Creative Destruction and the Rational Evolution of Bubbles∗

Creative destruction not only involves bringing new technology to market, it imposes higher risk on the future of existing assets. We contrast the asset pricing implications of creative destruction in a setting in which non-cooperative agents compete for market share with a socially optimal benchmark (i.e., a one agent case). Compared to the one-agent case, non-cooperative behavior leads to over-investment in uncertain projects, higher asset prices and risk premia, and price reversals, all of which resemble a bubble. However, these pricing patterns solely arise from competitive behavior and do not require information asymmetry, behavioral biases, or financial frictions to arise. As such, the explanation that bubbles occur when the price of an asset exceeds the asset’s fundamental value is sufficient, but not necessary, to rationalize the pricing patterns that we observe during technology booms. ∗We are grateful to Tony Bernardo, Murray Carlson, Lorenzo Garlappi, Mark Huson, Francis Longstaff, Jeff Pontiff, and Avindhar Subramanyam for their comments and input. †Anderson School of Management, University of California, Los Angeles, 110 Westwood Plaza, Los Angeles, CA 90095, [email protected]. ‡Anderson School of Management, University of California, Los Angeles, 110 Westwood Plaza, Los Angeles, CA 90095, [email protected]. “There is much more to a bubble than a mere security price increase. There is innovation, displacement of existing firms, creation of new ones, and more generally a paradigm shift as entrepreneurs and investors rush toward a new Eldorado.” –Greenwood, Shleifer, and You (2016)