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The famous maxim “you get what you pay for” may hold in most transactions, but not at all times.
In reality, there are times when an assets’ price and its fundamental value diverge to a great degree.
This is the essence of a bubble.
Properly defined, a bubble is an economic cycle characterized by rapid escalation of asset prices followed by a sharp contraction.
It is created by a surge in asset prices unwarranted by the fundamentals of the asset and driven by exuberant market behavior.
When no more buyers are willing to purchase at the elevated prices, a massive sell-off occurs causing the bubble to deflate.
Bubbles form in economies, securities, stock markets and business sectors because of a change in investor behavior.
Bubbles can result from a real change (for example in the deregulation of certain markets) or through a paradigm shift where some major change in how a process is accomplished takes place.
Bubbles in stock markets or economies cause resources to be transferred to areas of rapid growth.
Asset bubbles date back as far as the 1600s and are now widely regarded as a recurrent feature of modern economic history.
Because it is often difficult to observe fundamental values in real-life markets, bubbles are often conclusively identified only in retrospect, once a sudden drop in prices has occurred.
The impact of economic bubbles is debated within and between schools of economic thought; they are not generally considered beneficial, but it is debated how harmful their formation and bursting is.
Famous bubbles include tulip mania in Holland during the 17th century, when the prices of tulip bulbs reached unheard of levels, and the South Sea Bubble in Britain a century later, although there have been many others since, including the dotcom bubble in internet company shares that burst in 2000.
Economists also argue about whether bubbles are the result of irrational crowd behaviour (perhaps coupled with exploitation of the gullible masses by some savvy speculators) or, instead, are the result of rational decisions by people who have only limited information about the fundamental value of an asset and thus for whom it may be quite sensible to assume the market price is sound.
Whatever their cause, bubbles do not last forever and often end not with a pop but with a crash.
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