2008 Housing Bubble: Information cascade and asymmetry
In this class, we have covered information cascades as people ignore their personal knowledge or lack of information and instead, make their own decisions after observing those of others. We have seen detrimental network effects that have affected the economy in the past, such as the housing bubble in the Financial Crisis of 2007-2008. The theory of information cascades can provide an explanation as to how so many people participated in the purchasing of real estate despite their own self-interest and lack of information. Many of these buyers had incomplete information about the profitability and overall health of this industry in the economy. As people continued to make housing purchases at rising prices, an increasing number of people would make these same decisions, concluding that outsider information outweighs their own private information. Economists Sushil Bikhchandani, David Hirshleifer and Ivo Welch defined this herding theory and also constructed a game theory model that showcases the effects of an information cascade. “More than one-third of the time, rational individuals, each given information that is 60% accurate, will reach the wrong collective conclusion.” As herding behavior causes rational individuals to abandon their own information and judgment, this leads to a social contagion in a financial market such as real estate.
We can also look to information asymmetry between informed and uninformed investors as a cause of this information cascade. Interestingly enough, asymmetric information can occur in most financial transactions as buyers and sellers wish to make the most out of their purchase or sale. Therefore, there are often information gaps, such as when buyers do not know the quality of the product they wish to buy. These gaps call for the importance of seller reputation and quality in the marketplace. However, even during the financial crisis, decisions based off of reputation still proved to be risky as people were too willing to loan from banks with great reputations but at financial risk. As a result, it is said that in financial markets, information is the product because financial assets have value that changes in the future.
https://www.nytimes.com/2008/03/02/business/02view.html?mtrref=www.google.com&assetType=REGIWALL
https://economistsview.typepad.com/economistsview/2008/10/informational-c.html
https://www.brookings.edu/wp-content/uploads/2016/06/11_origins_crisis_baily_litan.pdf