Topic Videos

Economics of Speculative Bubbles

AS, A-Level, IB
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 9 Mar 2020

In this revision video we look at the economics of speculative bubbles in financial markets.

Economics of Speculative Bubbles

A bubble exists when the market price of something is driven well above what it should be, usually due to the herd behaviour of consumers / investors especially in financial markets.

Good examples to quote in exams of speculative bubbles




•DOT COM BOOM FROM 1997-2000



Five stages of a speculative bubble

  1. Displacement stage – excitement grows about a new product / emerging technology
  2. Prices boom as demand surges + limited (inelastic) supply causing market prices to spike higher
  3. Euphoria as more investors look to take advantage (Robert Shiller calls this “irrational exuberance”)
  4. Profit taking stage – some investors sell as they realise prices are out of line with fundamentals
  5. Panic – the herd mentality switches to desperate selling and prices fall fast inflicting big losses

Herd behaviour in financial markets

  • Herd behaviour is a phenomenon in which individuals act collectively as part of a group, often making decisions as a group that they would not make as an individual.
  • Social pressure to conform - individuals want to be accepted – and this means behaving in the same way as others, even if that behaviour goes against your natural instincts.
  • Individuals find it hard to believe that a large group could be wrong and follow the group’s behaviour in the mistaken belief that the group knows something an individual doesn’t.
  • This is described as the bandwagon effect or group think

The hot hand fallacy and over-confidence

  • This is a behavioural bias where someone believes that they are less at risk of a negative event happening to them compared to the rest of the population.
  • Traders in financial markets who have made big profits might then under-estimate the probability / risk of a downturn in share prices.
  • The hot hand fallacy in short means "whatever is currently happening will continue to happen forever.”
  • Traders in financial markets become over-confident, have mistaken valuations and believe them too strongly. Investors credit their own talents and abilities for past successes.

Prospect theory and speculative bubbles

  • A theory of human behaviour under uncertainty
  • As a market goes up, people become less risk averse and become more willing to gamble
  • This accelerates the rate of increase of asset prices
  • Investors also suffer from loss aversion
  • When asset prices start falling, many are initially reluctant to sell because that might crystalize a loss
  • They hold on their investments for too long – before panic selling sets in and prices fall rapidly

© 2002-2022 Tutor2u Limited. Company Reg no: 04489574. VAT reg no 816865400.