Information Cascade and the Housing Bubble
Information cascades arise when individuals rationally choose identical actions despite having different private information. Cascades have arisen in a variety of settings, including technology adoption, medical treatment, and financial markets. In economic and financial environments in which decision makers have imperfect information about the true state of the world, it can be rational to ignore one’s own private information and make decisions based upon what are believed to be more informative public signals. This type of behavior can (and has) lead to market bubbles, where market participants inadvertantly drive up the price of a stock due to incomplete information. The price rises until it is way above the true value, in which the price will be unstable and the bubble will “pop” causing a market crash. Two well-known, recent cases where this has happened on a large scale is the tech bubble (dot-com boom) in the late 90’s/early 2000’s and the housing bubble in the early 2000’s.
The failure to recognize the development of the housing bubble is root cause for the collapse of the housing market. If people only see the prospect of outsized investment returns mostly based on the opinions of the public, they pursue these returns disregarding any risks. These people form opinions based on compounded error of other individuals rather than sticking to their own opinion on the subject. This is how perfectly rational individuals can get caught sitting on a growing bubble.
Studies have shown that market professionals tend to make use of their private signal to a greater degree and base their decisions on the quality of the public signal to a greater extent. This leads to the conclusion that the bubble was mostly created by uninformed and inexperienced individuals chasing a “quick & easy” ROI.
A study on the causation of the housing bubble shows that around 40% of the time, a person will make a decision that will reach the wrong conclusion. Suppose houses are of low investment value but the first person to make a decision makes the wrong decision and pays a high price for a home. This signals to others that houses are a good investment. Other people who may or may not be informed on the housing market see that people are willing to pay a high price. As others make purchases at rising prices, more and more people will conclude that these buyers’ information about the market outweighs their own opinion. These decisions are based on informational effects and are not always correct. Such scenarios may lead to information cascades and ultimately, a bubble waiting to burst as seen by the housing market a couple years back.
Sources:
http://www.nytimes.com/2008/03/02/business/02view.html?pagewanted=all
http://online.wsj.com/news/articles/SB121089412378097011?mg=reno64-wsj&url=http%3A%2F%2Fonline.wsj.com%2Farticle%2FSB121089412378097011.htm