Information Cascades in Rational Expectations
The theory of rational expectations is one of the most widely used modeling techniques in the field of economics. Rational expectations states that in an economic situation, the outcome is partly determined by what the people expects to happen. This concept connects to information cascades that we learned in lecture in that people base their decisions on what other people think. In many economic situations, what the majority of people think will happen actually do happen, which mainly results from information cascades. For example, if people start thinking a certain industry will be extremely lucrative to invest in, many other people will jump in and also decide it is very lucrative based on what those other people are saying. In turn, the industry will most likely boom. That is one thing I find fascinating in economic modeling – that many beliefs by the public are self-fulfilling.
A good example that illustrates information cascades is the stock market. Investors tend to buy stocks they expect to have higher return rates. Ironically, a key factor in this decision is what other people are investing in. If demand for a certain stock begins to rise, that is certainly a good sign for an investor and he may also jump onto the stock. Therefore, the cascade begins and it actually influences the final outcomes. In this case, higher investor expectations, which come from other investors’ expectations and actions, actually contribute the price of the stock. Essentially, the expectation of a stock’s price is built into the final price of a stock in a certain time period. How that expectation formulates is through information cascades.
http://www.econlib.org/library/Enc/RationalExpectations.html