[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

firm can buy or sell as much as it wants at that price; and the transaction is virtually
without cost. But these assumptions are not always met: the costs of selling or
buying an asset are often significant. As noted above, for instance, the costs of selling
a house can be 5 percent or more of the house’s value. At times, even municipal
bonds have been fairly illiquid. The prices at which such bonds could be bought and
sold have been known to differ by more than 20 percent.
Expectations and the Market
for Assets
Gardeners today find shocking the price of tulip bulbs in early-seventeenth-century
Holland, where one bulb sold for the equivalent of $16,000 in today’s dollars. The
golden age of tulips did not last long, however; and in 1637, prices of bulbs fell by
more than 90 percent. Dramatic price swings for assets are not only curiosities of
history. Between 1973 and 1980, the price of gold rose from $98 to $613, or by 525
percent; then, from 1980 to 1985, it fell to $318. Between 1977 and 1980, the price of
farm land in Iowa increased by 40 percent, only to fall by more than 60 percent from
1980 to 1987. On October 19, 1987, stock values on the U.S. stock market fell by half
a trillion dollars—almost 25 percent. Even a major war would be unlikely to destroy
one-fourth of the U.S. capital stock in a single day. But there was no war or other
external event to explain the 1987 drop.
How can the basic demand and supply model explain these huge price swings?
If asset prices depend on the four basic attributes discussed above—expected return,
risk, tax treatment, and liquidity—how can demand curves, or supply curves, shift
so dramatically as to cause these large price movements?
The answer lies in the critical role that expectations play in the market for assets.
Assets such as gold, land, or stocks are long-lived; they can be bought at one date and
sold at another. For this reason, the price that individuals are willing to pay for them
today depends not only on today’s conditions—the immediate return or benefit—but
also on some expectation of what tomorrow’s conditions will be. In particular, the
demand for an asset will depend on what the asset is expected to be worth in the future.
To see how expectations concerning future events affect current prices, consider
a hypothetical example. People suddenly realize that new smog-control devices will,
ten years from now, make certain parts of Los Angeles much more attractive places
to live than they are today. As a result, future-oriented individuals will think that
ten years from now the price of land in those areas will be much higher, say $1 million
an acre. But, they also think, nine years from now it will already be widely recognized
that in one short year an acre will be worth $1 million. Hence, nine years
from now investors will be willing to pay almost $1 million for the land—even if, at
that date (nine years from now), the smog has not yet been eliminated. In that case,
these same individuals think, eight years from now investors will realize that in one
short year the price will rise to almost $1 million and will pay close to that amount.
Working backward like this makes it apparent that if people are confident land is
going to be much more valuable in ten years, its price rises today.
878 ∂ CHAPTER 39 A STUDENT’S GUIDE TO INVESTING