One thing economists give too little importance too is the psychology of bubbles or ‘irrational exuberance’ In economic literature we all too often assume markets clear, and consumers are rational. Yet, even very competitive commodity markets can have prices far distorted from reality.
Why do Bubbles and Busts Occur?
- Herding effect. People follow crowd and assume rising prices must be for a good reason.
- Poor information
- Short termism. People make decision based on short term rather than long term.
- Belief system can be beaten. People may expect the bubble to burst at sometime, but, many will feel they will be able to time their exit out just before.
- Cognitive dissonance – a filtering out of bad news.
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