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*5.4 The Demand for Risky Assets

*5.4 The Demand for Risky Assets

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CHAPTER 5 • Uncertainty and Consumer Behavior 177



The monetary flow that one receives from asset ownership can take the form

of an explicit payment, such as the rental income from an apartment building: Every month, the landlord receives rent checks from the tenants. Another

form of explicit payment is the dividend on shares of common stock: Every

three months, the owner of a share of General Motors stock receives a quarterly

dividend payment.

But sometimes the monetary flow from ownership of an asset is implicit: It

takes the form of an increase or decrease in the price or value of the asset. An

increase in the value of an asset is a capital gain; a decrease is a capital loss. For

example, as the population of a city grows, the value of an apartment building

may increase. The owner of the building will then earn a capital gain beyond

the rental income. The capital gain is unrealized until the building is sold because

no money is actually received until then. There is, however, an implicit monetary flow because the building could be sold at any time. The monetary flow

from owning General Motors stock is also partly implicit. The price of the stock

changes from day to day, and each time it does, owners gain or lose.



Risky and Riskless Assets

A risky asset provides a monetary flow that is at least in part random. In other words,

the monetary flow is not known with certainty in advance. A share of General

Motors stock is an obvious example of a risky asset: You cannot know whether

the price of the stock will rise or fall over time, nor can you even be sure that the

company will continue to pay the same (or any) dividend per share. Although

people often associate risk with the stock market, most other assets are also risky.

An apartment building is one example. You cannot know how much land

values will rise or fall, whether the building will be fully rented all the time,

or even whether the tenants will pay their rents promptly. Corporate bonds

are another example—the issuing corporation could go bankrupt and fail

to pay bond owners their interest and principal. Even long-term U.S. government bonds that mature in 10 or 20 years are risky. Although it is highly

unlikely that the federal government will go bankrupt, the rate of inflation

could unexpectedly increase and make future interest payments and the

eventual repayment of principal worth less in real terms, thereby reducing

the value of the bonds.

In contrast, a riskless (or risk-free) asset pays a monetary flow that is known

with certainty. Short-term U.S. government bonds—called Treasury bills—are

riskless, or almost riskless. Because they mature in a few months, there is very

little risk from an unexpected increase in the rate of inflation. You can also be

reasonably confident that the U.S. government will not default on the bond (i.e.,

refuse to pay back the holder when the bond comes due). Other examples of

riskless or almost riskless assets include passbook savings accounts and shortterm certificates of deposit.



• risky asset Asset that

provides an uncertain flow of

money or services to its owner.



• riskless (or risk-free)

asset Asset that provides a

flow of money or services that is

known with certainty.



Asset Returns

People buy and hold assets because of the monetary flows they provide. To

compare assets with each other, it helps to think of this monetary flow relative

to an asset’s price or value. The return on an asset is the total monetary flow it

yields—including capital gains or losses—as a fraction of its price. For example, a bond

worth $1000 today that pays out $100 this year (and every year) has a return of



• return Total monetary flow

of an asset as a fraction of its

price.



178 PART 2 • Producers, Consumers, and Competitive Markets



• real return Simple (or

nominal) return on an asset, less

the rate of inflation.



• expected return Return

that an asset should earn on

average.

• actual return Return that an

asset earns.



10 percent.11 If an apartment building was worth $10 million last year, increased

in value to $11 million this year, and also provided rental income (after expenses)

of $0.5 million, it would have yielded a return of 15 percent over the past year. If

a share of General Motors stock was worth $80 at the beginning of the year, fell to

$72 by the end of the year, and paid a dividend of $4, it will have yielded a return

of -5 percent (the dividend yield of 5 percent less the capital loss of 10 percent).

When people invest their savings in stocks, bonds, land, or other assets, they

usually hope to earn a return that exceeds the rate of inflation. Thus, by delaying consumption, they can buy more in the future than they can by spending

all their income now. Consequently, we often express the return on an asset in

real—i.e., inflation-adjusted—terms. The real return on an asset is its simple (or

nominal) return less the rate of inflation. For example, with an annual inflation

rate of 5 percent, our bond, apartment building, and share of GM stock have

yielded real returns of 5 percent, 10 percent, and −10 percent, respectively.

