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Unit 8 Economic dynamics: Financial and environmental crises

8.4 Assets and price bubbles

capital gain
If the market value of an asset increases, the owner of an asset receives a capital gain equal to the difference between the current and previous market prices.
asset
Something that is owned, and has value.

People buy food or clothes to use them—to eat or to wear. But when they buy an asset—a house, a work of art, digital currency like Bitcoin, or a share (in the ownership in a company)—they typically have another motive. They hope to be able to sell it later for more than they paid for it. As a result, owners care about the resale value of their assets in the future: if the price goes up, the owner enjoys a capital gain, simply as a result of holding the asset.

Because how much a person will be willing to pay for an asset depends on what they guess others will be willing to pay in the future, asset prices may be subject to positive feedback resulting in instability. We will explain this for the case of housing below, but the basic idea is simple: some people place a high value on an asset so ⇒ they purchase it, and ⇒ this will tend to raise the price of this type of asset ⇒ leading other people (rightly) to think that prices will be higher in the future ⇒ motivating them to purchase these assets too ⇒ leading other people … and so on. And so expectations of high prices in the future become contagious, confirmed by how the market translates expectations of higher prices into actual price increases.

asset price bubble
An asset price bubble is an episode in which the market price of an asset rises substantially and continuously over time, fuelled by expectations of future price increases (that is, people want to hold the asset because they believe that its price will be higher in future). Eventually the bubble bursts and the price drops suddenly.

The result is called an asset price bubble, which is a substantial rise in the price of an asset (financial or otherwise) caused by the belief that the price will rise, rather than other reasons why the asset may be more valuable now than in the past. The term ‘bubble’ is well-chosen because bubbles do not last, they burst. And the same is true of bubbles in asset prices.

The influential economist Friedrich Hayek pointed out that changes in prices are messages containing information. (Hayek’s ideas are explained in Sections 8.1 and 10.1 of the microeconomics volume.) If markets are to work well, traders must respond to these price messages. If the price were for bread, then the message is clear: if the price goes up, buy less or, if you are a bakery, produce more. This is the negative feedback that stabilizes prices in the neighbourhood of a stable equilibrium.

Bubbles can happen because asset prices can send different messages: an increase in the price of an asset may be interpreted as a sign of further price increases in future. The result of this positive feedback process can be a runaway increase in price.

Take the price of company shares as an example. Changes in people’s beliefs about a firm’s future profits result in virtually instantaneous adjustments in its share price. Both good and bad news about the firm’s patents or lawsuits, the illness or unexpected death of important personnel, earnings surprises, or mergers and acquisitions can all result in swift price movements. Because share price movements often reflect important information about the financial health of a firm, traders who lack this information can try to deduce it from price movements. They will interpret the increase in the price of the asset as a sign that the price is likely to increase further. If there are many such traders, the result of this positive feedback process further increases prices.

This is why price increases or declines can be contagious. And the same process can run in reverse: my belief that an asset is overvalued in the market (so I do not buy it) becomes contagious by the same process of positive feedback. The result is asset price bubbles followed by sudden price declines, called crashes or busts.

Figure 8.8 illustrates the long-term trend in house prices in the US as well as the house price bubble and its collapse, which precipitated the financial crisis. At the end of the twentieth century, house prices were around four times the average income, and had been stable for several decades. Then they rose rapidly, until the crash began in the spring of 2006.

The line chart illustrates the ratio of house prices to median income in the US from 1945 to 2024. The horizontal axis displays the years from 1945 to 2025, and the vertical axis shows the ratio of house prices relative to median household income, ranging from 3 to 8. Initially, the ratio decreases from about 6.5 in the late 1940s to a low of 3.5 in the early 1970s. It shows a plateau with minor peaks of around 4.5 in 1980 and 1990. The ratio then increases dramatically from the late 1990s, rising from just above 4 to nearly 7 during the US housing-credit boom. Following the bankruptcy of Lehman Brothers, the ratio falls significantly to below 5 during the great recession following global financial crisis. It then rises again during the COVID-19 pandemic, reaching around 7.5 by the end of 2024.
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https://www.core-econ.org/macroeconomics/08-financial-environmental-crises-04-assets-price-bubbles.html#figure-8-8

Figure 8.8 The ratio of house prices to median income in the US (1945–2024).

Home Price to Median Household Income Ratio (US). Longtermtrends.

In the next section, we will develop a model of asset price dynamics to help us understand how such rapid and destabilizing changes in prices can occur.

Question 8.3 Choose the correct answer(s)

Read the following statements about bubbles and choose the correct option(s).

  • A bubble occurs when the price of a share rises too quickly.
  • A bubble is less likely to occur in a market where people can easily switch from buying to selling.
  • Trading strategies based on price movements make bubbles more likely to occur.
  • Bubbles can only occur in financial markets.
  • It is not the rate at which the price rises that defines a bubble, but the cause. A bubble occurs when the market price deviates in a sustained and significant way because of the belief by market participants that the price will rise further.
  • Bubbles are more likely in these circumstances.
  • According to these strategies, traders interpret an increase in the price of an asset as a sign that the price is likely to increase further. These strategies can contribute to the formation of a bubble.
  • A bubble could occur in a market for any asset that can be re-sold, for example the housing market.