Stock markets often experience fluctuations that seem too large to be entirely driven by fundamentals. One example is the U.S. stock market during the dotcom bubble: between October 1995 and March 2000, the NASDAQ composite index increased by almost sixfold to then collapse by 77% in the following 2 years.
Examples like these are not rare in financial history (i.e., the Mississippi and the South Sea bubbles of 1720 or the British railway mania of the 1840s). One aspect of these fluctuations is that they are typically concentrated in a particular industry and tend to stimulate firm entry and competition. However, firms entering during periods of stock market bubbles tend to be unproductive and lack sound business plans. These considerations have raised the question: are stock market bubbles positive or detrimental to economic activity and welfare? Should policymakers aim at controlling stock market bubbles, or should they rather try to burst them?
In my paper “Asset Bubbles and Product Market Competition” (Theoretical Economics, 2024), I develop a model to answer these and other questions. I show that, in product markets characterized by low levels of competition, a financial bubble that subsidizes entry can have positive welfare effects. This happens even if the bubble subsidizes the entry of unproductive firms, provided that (productive) incumbents are forced to react. However, in competitive markets, bubbles can result in excessive entry, investment, and competition and may actually result in negative profit margins. My theory can, therefore, explain the low and sometimes negative profit rates that many firms exhibited during the dotcom bubble of the late 1990s.
I also characterize the conditions for (rational) asset bubbles to exist and be traded. I show that economies characterized by low levels of competition end up having lower interest rates, making it easier for rational bubbles to be traded.
https://econtheory.org/ojs/index.php/te/article/viewFile/20240325/38419/1177
