(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 210

CHAPTER 5 • Uncertainty and Consumer Behavior 185

5.5 Bubbles
During 1995 to 2000, the stock prices of many Internet companies rose
sharply. What was behind these sharp price increases? One could argue—as
many stock analysts, investment advisors, and ordinary investors did at the
time—that these price increases were justified by fundamentals. Many people thought that the Internet’s potential was virtually unbounded, particularly as high-speed Internet access became more widely available. After all,
more and more goods and services were being bought online through companies such as Amazon.com, Craigslist.org, Ticketmaster.com, Fandango.
com, and a host of others. In addition, more and more people began to read
the news online rather than buying physical newspapers and magazines, and
more and more information became available online through sources like
Google, Bing, Wikipedia, and WebMD. And as a result, companies began to
shift more and more of their advertising from newspapers and television to
the Internet.
Yes, the Internet has certainly changed the way most of us live. (In fact, some
of you may be reading the electronic version of this book, which you downloaded from the Pearson website and hopefully paid for!) But does that mean
that any company with a name that ends in “.com” is sure to make high profits
in the future? Probably not. And yet many investors (perhaps “speculators” is a
better word) bought the stocks of Internet companies at very high prices, prices
that were increasingly difficult to justify based on fundamentals, i.e., based on
rational projections of future profitability. The result was the Internet bubble,
an increase in the prices of Internet stocks based not on the fundamentals of
business profitability, but instead on the belief that the prices of those stocks
would keep going up. The bubble burst when people started to realize that the
profitability of these companies was far from a sure thing, and that prices that
go up can also come down.
Bubbles are often the result of irrational behavior. People stop thinking
straight. They buy something because the price has been going up, and they
believe (perhaps encouraged by their friends) that the price will keep going
up, so that making a profit is a sure thing. If you ask these people whether
the price might at some point drop, they typically will answer “Yes, but I will

sell before the price drops.” And if you push them further by asking how
they will know when the price is about to drop, the answer might be “I’ll just
know.” But, of course, most of the time they won’t know; they will sell after
the price has dropped, and they will lose at least part of their investment.
(There might be a silver lining—perhaps they will learn some economics from
the experience.)
Bubbles are often harmless in the sense that while people lose money, there
is no lasting damage to the overall economy. But that is not always the case.
The United States experienced a prolonged housing price bubble that burst in
2008, causing financial losses to large banks that had sold mortgages to home
buyers who could not afford to make their monthly payments (but thought
housing prices would keep rising). Some of these banks were given large government bailouts to keep them from going bankrupt, but many homeowners
were less fortunate, and facing foreclosure, they lost their homes. By the end
of 2008, the United States was in its worst recession since the Great Depression
of the 1930s. The housing price bubble, far from harmless, was partly to blame
for this.

• bubble An increase in the
price of a good based not on
the fundamentals of demand or
value, but instead on a belief
that the price will keep going up.

Recall from Section 4.3
that speculative demand is
driven not by the direct benefits one obtains from owning or consuming a good
but instead is driven by an
expectation that the price of
the good will increase.