Speculative bubbles are not a new phenomenon; history is littered with colorful examples such as “Tulip Mania” and the “South Sea Bubble”. A bubble in the market occurs when the price of an asset rises far higher than can be explained by characteristics, such as the income likely to derive from holding the asset. Consumers buy these assets, whether they are real estate, tulip bulbs, or stocks, at prices they usually know are fictitious under the belief that another consumer will buy it from them at a still greater price. Unfortunately the market of “greater fools” eventually runs out, and the price typically plummets as owners try to unload the quickly devaluing asset. Economists disagree whether bubbles are the result of irrational crowd behavior or, instead, are the result of rational decisions by people who have only limited information about the fundamental value of an asset and thus for whom it may be quite sensible to assume the market price is sound (Economics A-Z).
The “dot-com bubble” was a speculative bubble between 1995-2001 during which the stock markets of the U.S. and other western nations saw rapid growth fueled by the Internet sector and related fields. These companies were primarily financed by venture capital and IPO’s (Initial Public Offerings) of stocks. The novelty of the stocks and the difficulty of valuing the nontraditional firms meant the stocks were initially overvalued and, combined with enormous demand from investors wanting to get in on the ground floor of the “next big thing”, the stock price would soar upwards as soon as the company went public. This was true even if the company had never made a profit or even a stream of revenues (Dot-com Bubble).
During the bubble traditional business acumen was eschewed in favor of operating at a net loss in order to capture market share and build brand awareness. It was thought that moving quickly to capture market share would result in a solid foundation (Dot-com Bubble). Amazon is the company most famous for its strategy of forgoing current profits in order to establish its brand name and generate a large market share (Liebowitz). However, it is also one of the few companies to successfully execute it. This thinking was flawed in that a vast number of Internet companies all had this same business plan of monopolizing their respective sectors through network effects. Even if the plan was sound, there could only be at most one network effects winner in each sector, and therefore most companies with this business plan would fail (Dot-com Bubble).
The dot-com bubble officially burst on March 10, 2000 as the NASDAQ peaked at 5,048.62. There are several possible explanations for the subsequent collapse of the NASDAQ. One possibility is enormous sell orders for major tech stocks (CISCO, dell, etc) that happened to be processed simultaneously on the Monday after March 10th. This initial batch of selling sparked a chain reaction of selling that fed on itself. Another theory involves the accelerated technology spending for the Y2K switchover. After the New Year had passed, businesses and individuals found themselves with all the equipment they needed for a while, thus business spending declined. Another theory is that the bubble burst because of the poor performance of online retailers during the 1999 Christmas season. This was the first indication that the strategy of many Internet companies was flawed and this evidence was made public in March when annual and quarterly reports of public companies are issued (Dot-com Bubble).
Despite the fact that only a few companies succeeded in capitalizing on the Internet boom doesn’t mean that there was no social value in the investment that took place during 1999-2001. Competition worked very well during this period, so that much of the social gain from Internet technology ended up being passed along to consumers, leaving little surplus in the hands of investors (Varian et al. 2). In fact, the biggest capital investment during the bubble was probably in human capital (Varian et al. 10).
Back to Economics of the Internet & Ecommerce
“Dot-com Bubble.” Wikipedia: The Free Encyclopedia.2 May 2007. 12 May 2007. http://en.wikipedia.org/wiki/Dot-com_bubble
“Economics A-Z” The Economist. 13 May 2007.
Liebowitz, Stan J. Rethinking the Network Economy. New York: Amacom. 2002.
Varian, Hal R., Joseph Farrell, and Carl Shapiro. The Economics of Information Technology. Cambridge: University Press. 2004.