The dot-com bubble

1. Introduction

This paper is concerned with the dot-com bubble, also called I.T. bubble or dot-com phenomenon[1], a stock market bubble that roughly occurred between the years of 1995 and 2002, culminating in 2000, when prices for TMT (i.e. technology, media, and telecom) shares reached the highest level of their over-inflation.[2]

Unfortunately, most of the literature concerned with this phenomenon focuses on ‘rational’, statistical, and mathematical models that do not show significant correlations and simply do not provide satisfactory explanations for how those share prices could ever rise so high.[3]

This paper sees things from a different perspective: The main part of the paper is dedicated to the question how the prices could rise in the first place, acknowledging that this cannot be explained with standard financial theories, but that one has to look into the minds of the people involved and to analyse the psychological dimension.

Later, the grounds for the subsequent slump are discussed before the author finishes the paper deriving conclusions from the whole discussion.


2. The Rise and Fall of the Dot-coms

Beginning in 1995, the prices of those so-called dot-com shares or simply called dot-coms began rising constantly and at a more or less steady path. However, by the end of 1998, those prices tumbled a little bit. But this was not the end of the dot-coms’ rise. Alan Greenspan, the then Chairman of the Federal Reserve Bank of the United States, who also used to be a proponent of the New Economy, cut the interest rates twice despite strong economic growth. Thereby he, besides others, (re-)encouraged investments in the dot-coms. Hence, Taffler and Tuckett (2005) accused Greenspan stating that his monetary policy gave the speculation green light and ultimately led to ‘moral hazard’[4].[5]

Then, between 1999 and March 2000, prices of the dot-coms skyrocketed—and with them the NASDAQ as well as the Dow Jones Internet Price Index, and in Germany the Nemax50.[6]

By February 2000, the internet sector accounted for some six per cent of all U.S. public companies’ market capitalisation. Furthermore, the internet sector gained returns of over 1000 % on their public equity within the time frame of only two years.[7] Also very impressive is the 500 % rise of the Dow Jones Internet Price Index between 1 October 1998, when it was launched, and 9 March 2000, when it peaked standing at 5,048 (during the same period of time, the S&P 500 increased by only 35 %).[8] The NASDAQ reached a climax on 10 March 2000, standing at 5,132.52 (intra-day peak).[9]

Graph 1: Development of the NASDAQ between 1997 and 2002



On 13 March 2000, coinciding multi-billion sell orders for dot-coms triggered a chain reaction and the bubble finally began to burst. The NASDAQ almost lost 500 points within a three-day period after Monday, 13 March 2000.[10]

Within two years’ time, some $5 trillion were wiped out on the NASDAQ.[11]


3. Reasons for the Rise

‘The great mystery is why internet stock prices grew so dramatically in the first place, not why they crashed.’[12] This statement by Keating, Lys, and Magee (2003) surely is true; thus, the main part of the paper in front of you deals with the question of how the bubble could over-inflate in the first place.

Before discussing how this could come about, one has to notice that bubbles like the dot-com bubble cannot be explained with the mostly applied theory about markets, the Efficient Market Hypothesis (EMH).


3.1. EMH – Why Bubbles Should Not Occur

The Efficient Market Hypothesis is based on the classical economic principle that people are rational maximisers. For a long time, the concept of the homo oeconomicus was an unchallenged starting point for many (not only neo-classical) economic models. However, recent research in the area of neuroscience and the derived fields of neuroeconomics and neuromarketing has proven the model of the homo oeconomicus to be wrong (more on that under section 3.2). People never purely decide on rational bases; on the contrary emotions play a major role in our decision-making process. Researchers ascertain that no decision in the human brain is made without emotions—we are just not (consciously) aware of this fact.[13]

Nevertheless, the EMH is still considered a valid theory and is considered one of the foundations of modern financial theory. By and large it states that markets are efficient, especially informationally efficient, which means that every information available is considered in a share’s price.[14]

The main statement of the EMH is that share prices are solely based on fundamental data (like a company’s cash flow, turnover, profitability, etc.). Seen in that way, no one should be able to outperform an index in the long run.