EXPECTED VERSUS ACTUAL RETURNS Because most assets are risky, an

investor cannot know in advance what returns they will yield over the coming year. For example, our apartment building might have depreciated in value

instead of appreciating, and the price of GM stock might have risen instead of

fallen. However, we can still compare assets by looking at their expected returns.

The expected return on an asset is the expected value of its return, i.e., the return

that it should earn on average. In some years, an asset’s actual return may be

much higher than its expected return and in some years much lower. Over a

long period, however, the average return should be close to the expected return.

Different assets have different expected returns. Table 5.8, for example, shows

that while the expected real return of a U.S. Treasury bill has been less than 1

percent, the expected real return on a group of representative stocks on the New

York Stock Exchange has been more than 9 percent.12 Why would anyone buy

a Treasury bill when the expected return on stocks is so much higher? Because

the demand for an asset depends not just on its expected return, but also on its

risk: Although stocks have a higher expected return than Treasury bills, they

also carry much more risk. One measure of risk, the standard deviation of the

real annual return, is equal to 20.4 percent for common stocks, 8.3 percent for

corporate bonds, and only 3.1 percent for U.S. Treasury bills.

The numbers in Table 5.8 suggest that the higher the expected return on an

investment, the greater the risk involved. Assuming that one’s investments are

well diversified, this is indeed the case.13 As a result, the risk-averse investor

must balance expected return against risk. We examine this trade-off in more

detail in the next section.



11



The price of a bond often changes during the course of a year. If the bond appreciates (or depreciates) in value during the year, its return will be greater (or less) than 10 percent. In addition, the

definition of return given above should not be confused with the “internal rate of return,” which

is sometimes used to compare monetary flows occurring over a period of time. We discuss other

return measures in Chapter 15, when we deal with present discounted values.

12



For some stocks, the expected return is higher, and for some it is lower. Stocks of smaller companies (e.g., some of those traded on the NASDAQ) have higher expected rates of return—and higher

return standard deviations.

13

It is nondiversifiable risk that matters. An individual stock may be very risky but still have a low

expected return because most of the risk could be diversified away by holding a large number of

such stocks. Nondiversifiable risk, which arises from the fact that individual stock prices are correlated

with the overall stock market, is the risk that remains even if one holds a diversified portfolio of

stocks. We discuss this point in detail in the context of the capital asset pricing model in Chapter 15.



CHAPTER 5 • Uncertainty and Consumer Behavior 179



TABLE 5.8



INVESTMENTS—RISK AND RETURN (1926–2010)

AVERAGE RATE OF

RETURN (%)



AVERAGE REAL

RATE OF RETURN

(%)



RISK (STANDARD

DEVIATION)



11.9



8.7



20.4



Long-term corporate

bonds



6.2



3.3



8.3



U.S. Treasury bills



3.7



0.7



3.1



Common stocks

(S&P 500)



Source: Ibbotson® SBBI® 2001 Classic Yearbook: Market results for Stocks, Bonds, Bills, and Inflation 1926–2010.

© 2011 Morningstar.



The Trade-Off Between Risk and Return

Suppose a woman wants to invest her savings in two assets—Treasury bills,

which are almost risk free, and a representative group of stocks. She must

decide how much to invest in each asset. She might, for instance, invest only

in Treasury bills, only in stocks, or in some combination of the two. As we will

see, this problem is analogous to the consumer’s problem of allocating a budget

between purchases of food and clothing.

Let’s denote the risk-free return on the Treasury bill by Rf . Because the

return is risk free, the expected and actual returns are the same. In addition, let the expected return from investing in the stock market be Rm and the

actual return be rm. The actual return is risky. At the time of the investment

decision, we know the set of possible outcomes and the likelihood of each,

but we do not know what particular outcome will occur. The risky asset will

have a higher expected return than the risk-free asset (Rm 7 Rf). Otherwise,

risk-averse investors would buy only Treasury bills and no stocks would

be sold.

