Economic Bubble
What is Economic Bubble?
An economic bubble is when an asset's price rises far above its fundamental value, driven by speculation, before crashing.
Optimism and herd behavior push prices up until confidence breaks and prices collapse. Examples include the dot-com bubble and the 2000s housing bubble. Bursting bubbles can trigger recessions.
Economic Bubble: a worked example
A storage shed in a harbor town rents for $6,000 a year net of costs. With investors earning 6% elsewhere, its fundamental value is $6,000 ÷ 0.06 = $100,000. Word spreads that shed prices only go up, and bidding carries the price to $250,000. At that price the rent yields $6,000 ÷ $250,000 = 2.4%, well under the 6% available elsewhere, so the only thing justifying a purchase is the next buyer. When lending tightens and that buyer fails to appear, the price falls back toward $100,000: a 60% loss for whoever bought at the top.
The mistake students make with economic bubble
The error is calling every sharp price rise a bubble. A price can climb legitimately when the cash flows an asset produces rise, or when the return available elsewhere falls; that is repricing, not a bubble. A bubble specifically requires the price to detach from fundamentals and be held up by expected resale. The trap is that fundamental value is never directly observed, so the label is easy to apply after a crash and genuinely hard to apply before one. Hindsight makes every past bubble look obvious.
Economic Bubble questions
How can you tell a bubble from a normal price increase?
A bubble is separated from a normal price rise by whether the income an asset produces can justify what people are paying. Warning signs are a yield that keeps shrinking as the price climbs, buyers who explain the purchase by resale value rather than rent, earnings or use, and purchases funded with borrowed money. None of these is proof, since a rising price can also reflect genuinely better prospects.
Why do bubbles burst?
A bubble bursts when the supply of new buyers runs out. Once a price rests on expected resale rather than on income, it has to keep climbing to reward the people already holding the asset, so any stall turns their bet into a loss and prompts selling. Borrowed money speeds the reversal, because a modest drop triggers demands for more collateral and forces further sales.
What is the greater fool theory?
The greater fool theory is the idea that an overpriced asset is still worth buying as long as someone else will pay even more for it later. It describes the logic that keeps a bubble inflating: each buyer can be entirely right that the price is too high and still profit, provided a greater fool follows. The strategy fails for whoever is holding when the buyers stop arriving.
Related terms
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