I’ve tried to do my own research but I just can’t seem to grasp the concept. How do bubbles form? Why doesn’t the “invisible hand” of the market keep this from happening? Wouldn’t supply/demand naturally control prices and keep this from happening? Why do some markets form bubbles when others, like the diamond industry, don’t?
In: Economics
On the invisible hand — the big assumptions with this are rationality and information symmetry. That is, the invisible hand works to produce the optimal outcome GIVEN that all players are rationale and everyone knows what everyone else knows. When these conditions aren’t met, you have a market failure i.e. the market forces (invisible hand) fail to produce the optimal outcome. Bubbles form when some market players think the value of the thing will continue to go up, when in fact they don’t know (or irrationally refuse to believe) that the price is already way above the true value of the thing.
EDIT: information symmetry, not asymmetry.
Usually they’re based on extrapolated *forecasted* demand, which briefly drives *current* demand by investors that greatly exceeds the normal producer/consumer supply/demand equilibrium.
Whether it’s beanie babies or houses in Estero, Florida or tulip bulbs, something grows in popularity and demand for legitimate reasons.
Then, seeing the uptrend in demand and limited supply, shrewd early investors buy low and sell high as prices rise. The tales of quick riches attracts less shrewd investors who want the same thing, and they buy high and sell higher.
This continues until the prices and hysteria reach unsustainable levels. Everyone and their dog knows that you’ll get stabbed in a McDonalds over teenie beanies, but once the speculators and collectors have all built their stockpiles a question arises:
Who the F will pay $500 for that kids toy now that all the investors have bought in and only the original underlying base demand is left?
The answer is nobody, and once the real consumer demand is the only demand left, prices crater back to earth.
Bubbles form largely due to speculation on the part of investors. You are correct that supply and demand dictate the price of a given thing, but investors thinking something might be more valuable in the future will raise demand as the investors are purchasing. What often makes the bubble worse is that investors see other investors buying the thing and want to get in on that, often neglecting to properly research the stability of the underlying value. Eventually though, investors realize they overestimated the true value of their investment and start to sell. Demand dips, the price lowers, other investors see this, decide to sell while they can, and before you know it the bubble bursts as everyone tries to get what they can as the price drops.
As for your question about the diamond industry, a few companies have a functional monopoly on their product. So even though the true supply is quite high, they tightly control the release of that supply into the market to keep price up. Should there be a viable competitor that could release more into the market, you would indeed see the price drop.
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