There are three common forms of the EMH according to Fama (1970): [15]

In the weak-form efficiency all publicly available information about the past is incorporated in a share’s price.

In the semi-strong form efficiency all publicly available information is incorporated.

In the strong-form efficiency all information is incorporated, meaning that even private and insider information is considered.[16]

The success of index tracker funds, i.e. funds that emulate the general structure of a whole index, can be seen as evidence that markets are generally efficient.[17]

However, speculative bubbles are special situations that prove markets to be inefficient at some points in time. As Warren Buffet once said: ‘I’d be a bum on the street with a tin cup if the markets were always efficient.’[18]

In the case of bubbles, the rise in value of share prices is not backed by fundamental data and is not rational in an economic sense. There is not even a weak-form efficiency. Many traders, especially the so-called noise traders, i.e. people lacking special knowledge or information about trading, invested in dot-com shares not because they thought they were undervalued but merely because they thought they would see (and profit from) a further increase in their value.[19]

At the culmination of the dotcoms, they were heavily overvalued. After their downfall, their prices were even undervalued. Both unbalanced states of value could not exist if the EMH was always correct.[20]


3.2. Bye-Bye, Homo Oeconomicus

Since financial economists seem to be unable to provide plausible explanations for how the dot-coms could become so overvalued, since the aforementioned classical concept of market efficacy does not take into account the existence of such bubbles, and since most financial economists got used to shun finding explanations for what happened and contended themselves calling the phenomenon a ‘mania’[21], one has to look elsewhere for explanations, one has to get rid of pure and complex financial mathematical models which are all, ultimately, based on the over-simplistic concept of the homo oeconomicus, simply ignoring what is really going on in peoples’ minds.

Raab (2009) proves the concept of the homo oeconomicus to be wrong by, besides others, referring to an experiment carried out by Guth et al. in 1992. $10 were given to a test subject A. A could freely decide to give a test subject B a specific amount out of those $10 (from 1 cent up to the whole $10). If B accepted the deal, A and B would get the money. If B refused, both would come away empty-handed. If A and B decided in the way the model of the homo oeconomicus suggests, A would only give 1 cent to B and B would accept. By that, both would maximise their utility in the best way possible. However, one can easily imagine what happened in reality: If B felt he was treated unfairly, he did not accept and both did not receive any money. And in the same way, the different test subjects A tended to base their decisions on principles like fairness, morality, etc., certainly anticipating test subjects B declining the offer if it was perceived to be unfair. Guth comes to the conclusion: ‘When thinking conflicts with emotion, emotion wins.’[22] Another example of irrational behaviour is buying a lottery ticket since in the long run, on average, one will lose more and more money (whereas the chances of winning a fortune are infinitesimal).[23],[24]

The wording at the beginning of this chapter may well seem harsh; nevertheless, the author thinks it is justified as he is convinced that some still accepted general theories are based on a myth. There is no homo oeconomicus, and there has never been one[25], he was only in our minds—and mind is the magical word we are going to focus on in the following.

One of the theories that sound most promising to the author’s ears is to be discussed next.


3.3. Behavioural Finance / Behavioural Economics

Behavioural finance or Behavioural Economics is one of the promising fields of study that might be able to find valid explanations for what was going on in the investors’ minds propelling prices sky high. It is a relatively young field of study with Nobel laureate Daniel Kahneman as well as Amos Tversky and Richard Thaler belonging to the ‘biggest names’ in the field.[26] According to Shleifer, ‘at the most general level, behavioural finance is the study of human fallibility in competitive markets.’[27] Its focus is on social and cognitive biases that affect economic decisions (and, hence, incorporates a lot of findings from psychology and sociology). Behavioural finance is concerned mostly with rationality as well as with the lack thereof. In former times, economics used to be closely linked with psychology. So, for instance, in 1759, the renowned and often-cited Adam Smith—who was a Scottish moral philosopher(!)—published ‘The Theory of Moral Sentiments’ (first edition).[28],[29] Whereas most of the neo-classical economists distanced themselves and continued to focus on models based on the principle of the homo oeconomicus, some economists still adopted psychological approaches, e.g. J. M. Keynes, Vilfredo Pareto and Irving Fisher, but in the end, statistics and mathematical models have become prevalent.[30]