THE INVESTMENT PORTFOLIO To determine how much money the investor

should put in each asset, let’s set b equal to the fraction of her savings placed

in the stock market and (1 - b) the fraction used to purchase Treasury bills. The

expected return on her total portfolio, Rp, is a weighted average of the expected

return on the two assets:14

R p = bR m + (1 - b)R f



(5.1)



Suppose, for example, that Treasury bills pay 4 percent (Rf ϭ .04), the stock

market’s expected return is 12 percent (Rm ϭ .12), and b ϭ 1/2. Then Rp ϭ 8

percent. How risky is this portfolio? One measure of riskiness is the standard

deviation of its return. We will denote the standard deviation of the risky stock

market investment by ␴m. With some algebra, we can show that the standard

deviation of the portfolio, ␴p (with one risky and one risk-free asset) is the fraction

14



The expected value of the sum of two variables is the sum of the expected values. Therefore

R p = E[brm] + E[(1 - b)R f] = bE[rm] + (1 - b)R f = bR m + (1 - b)R f



180 PART 2 • Producers, Consumers, and Competitive Markets

of the portfolio invested in the risky asset times the standard deviation of that

asset:15

sp = bsm



(5.2)



The Investor’s Choice Problem



In §3.2 we explain how a

budget line is determined

from an individual’s income

and the prices of the available goods.



We have still not determined how the investor should choose this fraction b. To

do so, we must first show that she faces a risk-return trade-off analogous to a

consumer’s budget line. To identify this trade-off, note that equation (5.1) for the

expected return on the portfolio can be rewritten as

R p = R f + b(R m - R f)

Now, from equation (5.2) we see that b ϭ ␴p/␴m, so that



Rp = Rf +



• Price of risk Extra risk that

an investor must incur to enjoy a

higher expected return.



(R m - R f)

sm



sp



(5.3)



RISK AND THE BUDGET LINE This equation is a budget line because it describes

the trade-off between risk (␴p) and expected return (Rp). Note that it is the equation for a straight line: Because Rm, Rf, and ␴m are constants, the slope (Rm − Rf)/

␴m is a constant, as is the intercept, Rf. The equation says that the expected return

on the portfolio Rp increases as the standard deviation of that return ␴p increases. We

call the slope of this budget line, (Rm − Rf)/␴m, the price of risk, because it tells us

how much extra risk an investor must incur to enjoy a higher expected return.

The budget line is drawn in Figure 5.6. If our investor wants no risk, she

can invest all her funds in Treasury bills (b ϭ 0) and earn an expected return

Rf. To receive a higher expected return, she must incur some risk. For example,

she could invest all her funds in stocks (b ϭ 1), earning an expected return Rm

but incurring a standard deviation ␴m. Or she might invest some fraction of her

funds in each type of asset, earning an expected return somewhere between Rf

and Rm and facing a standard deviation less than ␴m but greater than zero.

RISK AND INDIFFERENCE CURVES Figure 5.6 also shows the solution to the

investor’s problem. Three indifference curves are drawn in the figure. Each

curve describes combinations of risk and return that leave the investor equally

satisfied. The curves are upward-sloping because risk is undesirable. Thus, with

a greater amount of risk, it takes a greater expected return to make the investor

equally well-off. Curve U3 yields the greatest amount of satisfaction and U1 the

least amount: For a given amount of risk, the investor earns a higher expected

return on U3 than on U2 and a higher expected return on U2 than on U1.

15



To see why, we observe from footnote 4 that we can write the variance of the portfolio return as

s 2p = E[brm + (1 - b)R f - R p]2



Substituting equation (5.1) for the expected return on the portfolio, Rp, we have

s 2p = E[brm + (1 - b)R f - bR m - (1 - b)R f]2 = E[b(rm - R m)]2 = b 2s 2m

Because the standard deviation of a random variable is the square root of its variance, sp = bsm.



CHAPTER 5 • Uncertainty and Consumer Behavior 181



Expected

return, Rp



U3

U2

U1



Rm

Budget Line



R*



Rf



0



σ*



σm



Standard

deviation of

return, σp



F IGURE 5.6



CHOOSING BETWEEN RISK AND RETURN

An investor is dividing her funds between two assets—Treasury bills, which are risk free,

and stocks. The budget line describes the trade-off between the expected return and

its riskiness, as measured by the standard deviation of the return. The slope of the budget line is (Rm− R f )/␴m, which is the price of risk. Three indifference curves are drawn,

each showing combinations of risk and return that leave an investor equally satisfied.

