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
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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