Evidence for the theories of behavioural finance are bubbles (like the dot-com bubble) in which the rise of share prices cannot be explained by economically rational decisions. In fact, most of the dot-coms did without a proven business model and created nothing but loss; thus, they should never have received funding.[31]

Some of the literature of Behavioural Finance that is concerned with the dot-com bubble implies that soaring prices can be explained by herd behaviour: Under the headline ‘The Dotcom Herd’, Investopedia® tries to explain this phenomenon. They ascertain that herd behaviour is a deep-rooted instinct in humans, partially based on the desire for conformity. In this case it might also be well based on the reliance on the proverbial wisdom of the crowds.[32]

Throughout the rise of the dot-coms it had been especially the so-called noise traders. In their case it is quite conceivable that their purchasing decisions were not based on fundamental data (like cash flow of the company, turnover, etc.) but on the expectation and hope that those prices would rise even higher.

And indeed, looking at the effusive media coverage on the dot-coms and the hype about the New Economy at that time, this seemed to be most likely.[33] Taffler and Tuckett (2005) describe that the boom of the dot-coms ‘was characterized by the entrenchment of the idea that the US economy was being transformed into something fantastic called the “New Economy” by information technology and, in particular, the Internet’.ibd

Some people even proclaimed that old economic rules could be thrown overboard, that the real economy was losing ground since money could be produced at the stock markets and that the internet would significantly change the life of everybody.[34]

On 20 July 1998, Time Magazine was published with a cover story reading: ‘Kiss Your Mall Goodbye: Online Shopping Is Faster, Cheaper and Better’, on 8 February 1999, in Business Week one could read: ‘Amazon’s fourth quarter sales nearly quadrupled over 1997, and compared to that, Sears is dead’ [35],[36]

Taken in by this kind of media coverage, many ordinary people who had never possessed any shares before now bought the highly praised dot-coms.[37] And since all this leads to an almost insatiable demand pushing prices higher and higher, it is also a great opportunity for both day-traders as well as experienced fund managers to jump on the bandwagon and make quick money by buying those shares (pushing their prices even higher).[38]

Albeit the explanation just mentioned seems plausible and the author of this paper feels convinced that it played a major role in the bubble’s over-inflation, there are other conceivable causes (that might have worked together with the mentioned ones) one can find if one digs deeper into the human mind.


3.3. Psychoanalytical Explanations

Since, henceforth, for the author it is beyond question that the dot-com bubble as well as all the previous bubbles cannot be explained by classical economic theories, the author advocates the view that psychological effects play a major role in creating bubbles. Unfortunately, this is neglected in most of the publications regarding the dot-com phenomenon.

At least, Keating, Lys and Magee (2003) state that the prices of the dot-com stocks could not be justified applying the theory of efficient markets (the EMH mentioned before).[39] Nevertheless, they did not undertake great effort to find explanations lying outside the sphere of (neo-)classical or statistical models.

In March 2005, Richard J. Taffler, Professor of Accounting and Finance at Cranfield School of Management, UK and David A. Tuckett, Visiting Professor of Psychoanalysis at University College, University of London, UK published a paper analysing the psychological effects the dot-com bubble was probably based on.[40]

The authors are convinced that the reason for the extraordinary rise of the dot-coms lay in the fact that investors ‘became caught up emotionally’.[41] Stocks were not seen as mere financial objects or means of maximising utility, but they were, according to the authors, perceived as ‘phantastic objects’.ibd Buying those dot-coms, given the very favourable media coverage for those kind of shares at that time, might have been able to evoke several positive feelings in an individual. From psychology and consumer behaviour studies we know that lotteries not only sell the chance of winning, but they also provide people with the basis for daydreaming (‘what would I do if I won €10 million’).[42] In view of this fact, it is not far-fetched that irrationality and emotions played a major role in propelling the prices.

