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Information Casacade explains how Economic Bubble may occur

The failure to recognize the formation of the housing bubble is responsible for the recent economic turmoil in the US and around the world. Many experts and even Alan Greenspan, the former chair of the Federal Reserve Bank, did not see it coming. Then one might wonder: Were these people stupid?
No. One should take into account that perfectly rational people can get caught up in a bubble. Information cascade, the economic concept taught in Networks 2040 class, is useful for understanding how such an event can occur.

Information cascade occurs when people imitate the behavior of others. It can affect even perfectly rational people and cause bubble-like phenomena. Why? Eventually, people sometimes need to depend on the decision of others, and within lies the problem.

Consider a following example.Suppose that a group of individuals must make an important decision, based on useful but incomplete information. Each person has received some information relevant to the decision, but is incomplete and does not always point to the right conclusion. Let’s apply this example to the housing bubble. The individuals in the group must each decide whether real estate is a great investment and whether to purchase some. Suppose that there is a 60 percent probability
that any one person’s information will lead to the right decision.

Suppose the investment values of the houses are really bad. The first person reaches the wrong decision (which happens, as we have assumed, 4 percent of the time). The first person pays a high price and signals to others that houses are a good investment.

For the second person, there is no problem if the data of the second person matches that of the first. However, the second person faces a dilemma if his information contradicts first person’s decision. In that case, the second person may determine that he has no useful information, and so he must
make an arbitrary decision-by flipping a coin, for instance.

The result is that even if the values of the houses are really bad, there may be two people who make purchasing decisions that exhibit their belief that houses are a good investment. As others make purchases at increasing prices, more and more people will conclude that these buyers’ information about the market outweighs their own.

The previously depicted example shows how an information cascade can help to create the housing bubble. We can learn that the fundamental problem of information cascade is that the information obtained by any individual — even one as well-placed as the chairman of the
Federal Reserve — is bound to be incomplete which may lead to serious error.

 

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