Information Cascades and Economic Bubbles
An economic bubble is when an item or asset is valued at a price much higher than its intrinsic value. This surge in price occurs when frenzy like market behavior takes place in investing or buying a certain asset. These bubbles will always burst, causing huge economic repercussions, because the perceived value will continue to rise until they are so far above the actual value that a correction must be made, and the value of the asset will plummet. Since so many people were invested in this asset to make the bubble, this crash ends up affecting many. This article, What is a Bubble, gives examples of major bubbles throughout history like the Dot-Com Bubble and the U.S. Housing Bubble, and outlines what it sees as the 5 steps of a bubble. The first step, displacement, occurs when people begin to notice the new asset, and see that it stands out in some way from the norm. Next comes the boom, when the product begins to gain momentum and increase in value. The third state is euphoria, when people start blindly buying into the asset as the prices skyrocket. Then there is profit taking, where some people realize the bubble will burst, and are able to reap the benefits before it is too late. Lastly there is panic, as everyone tries to sell their asset, the value greatly decreases.
This third stage, euphoria, which seems to be the root of a bubble, may be explained by an information cascade. The first group of people who invest in the asset, say during the boom phase, are working with good information. They are able to see that investing in this asset will benefit them, so they do so. It is once word begins to spread that people begin to frenzy and invest in the asset solely because a lot of other people are doing so. This blind decision to invest in the asset based on the reason that others think it is a good idea, even though it may not have a direct benefit, and in the case of a bubble will eventually be harmful, is a perfect example of an information cascade. People will continue to buy and buy into the asset if enough people before them are doing so, regardless of what they know themselves, and this is how the cascade is formed. Information cascades, in this sense, seem to have a negative impact on the economy as a whole. People must be wary of how cascades like these form bubbles and make economic decisions based on the information they have in front of them, and not on what others have done before.
Source: https://www.investopedia.com/terms/b/bubble.asp