The sustained rise in the price of an asset above its “normal market value” results in the formation of a price bubble. Price bubbles are sustained by expectations of future increases in the price of an asset.
Historical Examples of a Price Bubble
The market for tulips in the Netherlands in the first half of the 17th The price of tulips went as high as $50,000. It was the first modern price bubble.
The dot-com bubble led to the rapid rise in the prices of technology-related stocks between 1995 and 2000.
The housing market in the US during 2000-2006 in the lead up to the subprime lending crisis.
Causes of Price Bubbles
1. Low interest rates
Low interest rates make it easy for people to get cheap credit. This allows them to spend more. The greater spending power, in turn, results in prices rising due to increased demand for goods.
2. Demand-pull inflation
The greater demand for an asset leads to a price increase for the asset. However, the price rise is seen as an indicator of future increases in price. This leads to the formation of a speculative bubble.
3. Supply shortage
The reduced supply or the expectation of a reduction in the supply of an asset in the future leads to increased demand for the asset. Investors think that there are only a limited number of assets available in the market, and they rush to buy as much as possible.
Understanding a Speculative Bubble
A price bubble is an example of an unstable equilibrium. In economic theory, an unstable equilibrium describes a market in which the forces of supply and demand do not correct price deviations away from the equilibrium price. A stable equilibrium describes a market in which the forces of demand and supply correct price deviations away from the equilibrium price.
Consider the following example of a stable equilibrium: The equilibrium market price of apples is $1. At this price, 100 units of apples are bought and sold in the market. Suppose, the price is raised to $2. At this price, the supply of apples would exceed the demand for apples. It would lead to apple producers increasing their inventory of unsold apples.
The only way apple producers could get rid of excess inventory is by reducing the current price of apples. Thus, the price would fall back to $1.
However, an unstable equilibrium works differently, as outlined below:
1. Stage 1 (Formation)
The equilibrium market price of a security is $10. Suppose, due to a shock, the price rises to $11. At this price, demand exceeds supply, as players in the market view the higher price as a sign of a further price rise in the future. Thus, the price does not fall back to $10.
2. Stage 2 (Burst)
The equilibrium market price of a security is $11. Suppose, due to a shock, the price falls to $10. At this price, supply exceeds demand, as players in the market view the lower price as a sign of a further price fall in the future. Thus, the price does not rise back to $11.
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