The curves are upward-sloping because a risk-averse investor will require a higher expected return if she is to bear a greater amount of risk. The utility-maximizing investment portfolio is at the point where indifference curve U2 is tangent to the budget line.



Of the three indifference curves, the investor would prefer to be on U3. This

position, however, is not feasible, because U3 does not touch the budget line.

Curve U1 is feasible, but the investor can do better. Like the consumer choosing

quantities of food and clothing, our investor does best by choosing a combination of risk and return at the point where an indifference curve (in this case U2)

is tangent to the budget line. At that point, the investor’s return has an expected

value R* and a standard deviation ␴*.

Naturally, people differ in their attitudes toward risk. This fact is illustrated

in Figure 5.7, which shows how two different investors choose their portfolios.

Investor A is quite risk averse. Because his indifference curve UA is tangent to

the budget line at a point of low risk, he will invest almost all of his funds in

Treasury bills and earn an expected return RA just slightly larger than the riskfree return Rf. Investor B is less risk averse. She will invest most of her funds in

stocks, and while the return on her portfolio will have a higher expected value

RB, it will also have a higher standard deviation ␴B.

If Investor B has a sufficiently low level of risk aversion, she might buy stocks

on margin: that is, she would borrow money from a brokerage firm in order



182 PART 2 • Producers, Consumers, and Competitive Markets



Expected

return, Rp



F IGURE 5.7



THE CHOICES OF TWO

DIFFERENT INVESTORS



Rm



Investor A is highly risk averse.

Because his portfolio will consist

mostly of the risk-free asset, his

expected return RA will be only slightly greater than the risk-free return.

His risk ␴A, however, will be small.

Investor B is less risk averse. She will

invest a large fraction of her funds in

stocks. Although the expected return

on her portfolio RB will be larger, it

will also be riskier.



RB



UA



UB



Budget Line



RA

Rf



0



σA



σB



σm



Standard

deviation of

return, σp



to invest more than she actually owns in the stock market. In effect, a person

who buys stocks on margin holds a portfolio with more than 100 percent of the

portfolio’s value invested in stocks. This situation is illustrated in Figure 5.8,

which shows indifference curves for two investors. Investor A, who is relatively

risk-averse, invests about half of his funds in stocks. Investor B, however, has

an indifference curve that is relatively flat and tangent with the budget line at



F IGURE 5.8



BUYING STOCKS ON

MARGIN

Because Investor A is risk averse, his

portfolio contains a mixture of stocks

and risk-free Treasury bills. Investor B,

however, has a very low degree of risk

aversion. Her indifference curve, UB, is

tangent to the budget line at a point

where the expected return and standard deviation for her portfolio exceed

those for the stock market overall. This

implies that she would like to invest

more than 100 percent of her wealth

in the stock market. She does so by

buying stocks on margin—i.e., by borrowing from a brokerage firm to help

finance her investment.



UB

UA

RB



Budget

Line



Rm



RA



Rf



0



σA



σm



σB



CHAPTER 5 • Uncertainty and Consumer Behavior 183



a point where the expected return on the portfolio exceeds the expected return

on the stock market. In order to hold this portfolio, the investor must borrow

money because she wants to invest more than 100 percent of her wealth in the

stock market. Buying stocks on margin in this way is a form of leverage: the

investor increases her expected return above that for the overall stock market,

but at the cost of increased risk.

In Chapters 3 and 4, we simplified the problem of consumer choice by

assuming that the consumer had only two goods from which to choose—

food and clothing. In the same spirit, we have simplified the investor ’s

choice by limiting it to Treasury bills and stocks. The basic principles, however, would be the same if we had more assets (e.g., corporate bonds, land,

and different types of stocks). Every investor faces a trade-off between risk

and return.16 The degree of extra risk that each is willing to bear in order to

earn a higher expected return depends on how risk averse he or she is. Less

risk-averse investors tend to include a larger fraction of risky assets in their

portfolios.