Keating (2000) encourages further investigation of the underlying grounds. However, in his list of potential explanations he (except for the last point) only refers to concepts building on rational behaviour and cognitive decisions: risk, functional fixation, supply and demand factors, life-cycle, pricing, or under/overreactions by investors or analysts.[43]

Hand (2000) analysed 167 internet companies and subsequently exemplifies that, while in accordance with common sense profits were valued positively, during the dot-coms’ rise losses were obviously seen as something positive. The larger the losses of a company, the greater market value it could reach on the stock markets.[44] Hand concludes that the reason for investors’ positive evaluations of losses might have been the belief that those losses were due to high investment in the sector of R&D and in marketing, paving the path for a company’s future success.ibd However, again one has to criticise that the question of whether all the dot-com stocks taken together were priced too high due to irrationality was not addressed in the analysis of Hand (2000).

Supportive of the general thesis that emotion (and not rational cognition) was the driving force throughout the rise of the dot-coms is a study by Cooper, Dimitrov and Rau (2001), who impressively demonstrated that merely adding .com to companies’ names during the years of 1998 and 1999 triggered buy orders for the shares of those companies. The cumulative average returns of those companies amounted to some 63 per cent within five days of the announcement that the companies would change their names. This phenomenon was later coined ‘prefix investing’.[45]

Interestingly, those companies who actually did not have any connection with the internet in their business activities profited more from the change of the name than companies who operated on the net.[46] Unfortunately, the authors of the study did not bring to light a plausible explanation for this phenomenon but, instead, contended themselves with calling the occurrences being caused by some kind of mania.ibd

The author of this paper presumes that linking companies to the IT sector in the peoples’ minds automatically increased the companies’ perceived value, meaning that people are willing to pay more for the shares of companies of whom they believe to be associated with the big boom and who provide them with the opportunity of daydreaming. There definitely is the temptation to think that emotion and irrationality were playing a larger role in the whole period of the dot-coms’ over-inflation than rational decision-making. However, as this is a thesis that cannot be validated by empirical or statistical means, it has to remain an unproven supposition. Anyhow the author advocates that there is one important fact: Without irrationality, everything could not have happened.

But before concluding the analysis of the dot-coms’ rise, there is one more important point: Even experienced fund managers that were convinced that the whole thing was just a bubble had to invest into the dot-coms. Why? Because if they had not, they simply would have lost their jobs. In those years, everybody seemed to make quick money; how could you explain to your customers why they are not?[47]

After this analysis of conceivable grounds for the rise of the dot-coms, the following chapter shall deal with the question why the bubble did not burst earlier and how the subsequent crash may be explained.

4. Reasons for the Fall of the Dot-coms

Looking for explanations for the fall of the dot-coms, one has to look at the behaviour of the investors as well as at reasons internal to the relevant companies. The latter issue will be discussed in the following chapter.

4.1. Internal Reasons for the Dot-coms’ failure

This time, explanations according to hard facts seem more plausible than in the case of the dot-coms’ spectacular rise.

Why did many dot-coms go bankrupt? The main reason for that is, very probably, that most of the dot-coms did not rely on a sound business plan, but instead just tried to go public and get funding through shares, which actually worked out in many cases. ‘Get big fast’ was the wisdom of the day; and to exaggerate, one might say that many companies were producing nothing but loss.[48]

Therefore, looking at the whole bubble ex post, it does not need a lot of explanation why the concept of most of the dot-coms did not work. What needed to be explained is why the dot-coms were a success, at least for a limited period of time. The author tried to explain the latter in the previous chapters. In the following chapter he is concentrates on giving some explanation for what happened on the investors’ side and why, for another limited period of time, the dot-coms became undervalued.[49]

4.2. Investors’ Behaviour on the Market

One has to acknowledge that the large part of the media coverage for the dot-coms was remarkably favourable towards them; only some commentators dared to question the whole development.

