Throwing good money after bad

Luca Rigotti, Matthew Ryan () and Rhema Vaithianathan ()
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Matthew Ryan: Auckland University of Technology
Rhema Vaithianathan: Auckland University of Technology

Decisions in Economics and Finance, 2016, vol. 39, issue 2, No 3, 175-202

Abstract: Abstract An “investment bubble” is a period of “excessive, and predictably unprofitable, investment” (DeMarzo et al. in J Financ Econ 85:737–754, 2007). Such bubbles most often accompany the arrival of some new technology, such as the tech stock boom and bust of the late 1990s and early 2000s. 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.

Keywords: Ambiguity; Belief function; Investment bubble; Inference (search for similar items in EconPapers)
JEL-codes: D51 D81 D83 J24 O31 (search for similar items in EconPapers)
Date: 2016
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Working Paper: Throwing Good Money After Bad (2014)
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DOI: 10.1007/s10203-016-0183-3

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