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Gold Bubble and Ponzi Scheme: Driven by Information Cascade

In class, discussion about Information Cascades has mostly involved people making decisions about adopting a technology or choosing a restaurant.  This closely ties into the ideas of the successful growth of a product in the marketplace, whether it’s a new technology or a social networking site like Facebook.  In these cases, expectations of how many people will use the site or product determines how many use it in the end, where the more people who use the product, the more likely of choosing to use the site or product.  In both cases, the situations cascade toward a final outcome because of expectations and previous decisions and experiences by previous users.

However, we can also use these same ideas in the stock market to explain phenomena such as market bubbles and Ponzi schemes.  For example, in the gold market, the price begins at a stable price.  First, savvy investors start investing in gold, noticing the potential for profit from normal indicators such as instability in normal currency prices and a historic commodity to store investment when the economy is rocky.  Later, other skilled investors see that there are reasons to place investments in the gold, raising the demand for gold and the price of gold per ounce.  This is where the cascade starts.  The public begins to see the profits some people have attained from the rise in gold prices, influencing them to also place money in the gold and make a profit as well, extrapolating prices.  These people are making the same type of decision as people deciding whether to join a networking site or not.  In expectations that more people will invest in gold, the price will increase and they will make a profit.

Unlike choosing to participate in a social networking site, investments do not reach equilibrium.  Assuming that no one sells their investment, investing in gold is exactly the same as a social network, but in order to realize profits, one must sell their investment.  When deciding to invest in gold, their decision relates to the theoretical profits of investment and the network effect of investment of others.  However, after investing, one plays the game of when to sell to realize this profit.  Once people realize the payouts of the gold they are investing in will never be bought for practical use, the bubble pops and the theoretical profits disappear.

What makes economic bubbles and Ponzi schemes so deceptive is the close resemblance to a network effect of social networking.  At a quick glance, it appears that by investing, since so many people are investing, the price is bound to go up and make a profit.  What is true is that the price will increase, but by trying to make a profit, selling the stocks breaks the cascade and a new cascade of selling is created, bursting the bubble.


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