Of Asset-Prices Bubbles and Rationality

A simple definition of bubbles and of possible explanations is to be found in an interesting post by Richard Posner on the Becker-Posner Blog, followed by a discussion, by Gary Becker, of the limits of an explanation by social interactions

Excerpts:

“Buying a house or other asset because other people are doing so may seem an example of irrational “herd” behavior. But herd behavior is not irrational. If you are an antelope, and you see your fellow antelopes begin to stampede, you are well advised to join them, because they may be fleeing from a lion. We commonly take our cues from people who we believe have desires and aversions similar to our own.” (Posner).

“The most plausible view of asset price bubbles is that the price increases of an asset are supported by expectations of even further price increases that makes it worthwhile to buy and hold the asset at prices that far exceed the prices determined by the fundamentals. A sophisticated and attractive version of this argument is that social interactions produce large and cumulative changes in prices from modest initiating forces. It is well known in social interaction theory (see, for example, the book Social Economics by Gary Becker and Kevin Murphy) that a “social multiplier” can magnify small initial changes in demand for a good or asset into large changes in prices or consumption.

(…) Although I find a social interaction approach to bubbles appealing, it does run into several difficulties. Why do not enough savvy investors see through what is going on, and build up large short positions. These short holdings would prevent a bubble from getting out of hand because they in effect increases the supply of the asset to help offset much of the unrealistic increase in demand?” (Becker).

Both posts are well worth reading in full.