't have "perfect information," they generally do not know the utility of a certain good. Therefore, they rely on cues - such as how expensive or limited something is - to determine how valuable something is. If everyone wants it, it must be good!

Examples of Scarcity in Action for Service Providers

I've personally seen numerous examples, both first and second hand, where increasing the price actually allowed people to sell more. Not too long ago, one of my clients was trying to choose between two service providers, one who charged $8,000/mo and the other $10,000/mo. I informed him that I thought the $8,000/mo provider would deliver better services. However, my client remained doubtful, feeling that the $10,000/mo provider must be better because of the pricing. I told him that just because one service charges more doesn't mean it is compellingly better. Ultimately my client decided to use both of the services for a period of three months. After this period was up, we saw that the $8,000/mo provider was exceptional, while the $10,000 was very disappointing. In this case, if the lesser service provider would charge $6000 instead of $10,000, he might not even get a chance to try for 3 months (of course, focusing on creating value is the most important so you don't lose your job after 3 months). On another occasion I had a client that needed a CPC campaign audit. I contacted a friend who was the best in the industry from Eastern Europe. Since I had done some favors for him in the past, I was able to persuade him to help my client with a free audit, which he would have charged thousands otherwise. Though my client was excited about the arrangement, he hesitated and moved very slowly. I pressed my client on this and he said, "What worries me is the free price … is he really as good as you say he is?" He had perceived that my friend’s service was not really valuable because it was offered for free. That's why it might have been more advantageous to charge a smaller fee such as $500 for the audit instead of giving it out for free.

Examples of Scarcity in Action for Goods and Products

This situation doesn't just happen in high end services. In the book Influence: Science and Practice, author Robert B. Cialdini describes a story of a friend he had who ran an Indian Jewelry Store in Arizona. The owner was trying to sell some high quality turquoise pieces during the peak tourist season. Despite her constant efforts to promote and emphasize these pieces to the shop visitors, no one bought them. Finally, the night prior to an out-of-town buying trip, the owner concluded that she needed to lower the prices and make the pieces more attractive to her customers. As a result, she left a note for her head salesperson with instructions to reduce the prices by half. However, the salesperson misunderstood the note, and mistakenly doubled the price on all the pieces. Upon returning a few days later, the owner was pleasantly surprised to learn that all the pieces had been sold. Doubling the price on each item had actually allowed her to sell more because the perceived value of each had increased. In his other book Yes! 50 Scientifically Proven Ways to Be Persuasive, Cialdini describes situations where inconveniencing people can result in them valuing something more. The book notes that, for infomercials, calls will increase substantially when the message is changed from, "Operators are waiting" to "If operators are busy, please call again later."Why would this be? In the first case viewers can imagine operators waiting to answer calls and take orders for products that may be of marginal value. In the second case viewers will more likely perceive that the operators will be struggling to answer a flood of calls and keeping up with the demand on orders. The perception will be that the product value is extremely high, and that the viewer better call in and order while they can. This type of perceived social proof works great in sales.