EX AMPLE 5. 6 INVESTING IN THE STOCK MARKET

The 1990s witnessed a shift in the

investing behavior of Americans.

First, many people started

investing in the stock market for

the first time. In 1989, about 32

percent of families in the United

States had part of their wealth

invested in the stock market,

either directly (by owning individual stocks) or indirectly (through mutual funds

or pension plans invested in stocks). By 1998, that

fraction had risen to 49 percent. In addition, the

share of wealth invested in stocks increased from

about 26 percent to about 54 percent during the

same period.17 Much of this shift is attributable

to younger investors. For those under the age of

35, participation in the stock market increased

from about 22 percent in 1989 to about 41 percent in 1998. In most respects, household investing behavior has stabilized after the 1990s shift.

The percent of families with investments in the

stock market was 51.1% in 2007. However, older

Americans have become much more active. By



2007, 40 percent of people over

age 75 held stocks, up from 29

percent in 1998.

Why have more people started

investing in the stock market?

One reason is the advent of

online trading, which has made

investing much easier. Another

reason may be the considerable increase in stock prices that occurred during the late 1990s, driven in part by the so-called

“dot com euphoria.” These increases may have

convinced some investors that prices could only

continue to rise in the future. As one analyst put

it, “The market’s relentless seven-year climb, the

popularity of mutual funds, the shift by employers to self-directed retirement plans, and the avalanche of do-it-yourself investment publications

all have combined to create a nation of financial

know-it-alls.”18

Figure 5.9 shows the dividend yield and price/

earnings (P/E) ratio for the S&P 500 (an index of

stocks of 500 large corporations) over the period



16



As mentioned earlier, what matters is nondiversifiable risk, because investors can eliminate diversifiable risk by holding many different stocks (e.g., via mutual funds). We discuss diversifiable

versus nondiversifiable risk in Chapter 15.

17



Data are from the Federal Reserve Bulletin, January 2000, and the Survey of Consumer Finances, 2011.



18

“We’re All Bulls Here: Strong Market Makes Everybody an Expert,” Wall Street Journal, September

12, 1997.



184 PART 2 • Producers, Consumers, and Competitive Markets



7



50

45



6



Dividend Yield

40



P/E Ratio



30



4



25

3



20

15



2



Dividend Yield (percent)



5



35



10

1

5

0

1970



P/E Ratio

1974



1978



1982



1986



1990 1994

Year



1998



2002



2006



2010



0



F IGURE 5.9



DIVIDEND YIELD AND P/E RATIO FOR S&P 500

The dividend yield for the S&P 500 (the annual dividend divided by the stock price) has fallen

dramatically, while the price/earnings ratio (the stock price divided by the annual earningsper-share) rose from 1980 to 2002 and then dropped.



1970 to 2011. Observe that the dividend yield

(the annual dividend divided by the stock price)

fell from about 5 percent in 1980 to below 2 percent by 2000. Meanwhile, however, the price/

earnings ratio (the share price divided by annual

earnings per share) increased from about 8 in

1980 to over 40 in 2002, before falling to around

20 between 2005 and 2007 and then increasing

through 2011. In retrospect, the increase in the

P/E ratio could only have occurred if investors

believed that corporate profits would continue

to grow rapidly in the coming decade. This suggests that in the late 1990s, many investors had a

low degree of risk aversion, were quite optimistic

about the economy, or both. Alternatively, some

economists have argued that the run-up of stock



19



prices during the 1990s was the result of “herd

behavior,” in which investors rushed to get into

the market after hearing of the successful experiences of others.19

The psychological motivations that explain herd

behavior can help to explain stock market bubbles.

However, they go far beyond the stock market.

They also apply to the behavior of consumers and

firm managers in a wide variety of settings. Such

behavior cannot always be captured by the simplified assumptions that we have made up to this point

about consumer choice. In the next section, we will

discuss these aspects of behavior in detail, and we

will see how the traditional models of Chapters 3

and 4 can be expanded to help us understand this

behavior.



See, for example, Robert Shiller, Irrational Exuberance, Princeton University Press, 2000.



