Scarcity Premium

Be it in the markets or in life, the right kind of scarcity commands a premium.

Over the years, I’ve understood through practical experience that true value in anything comes from identifying the arbitrage between demand and supply.

The people who can spot and capitalize on this arbitrage reap the rewards of what’s known as the scarcity premium.

I’ve learned this first principle not from textbooks, but from being in the field of professional investing. And through my profession, I’ve also seen its application in other areas of my life.

While it’s easy to grasp the theory of demand and supply from an economics textbook, you’d be surprised how few people actually understand and apply these principles in real life.

The best businesses, and the most successful people, identify these demand-supply gaps early and take the risks to reap the benefits of this arbitrage.

From The 48 Laws of Power:

By withdrawing something from the market, you create immense value.

In 17th century Holland, the upper classes wanted to turn the tulip into more than just a beautiful flower. They wanted it to become a status symbol.

So they made it scarce almost impossible to obtain. What followed is now known as Tulipmania, one of the earliest speculative bubbles in financial history.

A single tulip flower became worth more than its weight in gold. Rare tulip bulbs turned into status symbols among the wealthy. Demand and prices skyrocketed.

Speculators began treating tulip bulbs like tradable assets, often buying and selling them through futures contracts without ever taking delivery. Prices kept rising, and more people jumped in, thinking they could sell at even higher prices.

A classic example of a speculative bubble.

Then at routine tulip auction in February 1637, buyers failed to show up.

Everyone panicked and prices collapsed, eventually many were left holding worthless contracts.

This was one of the first recorded financial bubbles driven entirely by artificial scarcity.

These types of demand and supply imbalances cause euphoria. They create scarcity premiums that don’t last.

Eventually, they wither away.

However there is another type of positive and non fraudelent scacrity premium.

Professor Sanjay Bakshi explains the idea of scarcity premium brilliantly in a podcast episode I highly recommend.

He says that if you're investing in a cyclical company with low entry barriers, where there's a shortage of supply in the industry at that moment, your profits are going to boom for a period of time due to the lack of supply.

But the scarcity isn’t in your control.

Supply will eventually come back. And as supply outstrips demand as it always does at some point in a cyclical industry profits are going to nosedive, as we see with most companies in this type of industry.

But there’s a different kind of shortage he alludes to in the interview.

Take the example of Ferrari, which makes 13,000 cars a year, vs. Toyota, who probably makes 13,000 cars in a few days yet Toyota’s stock price hasn’t done as well as Ferraris despite this massive scale.

Ferrari has outperformed Toyota by a country mile in terms of stock performance.

Ferrari understands scarcity, the scarcity of Ferrari can only be solved by Ferrari. And that can’t be solved by anybody else, you can’t produce a luxury supercar to fill this supply demand gap.

But like the previous examples I mentioned, the scarcity of iron and steel can be addressed by any iron and steel company. And it’s also influenced by a lot of factors that are outside the company’s control.

So all shortages and scarcities are not the same.

But here’s the interesting thing, technology can come and disrupt even the best of scarcity premiums.

“Diamonds are a girl’s best friend.”

De Beers did well because they could control the supply and demand of diamonds and with it, the scarcity by creating this marketing campagin around diamonds.

They controlled diamond prices. They could dictate where prices went.

But then came lab-grown diamonds.

They disrupted the entire market, changed the supply-demand dynamics, and killed the diamond scarcity premium by a decent margin. Diamond prices nosedived.

Luxury goods companies probably fit this definition.

This is explained by the concept of Veblen Goods (learned it in my 11th standard economics textbook), where perceived status drives consumption more than utility.

This “scarcity premium” reflects more than just limited supply. It captures the emotional value consumers place on rarity and the pricing power that follows. Some individuals curate entire financial plans to simply buy these goods.

Luxury goods companies often command these superior metrics and have seen significant appreciation in their stock prices due to the leverage of this great premium they have created and maintained over decades.

It’s also evident in the Return on Equity and Return on Capital Employed that these companies generate.

There’s a strategy called the Blue Ocean Strategy. Instead of battling countless competitors in a crowded “red ocean,” it can be far more profitable to seek out uncontested “blue” water. The companies that use this strategy are often wildly different from anything else in their industry. And as a result, they grow rapidly.

This doesn’t mean the company has to be small. It can be a very large company doing this at scale and becoming even larger.

But as Professor Bakshi mentions, it’s about the kind of scarcity you’re chasing.

You can’t just seek scarcity for the sake of it, especially if there’s no demand for the product or service.

I can extrapolate this to any skill or business in life. So it’s important to ask:

What kind of scarcity are we really trying to exploit?

This same scarcity premium applies to your own skills.

Make what you offer rare and hard to find, you’ll instantly increase its value.

AI has levelled the knowledge arbitrage just like lab grown diamonds did for diamonds and many skills in the modern world today are losing their scarcity premium.

So why the hell shouldn’t everyone be able to do it, if it’s so straightforward?

Because eople aren’t willing to go through prolonged uncertainty or acknowledge the pain that comes with it in order to reap the benefits of this demand-supply gap.

If everyone did it, supply would meet demand and you’d create no value.

But if you’re able to find and hold that unique arbitrage, you can command what’s called a scarcity premium.

As I mentioned that it today’s world, due to AI levelling the playing field, it’s become even more important to embrace our authenticity and upskill ourseleves to maintain our scarcity premiums.

Conclusion

While I used investing as a base for my examples, you can see the scarcity premium manifests in many different ways in life.

It’s important to identify that premium in a way and try to maximize the benefits that can be derived from it be by investing your time in premiumizing yourself or trying to find a premium investment.

Relevant Reads from my blog:

1. Contrarian Investing

2. Just Stay Invested

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