In July 1997, Fortune was published with a cover story reading ‘Time to Cash in Your Blue Chips?’, and in July 1998, Business Week wrote ‘Click Here for Wacky Valuations: The latest buying frenzy overinflates most net stocks’ potential’, foretelling ‘the flip side of this stock-buying mania—web depression.’[50]

Also already in 1998, Forbes warned very impressively publishing a cover story under the headline ‘Armageddon: When the Music Stops’. In this article on could read that the extraordinary demand for those dot-coms was based on ‘gambling fever’ and that it was not backed by fundamental data (i.e. cash flow, turnover, efficiency, debt/equity ratio of the companies, etc.).[51] Also in 1998, Milton Friedman said in an interview with the New Yorker: I think there is a good deal of comparison between the market in 1929 and the market today […] I think both of them are bubbles […] if anything, I suspect there is more of a bubble in today’s market than there was in 1929.’[52]

Regrettably, all those comments did not have a great effect on the general behaviour. After a little slump of the stocks at the end of 1998, their rise had become even faster and faster, steeper and steeper, propelling their prices through the roof. The reason why this could happen was, according to Cassidy, that there had been a concomitant ‘media bubble’ or hype about the dot-coms, swamping away and discrediting all critical comments.[53]

Doomsday, Monday, 13 March 2000: If there was a pin that busted the bubble, then it was the coinciding multi-billion sell orders for dot-com shares which all happened to be processed in the morning of the aforementioned day.[54]

What happened after that is much easier conceivable than what had happened before, because ultimately, it had to happen. As discussed before, the bubble was something that could not be explained with the help of the long-standing models of economics like the Efficient Market Hypothesis. In the end, everything needed to return to normal. Companies were overvalued on the stock markets—a revision was inevitable.

One could compare the situation mentioned to a person waking up from some kind of daydream. However, in this case many people were startled from their wonderful dreams and thrown into a real-life nightmare. Many of them lost a lot of money, many of them panicked, and many of them wanted to get rid of their dot-com shares as quickly as possible—many of them, not all of them; others were hoping for a recovery of the market and lost their whole fortune.

The collapse can now be explained more easily: First, there was an initial slump on 13 March with the NASDAQ opening with a minus of about four per cent compared to the previous trading day, second, experienced fund managers who also invested into those dot-coms and who knew that this could be the beginning of a serious crisis, immediately sold their shares, and third, many of the noise traders did the same.[55]

Within two years’ time, some $5 trillion were wiped out on the NASDAQ.[56] Money, one could say, that had only existed in the investors’ minds and later just vaporised.

So on the one hand the downwards development was clearly based on rational thinking on the experienced traders’ side, but also partially based on herd behaviour and panic on the noise traders’ side which partially even led to the dot-com shares being undervalued for some time.[57]

Ultimately, the bubble had to burst in order for the economy to return to a ‘normal state’ (cf. chapter 4.1) with companies being valued according to the fundamental data. Insofar, in the end, the Efficient Market Hypothesis did not cover the time of the bubble, but in the long run, it seems to be valid most of the time.

Nevertheless, we have to keep in mind, that there will always be people out there speculating without knowing what is going on. Prove for that is a second study of Cooper, Dimitrov and Rau in 2001. This time they could prove that the removal of .com from a company’s name led, on average, to an increase in the company’s market capitalisation.[58]

The author of this paper supposes that the Efficient Market Hypothesis is still right in the long run, not because all people base their decisions on rational reflection but because the accumulated value of profit and loss of those inexperienced noise traders equals 0 in the long run.[59]


5. Conclusions and Outlook

The previous discussion and analysis of the dot-com bubbles leads the author to several conclusions.

First, one has to accept that even the best statistical and mathematical model, be it as good as possible, will never be able to explain all of the stages a market is going through. If economists want to come to improved models, they have to take into account how decisions are actually made in the human mind and at last acknowledge that the model of the homo oeconomicus is no stable basis for theoretical models that try to explain the behaviour of ordinary people. There needs to be a stronger focus on models derived by psychology and the relatively new field of neuroeconomics.

Second, since a bubble can only be identified as such after it burst, caution is needed at the stock markets. Some people surely earned a lot of money through daytrading, but others lost their whole fortune. In that, if one is not equipped with special knowledge, speculating might equal gambling. Furthermore, as we have seen, there can be enormous changes on the stock markets within just one day. Therefore, it is vital, to constantly monitor what is going on. If this cannot be guaranteed: Hands off!