CHAPTER 5 • Uncertainty and Consumer Behavior 185



5.5 Bubbles

During 1995 to 2000, the stock prices of many Internet companies rose

sharply. What was behind these sharp price increases? One could argue—as

many stock analysts, investment advisors, and ordinary investors did at the

time—that these price increases were justified by fundamentals. Many people thought that the Internet’s potential was virtually unbounded, particularly as high-speed Internet access became more widely available. After all,

more and more goods and services were being bought online through companies such as Amazon.com, Craigslist.org, Ticketmaster.com, Fandango.

com, and a host of others. In addition, more and more people began to read

the news online rather than buying physical newspapers and magazines, and

more and more information became available online through sources like

Google, Bing, Wikipedia, and WebMD. And as a result, companies began to

shift more and more of their advertising from newspapers and television to

the Internet.

Yes, the Internet has certainly changed the way most of us live. (In fact, some

of you may be reading the electronic version of this book, which you downloaded from the Pearson website and hopefully paid for!) But does that mean

that any company with a name that ends in “.com” is sure to make high profits

in the future? Probably not. And yet many investors (perhaps “speculators” is a

better word) bought the stocks of Internet companies at very high prices, prices

that were increasingly difficult to justify based on fundamentals, i.e., based on

rational projections of future profitability. The result was the Internet bubble,

an increase in the prices of Internet stocks based not on the fundamentals of

business profitability, but instead on the belief that the prices of those stocks

would keep going up. The bubble burst when people started to realize that the

profitability of these companies was far from a sure thing, and that prices that

go up can also come down.

Bubbles are often the result of irrational behavior. People stop thinking

straight. They buy something because the price has been going up, and they

believe (perhaps encouraged by their friends) that the price will keep going

up, so that making a profit is a sure thing. If you ask these people whether

the price might at some point drop, they typically will answer “Yes, but I will

sell before the price drops.” And if you push them further by asking how

they will know when the price is about to drop, the answer might be “I’ll just

know.” But, of course, most of the time they won’t know; they will sell after

the price has dropped, and they will lose at least part of their investment.

(There might be a silver lining—perhaps they will learn some economics from

the experience.)

Bubbles are often harmless in the sense that while people lose money, there

is no lasting damage to the overall economy. But that is not always the case.

The United States experienced a prolonged housing price bubble that burst in

2008, causing financial losses to large banks that had sold mortgages to home

buyers who could not afford to make their monthly payments (but thought

housing prices would keep rising). Some of these banks were given large government bailouts to keep them from going bankrupt, but many homeowners

were less fortunate, and facing foreclosure, they lost their homes. By the end

of 2008, the United States was in its worst recession since the Great Depression

of the 1930s. The housing price bubble, far from harmless, was partly to blame

for this.



• bubble An increase in the

price of a good based not on

the fundamentals of demand or

value, but instead on a belief

that the price will keep going up.



Recall from Section 4.3

that speculative demand is

driven not by the direct benefits one obtains from owning or consuming a good

but instead is driven by an

expectation that the price of

the good will increase.



186 PART 2 • Producers, Consumers, and Competitive Markets



E XA MPLE 5.7 THE HOUSING PRICE BUBBLE (I)

Starting around 1998, U.S. housing prices began rising sharply.

Figure 5.10 shows the S&P/CaseShiller housing price index at the

national level.20 From 1987 (when

the Index was first published) to

1998, the index rose around 3 percent per year in nominal terms. (In

real terms, i.e., net of inflation, the

index dropped about 0.5 percent per year.) This

was a normal rate of price increase, roughly commensurate with population and income growth and

with inflation. But then prices started rising much

more rapidly, with the index increasing about 10

percent per year until it reached its peak of 190 in

2006. During that 8-year period from 1998 to 2006,



many people bought into the

myth that housing was a sure-fire

investment, and that prices could

only keep going up. Many banks

also bought into this myth and

offered mortgages to people with

incomes well below what it would

take to make the monthly interest and principal payments over

the long term. The demand for housing increased

sharply, with some people buying four or five

houses under the assumption that they could “flip”

them in a year and make a quick profit. This speculative demand served to push prices up further.

However, in 2006 something funny happened.