Applications of Scarcity in Startups

The most obvious application for start-ups is to launch with a confident pricing strategy. Instead of just offering everything for free or easily available for everyone, a more premium pricing model or exclusivity might also increase the confidence of users/buyers with a result in increased conversion rates. Another excellent example is how Facebook utilized “scarcity” in the form of exclusivity. Initially Facebook was exclusive - being only for Harvard students. Then it opened up to the Ivy League schools, and eventually to all colleges and high schools. Finally, everyone was allowed to join. Because people early on couldn't get it, they were “crazy” about it. The sense of scarcity and exclusivity created more demand than if Facebook had been “open to all” from day one. Zynga's Farmville also manufactures scarcity to make their product more addicting. Instead of farming for as long as you want to play (the basis for most games), you are often forced to stop and wait for 8 hours before you can continue to play the game. This causes people to think about the game ALL THE TIME. They may log in after 3 hours, 4 hours, or 6 hours, just to check and see if they can reap their crops, even though they know as a fact that 8 hours have not transpired. If Farmville simply allowed people to farm to their hearts' content, people would eventually stop, and not think about it all the time. In the game Geomon (recently shutdown due to a business transaction with a major tech company), gamers try to capture all the monsters in order to fight against each other. The game is similar to Pokemon, but influenced by the environment where the gamers are physically based. In Geomon, there are certain scarce monsters that can only be found in very limited or special situations, such as in proximity to a company, or on days where the temperature is over 110 degrees. Because some of these monsters are extremely rare, people are willing to spend real money in order to obtain them. One such example is the Mozzy, which can only be caught next to a Mozilla Office. In this image, notice how people seem to be desperate to get a Mozzy: Gamification Scarcity 2   Gamification Scarcity Another example is the Laurelix, which at one point was owned by only 3 players in the game. The company actually received a call from the mother of a player, saying, "My son has been sick for a week, and he said only a Laruelix can cheer him up. I don't know what it is, but he said you have it. I'm willing to pay $20 for a Laurelix. Can you give that to my son?" Interestingly, these monsters are not necessarily more powerful than regular monsters, but because they are so hard to get, the perceived value increases immensely, helping the entrepreneurs to better monetize their game. Wootis another company that uses scarcity to drive sales. The enticing thing about Woot is that you never know what product will be promoted. The site also sets a limit on the number of people that can claim the deal. Many who check Woot at 4 PM will see an amazing deal, but typically find that the item is sold out. As a result their eagerness to get the next product will increase, motivating them to constantly return to the website. Eventually a great amount of buyers wait on the site at 11:59 PM each day, just to see the next product as soon as it becomes available. Once it does appear, they are ready to quickly snatch it up.

Accidental Fails sometimes become a Blessing

Another good example is the "Fail Whale" in early years of Twitter. The Twitter site was often down in 2006 and prior. Even though this frustrated many users, they waited more eagerly for the service to return (and talked about when it will return on Facebook). I've seen cases where people were planning to retire from playing a game , but then encountered issues due to massive servers problems, and instead of quitting, checking the app every day to see if they "can" play it or not. Even though they planned to quit, they needed to quit on their own terms. When they were prevented from playing because they "couldn't," their desire to play actually increased. What made the situation worse is that "sometimes" they would be able to play the game, only to experience another crash. If it was just indefinitely down, people would lose interest, but the "sometimes working" game would take on an addictive appeal. This behavior is much like how people pull on a slot machine, hoping for but not necessarily expecting good results. The same effect happend with Twitter, where users became obsessed with checking the service each minute to see if the service had been re-established, eventually increasing traction.

Viewing exclusivity as a form of scarcity is illustrated in the South Park episode "Cartman joins NAMBLA."Here, Cartman constantly brags about his new group of "mature grown-up friends" to his rival Kyle. After several exchanges of Kyle saying, "I don't WANT to join your group" and Cartman rebutting with, "No, you CAN'T join my group", Kyle finally feels compelled to learn how to join the group. The desire to become a member of Cartman’s group is now present in Kyle, where there was none before.

So now what?

Of course, this doesn't mean start-ups should pull down their servers on purpose. Besides pricing your service/product with confidence, you may want to create a sense of exclusivity for each step during the Discovery and Onboarding stages, where the service makes them feel that it's uniquely for them; that they uniquely qualify for the access (Email notification that is only sent to VIP members). They now have exclusivity as the "Harvard students", the "Apple Fans", or even more broadly as "people who signed up the newsletter." For actions that lead to rewards and investments, instead of allowing unlimited actions (such as “liking” as many times as you want), consider more restrictive options. Often, placing a cap on how many actions a person can take (or investments that they can make) will cause them to desire it more. Some entrepreneurs may have experienced this in the case where fundraising for their venture becomes smoother once they inform investors that the round is closing and that their money is no longer essential (Or that there is space for only half the amount that investors want to put in). By using scarcity and exclusivity, businesses can influence consumer perception of their products and services. By increasing perceived value, customers and users are more likely to stay engaged and take greater interest in your venture, while making sure you don't give out all your hard earned world-changing work for close to nothing. Of course, if you price an item outside what is affordable to your target market, then this could backfire. But more often than not, when customers don't buy your product, it's not because they can't afford it. It's because the perceived value they have for your product is not worth the cost (and sometimes that cost is in the simple form of time investment or "talking to my boss about it."). Learning Gamification and Human-Focused Design is a great way to craft customer perception and get them to see your service as valuable beyond anything else that exists in the market.