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Throwing Good Money After Bad

Author

Listed:
  • Matthew Ryan

    (Department of Economics, Faculty of Business and Law, Auckland University of Technology)

  • Rhema Vaithianathan

    (Department of Economics, Faculty of Business and Law, Auckland University of Technology)

  • Luca Rigotti

    (Department of Economics, University of Pittsburgh)

Abstract

An "investment bubble" is a period of "excessive, and predictably unprofitable, investment" (DeMarzo, Kaniel and Kremer, 2007, p.737). Such bubbles most often accompany the arrival of some new technology, such as the tech stock boom and bust of the late 1990's and early 2000's. We provide a rational explanation for investment bubbles based on the dynamics of learning in highly uncertain environments. Objective information about the earnings potential of a new technology gives rise to a set of priors, or a belief function. A generalised form of Bayes' Rule is used to update this set of priors using earnings data from the new economy. In each period, agents - who are heterogeneous in their tolerance for ambiguity - make optimal occupational choices, with wages in the new economy set to clear the labour market. A preponderance of bad news about the new technology may nevertheless give rise to increasing firm formation around this technology, at least initially. To a frequentist outside observer, the pattern of adoption appears as an investment bubble.

Suggested Citation

  • Matthew Ryan & Rhema Vaithianathan & Luca Rigotti, 2014. "Throwing Good Money After Bad," Working Papers 2014-01, Auckland University of Technology, Department of Economics.
    • Handle: RePEc:aut:wpaper:201401
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Ambiguity; Belief Function; Investment Bubble; Inference;
    All these keywords.

    JEL classification:

    • D51 - Microeconomics - - General Equilibrium and Disequilibrium - - - Exchange and Production Economies
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • J24 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Human Capital; Skills; Occupational Choice; Labor Productivity
    • O31 - Economic Development, Innovation, Technological Change, and Growth - - Innovation; Research and Development; Technological Change; Intellectual Property Rights - - - Innovation and Invention: Processes and Incentives

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