Prices stopped going up. In fact, during 2006, prices



190



Home Price Index



170

Housing Price Index

(nominal)



150

130

110

90

70



Housing Price Index

(real)



50

1987



1989



1991



1993



1995



1997



1999

Year



2001



2003



2005



2007



2009



2011



F IGURE 5.10



S&P/CASE-SHILLER HOUSING PRICE INDEX

The Index shows the average home price in the United States at the national level. Note the

increase in the index from 1998 to 2007, and then the sharp decline.



20

The S&P/Case-Shiller index measures the change in housing prices by tracking repeat sales of

single family homes in 20 cities across the United States. By comparing a home’s original sale price

with its price in subsequent sales, the index is able to control for other variables (i.e., size, location,

style) that might also lead to rising home prices.



CHAPTER 5 • Uncertainty and Consumer Behavior 187



actually fell slightly (about 2 percent in nominal terms).

Then, in 2007 prices started falling rapidly, and by 2008

it had become clear that the great housing boom was

just a bubble, and the bubble had burst. From its peak

in early 2006 through 2011, housing prices fell by over

33 percent in nominal terms. (In real terms they fell

by nearly 40% percent.) And this drop is an average

for the United States as a whole. In some states, such

as Florida, Arizona, and Nevada, the bubble was far

worse, with prices dropping by over 50 percent.

The United States was not the only country to

experience a housing price bubble. More or less

the same thing happened in Europe. In Ireland, for



example, a booming economy and increasing foreign

investment—along with widespread speculation—

pushed housing prices up 305% between 1995

and 2007 (641% between 1987 and 2007—both in

nominal terms). After over a decade of above average

growth, Ireland’s bubble burst. By 2010, housing

prices had fallen over 28% from their 2007 peak. Spain

and other European countries suffered similar fates,

contributing to a worldwide debt crisis. Other apparent bubbles have yet to deflate. Many Chinese cities,

including Shanghai and Beijing, have seen rapidly rising housing and land prices, with some apartments

reportedly doubling in value in mere months.21



Informational Cascades

Suppose you are considering investing in the stock of Ajax Corp., which is

trading at $20 per share. Ajax is a biotech company that is working on a radically new approach to the treatment of chronic boredom (a disease that often

afflicts students of economics). You find it difficult to evaluate the company’s

prospects, but $20 seems like a reasonable price. But now you see the price is

increasing—to $21, $22, then a jump to $25 per share. In fact, some friends of

yours have just bought in at $25. Now the price reaches $30. Other investors

must know something. Perhaps they consulted biochemists who can better

evaluate the company’s prospects. So you decide to buy the stock at $30. You

believe that positive information drove the actions of other investors, and you

acted accordingly.

Was buying the stock of Ajax at $30 a rational decision, or were you simply

buying into a bubble? It might indeed be rational. After all, it is reasonable to

expect that other investors tried to value the company as best they could and

that their analyses might have been more thorough or better informed than

yours. Thus the actions of other investors could well be informative and lead

you to rationally adjust your own valuation of the company.

Note that in this example, your investment decisions are based not on fundamental information that you have obtained (e.g., regarding the likelihood that

Ajax’s R&D will be successful), but rather on the investment decisions of others.

And note that you are implicitly assuming that: (i) these investment decisions of

others are based on fundamental information that they have obtained; or (ii) these

investment decisions of others are based on the investment decisions of others

still, which are based on fundamental information that they have obtained; or

(iii) these investment decisions of others are based on the investment decisions

of others still, which in turn are based on the investment decisions of still more

others, which are based on fundamental information that they obtained; or . . .

etc., etc. You get the idea. Maybe the “others” at the end of the chain based their

investment decisions on weak information that was no more informative than

the information you started with when you began thinking about Ajax. In other

21

Fearing a sudden collapse, the Chinese government took steps to curtail skyrocketing housing

prices, tightening lending requirements and requiring purchasers to put more money down. See

http://www.businessinsider.com/the-chinese-real-estate-bubble-is-the-most-obvious-bubbleever-2010-1#prices-are-way-out-of-whack-compared-to-global-standards-3.



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*5.4 The Demand for Risky Assets

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