Bubble is a large increase in prices for the whole economy or a part of the economy, followed by a massive, rapid drop.
It’s important to notice that a bubble is only a bubble if it applies to an entire economy or part of the economy. If the massive price swings are just between you and your circle of friends, it’s probably not a bubble.
Famous historical examples of bubbles are the Dutch Tulip bubble of the 1630s, the Dot-Com bubble of the 1990s, the housing bubble of the early 2000s and some like to say the Bitcoin bubble of 2017.
Let’s first look at the definition of “natural price”. Natural price is an amount of money being charged, set by the cost of producing a product. For example, if it costs $3.00 to produce 12 duck eggs, than the natural price is $3.00.
If demand goes up from unreasonable, unnatural causes, then prices will shoot up.
Here’s a ridiculous example of a bubble with duck eggs:
Let’s imagine that Joe buys 12 duck eggs every week from a duck farmer for $5. Under normal circumstances, the price will probably stay fixed at $5. But then let’s say the Kardashians tell the world they love duck eggs and themselves eat 3 every single day!
Suddenly millions of people also want duck eggs and the duck farmer is overwhelmed with of customers asking for his eggs. When Joe asks the farmer for his usual 12 eggs for $5, Bill who watched the Kardashians offers more money for those same eggs.
- Joe offers $10 for 12 eggs.
- Alice hears Bill’s offer and wants the eggs even more and offers $20.
- Susy hears Alice’s offer and offers a massive $50. In minutes, those $5 eggs are worth 10X at $50!
Several weeks later, the Kardashians and their friends don’t care about duck eggs. Silly Susy may have stocked up on hundreds of eggs, but now the Kardashians don’t care and neither does she. Susy begins to sell her duck eggs and the price of duck eggs drops rapidly.
Now Joe can continue buying his duck eggs for $5. The bubble has popped.
Prices only go up for two reasons: an increase in demand as we’ve seen above ora decrease in supply.
If the farmer’s ducks always make 24 eggs each week but this week they only make 12, the farmer could charge Joe more than $5 simply because they both want those 12 eggs.
By definition, a bubble must burst, if it doesn’t, then it wasn’t a bubble to begin with.