How does bounded rationality affect market bubbles and crashes?

Bounded rationality refers to the idea that individuals have limited cognitive abilities and information processing capabilities, which can lead to suboptimal decision-making. When it comes to market bubbles and crashes, bounded rationality can have a significant impact.

Market bubbles occur when the prices of certain assets, such as stocks or real estate, rise to unsustainable levels driven by excessive optimism and speculation. Bounded rationality plays a role in the formation of market bubbles as investors may not have access to all relevant information or may not be able to process it effectively. This can lead to irrational exuberance, where investors overestimate the potential returns of an asset and ignore the underlying fundamentals.

Bounded rationality also affects the behavior of market participants during market crashes. When a bubble bursts and asset prices start to decline rapidly, investors may panic and engage in herd behavior. This is because individuals tend to rely on the actions and decisions of others when making their own choices, especially in uncertain and stressful situations. As a result, market crashes can be exacerbated by the collective irrational behavior of investors, leading to a rapid and severe decline in asset prices.

Furthermore, bounded rationality can also contribute to the persistence of market bubbles and crashes. Investors may have limited attention spans and memory, which means they may not fully learn from past experiences. This can result in the repetition of similar patterns of behavior, leading to the formation of new bubbles and crashes.

Overall, bounded rationality affects market bubbles and crashes by influencing investor decision-making, contributing to irrational exuberance during bubbles and panic-driven selling during crashes. It also plays a role in the persistence of these phenomena by limiting the ability of individuals to fully learn from past experiences.