Shakeouts and Market Crashes*

Abstract

Stock-market crashes tend to follow run-ups in prices. These episodes look like bubbles that gradually inflate and then suddenly burst. We show that such bubbles can form in a Zeira-Rob type of model in which demand size is uncertain. Two conditions are sufficient for this to happen: A declining hazard rate in the prior distribution over market size and a convex cost of investment. For the period 1971-2001 we fit the model to the Telecom sector.

Innovations, Rents and Risk

“…5 Thus our analysis is in line with Zeira (1987Zeira ( , 1999, Rob (1991), Pastor and Veronesi (2006), and Barbarino and Jovanovic (2007), who show that learning induces fluctuations in industry size. 6 In our model, the project can be successful or fail.…”

Endogenous shakeouts

“…A second strand of models assumes that entrants learn about characteristics of the industry. As an example, Barbarino and Jovanovic (2007) assume that the demand curve is initially unknown and the point at which entry is unprofitable becomes known only after excess entry has occurred, leading to a sudden market crash. Finally, a third set of papers focuses on shakeouts induced by externalities among firms in the industry.…”

International capital flows and expectation-driven boom–bust cycles in the housing market

“…To generate housing-market boom-bust cycles, this paper considers uncertainty regarding the duration of a period of temporarily high income growth. This assumption is motivated by the work of Rob (1991), Zeira (1999) and Barbarino and Jovanovic (2007), which studies the behaviour of firms that are uncertain about how much the market for their products can grow. In particular, Zeira and Barbarino and Jovanovic show that stock-market boom-bust cycles can occur in this environment.…”