PrepTest 55, Section 4, Question 27

In economics, the term "speculative bubble" refers to a large upward move in an asset's price driven not by the asset's fundamentals�that is, by the earnings derivable from the asset�but rather by mere speculation that someone else will be willing to pay a higher price for it. The price increase is then followed by a dramatic decline in price, due to a loss in confidence that the price will continue to rise, and the "bubble" is said to have burst. According to Charles Mackay's classic nineteenth-century account, the seventeenth-century Dutch tulip market provides an example of a speculative bubble. But the economist Peter Garber challenges Mackay's view, arguing that there is no evidence that the Dutch tulip market really involved a speculative bubble.

By the seventeenth century, the Netherlands had become a center of cultivation and development of new tulip varieties, and a market had developed in which rare varieties of bulbs sold at high prices. For example, a Semper Augustus bulb sold in 1625 for an amount of gold worth about U.S.$11,000 in 1999. Common bulb varieties, on the other hand, sold for very low prices. According to Mackay, by 1636 rapid price rises attracted speculators, and prices of many varieties surged upward from November 1636 through January 1637. Mackay further states that in February 1637 prices suddenly collapsed; bulbs could not be sold at 10 percent of their peak values. By 1739, the prices of all the most prized kinds of bulbs had fallen to no more than one two-hundredth of 1 percent of Semper Augustus's peak price.

Garber acknowledges that bulb prices increased dramatically from 1636 to 1637 and eventually reached very low levels. But he argues that this episode should not be described as a speculative bubble, for the increase and eventual decline in bulb prices can be explained in terms of the fundamentals. Garber argues that a standard pricing pattern occurs for new varieties of flowers. When a particularly prized variety is developed, its original bulb sells for a high price. Thus, the dramatic rise in the price of some original tulip bulbs could have resulted as tulips in general, and certain varieties in particular, became fashionable. However, as the prized bulbs become more readily available through reproduction from the original bulb, their price falls rapidly; after less than 30 years, bulbs sell at reproduction cost. But this does not mean that the high prices of original bulbs are irrational, for earnings derivable from the millions of bulbs descendent from the original bulbs can be very high, even if each individual descendent bulb commands a very low price. Given that an original bulb can generate a reasonable return on investment even if the price of descendent bulbs decreases dramatically, a rapid rise and eventual fall of tulip bulb prices need not indicate a speculative bubble.

In economics, the term "speculative bubble" refers to a large upward move in an asset's price driven not by the asset's fundamentals�that is, by the earnings derivable from the asset�but rather by mere speculation that someone else will be willing to pay a higher price for it. The price increase is then followed by a dramatic decline in price, due to a loss in confidence that the price will continue to rise, and the "bubble" is said to have burst. According to Charles Mackay's classic nineteenth-century account, the seventeenth-century Dutch tulip market provides an example of a speculative bubble. But the economist Peter Garber challenges Mackay's view, arguing that there is no evidence that the Dutch tulip market really involved a speculative bubble.

By the seventeenth century, the Netherlands had become a center of cultivation and development of new tulip varieties, and a market had developed in which rare varieties of bulbs sold at high prices. For example, a Semper Augustus bulb sold in 1625 for an amount of gold worth about U.S.$11,000 in 1999. Common bulb varieties, on the other hand, sold for very low prices. According to Mackay, by 1636 rapid price rises attracted speculators, and prices of many varieties surged upward from November 1636 through January 1637. Mackay further states that in February 1637 prices suddenly collapsed; bulbs could not be sold at 10 percent of their peak values. By 1739, the prices of all the most prized kinds of bulbs had fallen to no more than one two-hundredth of 1 percent of Semper Augustus's peak price.

Garber acknowledges that bulb prices increased dramatically from 1636 to 1637 and eventually reached very low levels. But he argues that this episode should not be described as a speculative bubble, for the increase and eventual decline in bulb prices can be explained in terms of the fundamentals. Garber argues that a standard pricing pattern occurs for new varieties of flowers. When a particularly prized variety is developed, its original bulb sells for a high price. Thus, the dramatic rise in the price of some original tulip bulbs could have resulted as tulips in general, and certain varieties in particular, became fashionable. However, as the prized bulbs become more readily available through reproduction from the original bulb, their price falls rapidly; after less than 30 years, bulbs sell at reproduction cost. But this does not mean that the high prices of original bulbs are irrational, for earnings derivable from the millions of bulbs descendent from the original bulbs can be very high, even if each individual descendent bulb commands a very low price. Given that an original bulb can generate a reasonable return on investment even if the price of descendent bulbs decreases dramatically, a rapid rise and eventual fall of tulip bulb prices need not indicate a speculative bubble.