The Hindu Business Line : Economics of fear

Suppose a remote village in India is affected by bird flu. You would probably want to take drugs to protect yourself. You may not think about the chances of the virus spreading to your area. When it comes to fear of death, probabilities do not matter.

This fear factor will affect the economics of the drug market. When more people want the antiviral drug for bird flu, demand for it goes up. Supply may not match demand as drug companies find it difficult to increase production. This higher demand than supply will push up the price of the drug.

Fear also drives down stock prices and leads to market crashes.

Suppose you hold shares in a company that runs a poultry farm.

You might conclude that the virus could cause financial losses for the company. Besides, who will want to consume bird meat knowing that bird flu could be fatal?

You and most other investors/traders will sell the company's shares at any price. The stock will plunge because fewer people will want to buy it.

Fear, in short, is driven by our perception of risk. Research shows that we tend to overreact when gripped by fear. That is, we consider something more risky than it actually is.

Bird flu was a new experience. So was the record level in the stock market at the beginning of October. Such new experiences create the fear of the unknown.

And that changes the economics of pricing drugs, stocks or other assets.

(The author is Head, Research, Navia Markets.)

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