Thirdly, since bubbles are not predictable with certainty, we are going to see a lot more bubbles in the future. People will make the same mistakes, and people (or even the general public like in the current financial crisis, which was probably also caused by a bubble, namely the housing bubble in the US) will have to pay the price.







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[1] Sometimes one encounters the spelling, which is a tautology and, hence, should not be used.

[2] Galbraith, J. K. and Hale, T. (2004), p. 2; Ofek, E. and Richardson, M. (2003), p. 12 and Figure 1;
Howells, P. and Bain, K. (2005), p. 559

[3] Taffler, R. J. and Tuckett, D. A. (2005), p. 20

[4] Moral hazard refers to a situation in which one party (to a contract) ‘has an incentive […] to act in a manner that brings benefits to himself at the expense of the other party […]’ (Collins Dictionary of Economics (2005)) or where one party gains benefits at the expense of the general public.

[5] Taffler, R. J. and Tuckett, D. A. (2005), p. 11

[6] Deutsche Bank Research (2003)

[7] Ofek, E. and Richardson, M. (2001), p. 1

[8] Taffler, R. J. and Tuckett, D. A. (2005), p. 1; BBC News Online (2002)

[9] (without date)

[10] Pearson Education (without date)

[11] Quad-City Times (2006)

[12] Keating, Lys and Magee (2003), p. 244

[13] Raab, G., et al. (2009), p. 219

[14] Howells, P. and Bain, K. (2005), p. 540

[15] In 1970, Fama stated three levels of the EMH based on three different stringencies. The form most commonly used as a basis for empirical research is the semi-strong form. (cf. (without date); Fama, E. (1980), pp. 383 – 417)

[16] Howells, P. and Bain, K. (2005), p. 543

[17] index funds of index (2007)

[18] Ezine Articles (without date)

[19] Investopedia® (without date, a); (without date)

[20] At this point it is sensible to point out that that, according to the prevailing opinion, markets are (semi-strong) efficient most of the times and the EMH is valid most of the time. Bubbles form an exception thereof. However, they are just temporary phenomena and therefore do not refute the whole concept of the EMH. (cf. Investopedia® (without date, b)) In the author’s opinion, however, this is not because of people being rational in making decisions but because of the interplay between supply and demand regulating prices in a market.

[21] Ofek, E. and Richardson, M. (2003); Taffler, R. J. and Tuckett, D. A. (2005), p. 1

[22] cited after Raab, G. (2009), p. 205

[23] cf. Investopedia® (without date, b)

[24] In case you want to learn more about the falsification of the above-mentioned concept, please refer to Appendix 1.

[25] Raab, G. (2009), p. 219

[26] Investopedia® (without date, b)

[27] Shleifer, A. (2000), p. 23

[28] Smith, A. (1759); Adam Smith Institute (without date)

[29] In 1776, Smith published the book he is best known for: ‘An Inquiry into the Nature And Causes of the Wealth of Nations’, better known as ‘The Wealth of Nations’ (Adam Smith Institute (without date)).

[30] Weise, T. (2008), p. 10

[31] Self Seo (2006)

[32] Investopedia® (without date, a)

[33] Taffler, R. J. and Tuckett, D. A. (2005), p. 10

[34] Martin Schulz (2009); Wikipedia (2009a)

[35] Time Magazine (1998), p. 1; Business Week (1999)

[36] Obviously, there had always been some enthusiasm about the internet. Back in 1995, Forbes proclaimed Marc Andreesen, the founder of Netscape, the new Bill Gates and arrogated that the internet would ‘displace both telephone and television over the next five years or so.’ (Forbes (1995)).

[37] Investopedia® (without date, a); (without date)

[38] New York News & Features (2009)

[39] Keating, E. K., Lys, T., and Magee, R. (2003), p. 230

[40] Taffler, R. J. and Tuckett, D. A. (2005)

[41] Taffler, R. J. and Tuckett, D. A. (2005), pp. 2 ff.

