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Information Cascades and Housing Bubbles

One of the highly discussed questions in modern economics is how the real estate bubble formed and how no one realized what was happening until it burst. People have blamed a variety of causes rooted in many different fields, some of which include subprime loans, insufficient regulation, and excessive speculation. While it is likely that a combination of these factors contributed to the formation of the bubble, the more interesting question is how come no one noticed until it was too late?

To model this phenomenon we need to make a few underlying assumptions. The first is that there is some true value that representing the real estate market as a whole. Each investor will try to evaluate this value using the information he has. If he thinks that the market value is cheaper than the true value, he will buy real estate. Otherwise, he will sell it. Another assumption we will make is that real estate transactions are public information; that is, all investors will have access to records of what previous investors have done.

Now suppose the first few investors, using their own private information, determine that real estate prices are cheaper than they should be and start buying real estate. This will also cause real estate prices to rise marginally. Next, a second group of investors try to evaluate this market. In addition to their own private information, they also know what actions the first group of investors took. Their own information might not fully direct them to believe that real estate prices are below their true value, but after seeing that the first group believed it to be true, may decide to trust the first group’s information and buy real estate as well.

As this process continues, more and more people start buying real estate and as they do, more and more information points to the conclusion that real estate prices are below their true value, even as prices continue to increase. Any outside investor with no previous information might even look into the real estate market and think: “Given that all these other investors believe that housing prices will continue to increase, it’s highly unlikely they are all mistaken since with all their information combined, it is likely that every possible piece of relevant information has been taken into account when judging the true value of the real estate market.” As such, they do not see a bubble, but rather a certainty that in reality consists of no more that the information possessed by the first few batches of investors. The information that each new investor brought to the table pales in comparison and was essentially discarded. While strongly simplified, this sort of “information cascade” could very well be a reason no one was able to tell that the real estate market was grossly inflated. Even if a few people caught on, their actions could be completely overshadowed by the sheer numbers of investors caught in the cascade of information.

For more details, check out this link: http://www.nytimes.com/2008/03/02/business/02view.html?pagewanted=all

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