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 peo- ple thought that the Internet’s potential was virtually unbounded, particu- larly as high-speed Internet access became more widely available. After all, more and more goods and services were being bought online through com- panies 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 down- loaded 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 gov- ernment 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.
Source: Pindyck Robert, Rubinfeld Daniel (2012), Microeconomics, Pearson, 8th edition.