[42] (2007)

[43] Keating, E. K. (2000), p. 169; Taffler, R. J. and Tuckett, D. A. (2005), p. 3

[44] Hand, J. R. M. (2000); Social Science Research Network (2000)

[45] (2003)

[46] Cooper, M. J., Dimitrov, O. and Rau, P. R. (2001)

[47] Howells, P. and Bain, K. (2005), p. 560

[48]™ (without date); Medscape Today (without date); Kirsh, D. and Goldfarb, B. (2006), p. 2

[49] Zeal LLC (2003)

[50] Fortune (1997), p. 1; Business Week (1998), p. 1

[51] Forbes (1998), p. 1

[52] cited after Cassidy (2002), p. 183 (original quote was in the New Yorker, issue of 17 August 1998); Wikipedia (2009b)

[53] Cassidy (2002), p. 166

[54] Pearson Education (without date), p. 20

[55] Howells, P. and Bain, K. (2005), p. 559

[56] Quad-City Times (2006)

[57] Investopedia® (without date, a):

[58] Cooper, M. J., Dimitrov, O. and Rau, P. R. (2001)

[59] This would be consistent with the well-known fact that, e.g. in roulette the colours red and black will show up both in 50% of the times in the long run; none of the two colours will show up more often than the other one if there are infinite rounds.



Appendix 1: Homo oeconomicus†

A disillusionment right at the beginning: As we know, most of the marketing research as well as many theories in marketing base on the assumption that people are rational maximisers and that purchasing decisions are based on a rational or cognitive evaluation of alternatives.[1]

The reason for this lies in the fact that people assume of themselves that they are making their decisions on rational bases. Therefore, the model of the homo oeconomicus had been created and it is also why it has been well accepted.[2]

However, in reality things are way different. We are not the conscious people we think we are. We are not consciously making most of our decisions. In fact, most of them are prepared and even made subconsciously, without our knowing it.[3]

Raab proves the concept of the homo oeconomicus to be wrong by, besides others, referring to an experiment carried out by Guth et al. in 1992. $10 were given to a test subject, let us call him A. A had to share the amount with test person B. However, he could freely decide on how much out of those $10 (from 1 cent up to the whole amount of $10) to give to B. If B accepted the deal, A and B would get the money. If B refused, both would come away empty-handed.

Now, if A and B decided in the way the model of the homo oeconomicus suggests, A would only give 1 cent to B, and B would accept. By that, both would maximise their utility in the best way possible.

However, one can easily imagine what happened in reality: If B felt he was treated unfairly, he did not accept and both did not receive any money. And in the same way, the different test subjects A tended to base their decisions on principles like fairness, morality, etc. anticipating test subjects B declining the offer if it was perceived to be unfair. Guth concludes referring to a quotation of Franzen and Bouwman: ‘When thinking conflicts with emotion, emotion wins.’[4]

Another example provides us with one more argument against the theory of the homo oeconomicus. Even people who really try to be wise in their purchasing decisions and try to live according to the principle of utility maximisation sometimes fall prey to (economically) irrational behaviour and even do not recognise it: Amos Tversky and Nobel Laureate Daniel Kahneman proved that none of us is able to make decisions according to the utility maximisation principle at all times.[5]

Just imagine you are about to buy two things today, a new pen as well as a new suit. Now you are in the shop and have found the pen you want. Its price is $25. But suddenly you remember that the same pen is on offer in another shop, which is just 15 minutes away. Would you take the walk and buy the pen at the other shop?

Now imagine a second situation: You are about to buy the new suit. You have found a pinstripe suit for $455 and want to proceed to the pay desk when suddenly someone whispers into your ear that you could buy the same pinstripe suit for $448 in a shop that is just 15 minutes away.

Would you take the walk?

In the study of Tversky and Kahneman, most of the people interviewed would take the walk in the first situation, but not in the second situation. And why is that? In both cases one could save $7.

What most people do is that they try to see the money they save in relation to the price of the item they want to purchase. So in the first case, they could save 28% of the money, in the second case they could only safe some 1.5%.ibd, [6]

Even though this probably sounds reasonable to most of the people, we have to realise that in both cases we could save $7 and that in both cases there is a decision between a walk of 15 minutes and $7. Creating a relation between the amount we could save and the price we are about to spend is contradictory to the principles of the homo oeconomicus and not rational.[7]

And there is even more contradicting the belief that people decide rationally. Elger and Weber conducted a marketing research study with the help of functional magnetic resonance imaging (fMRI). In the experiment, people were shown products as well as the price for the product. Some of the products were cheap, others were overpriced. In addition, some of the products—regardless whether they were cheap or overprices—had been marked with a discount tag.[8]

The researchers established that every time a discount tag was shown, the nucleus accumbens, i.e. the brain’s reward system, was activated whereas the gyrus cinguli, a part of the brain that shall prevent us from making irrational (purchasing) decisions, was deactivated.ibd

Similarly, Traindl states that pictures of babies and smilies (sometimes used at the point of sale) cause the brain to set free happiness hormones like endorphins, dopamine, and serotonin, which are all capable of influencing our behaviour.[9]


So one major insight we have already gained from neuroscience is that there is no such thing as strictly rational decisions. Even if most of the people feel convinced that they are able to make decisions without emotions: In fact, no one can![10]

In line with this opinion, Heath expressly stated that humans are unable to make decisions on the basis of pure logic.[11]

Roth concludes that rationality is embedded in our affective and emotional framework of behaviour. The limbic system decides to what extend rationality and reason are used or activated.[12]

In 1994, Damasio could, underscoring the previous statement, prove that without emotions one even cannot make rational decisions by referring to the spectacular case of Phineas Gage, a railroad construction foreman in the 19th century. [13]

Gage’s emotional centre in the brain had been irreversibly destroyed due to an accident at which a crowbar penetrated his skull. After this incident, Gage was no longer able to make decisions according to the utility maximisation principle.ibd

So today, the prevailing opinion amongst neuroscientists is that not the prefrontal cortex, which hosts our working memory as well as our (higher) consciousness, is making the decisions for our purchases, but especially the limbic system, which controls our emotions and which is as well, presumably, the origin of all our wishes.[14]


Bibliography for the Appendix


  • Ariel, D. (2008): Predictably Irrational. HaperCollins Publishers, New York.
  • Raab, G., et al. (2009): Neuromarketing. Grundlagen – Erkenntnisse – Anwendungen. Gabler Edition Wissenschaft.
  • Roth, G. (2001): Fühlen, Denken, Handeln. Suhrkamp Verlag. Frankfurt am Main.
  • Roth, G. (2003): Aus Sicht des Gehirns. Suhrkamp Verlag. Frankfurt am Main.
  • Traindl, A. (2007): Neuromarketing. Trauner Verlag + Buchservice



  • Heath, R. (2001): Low involvement processing – a new model of brand communication. Journal of Marketing Communications, Vol.7, pp. 27 – 33.
  • Sanfey, A. G. et al. (2006): Neuroeconomics: Cross-currents in research on decision-making. TRENDS in Cognitive Sciences, Vol. 10, Issue 3, pp. 108 – 116.



  • (2009): Humans Are Bad With Money.
    Available from:
    [last access on 5 May 2009]  HuH


[1] Franz, S. (2004), pp. 3 ff.; Scheier, C. and Held, D. (2006), pp. 54 f.

[2] Roth, G. (2001), p. 206; Kirichuk, I. (2008), pp. 14 f.; Scheier, C. and Held, D. (2006), pp. 54 f.

[3] Roth, G. (2001), p. 206; Zaltman, G. (2004), pp. 8 ff.

[4] Franzen, G. and Bouwman, M. (2001), cited after Raab, G. et al. (2009), p. 205

[5] Ariel, D. (2008), pp. 43 f.

[6] (2009)

[7] Ariel, D. (2008), pp. 43 f.

[8] Sanfey et al. (2006); Eshel et al. (2006); Raab, G. (2009), pp. 224 f.

[9] Traindl, A. (2007), p. 75

[10] Roth, G. (2001), p. 206

[11] Heath (2001), cited after Bechara/Damasio (2004)

[12] Roth, G. (2003), p. 164

[13] Raab, G. (2009), pp. 275 f.

[14] Lange (2002), p. 13

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