Informational Cascades and Related Thoughts on Local Rationality
In Sushil Bikhchandani, David Hirshleifer, Ivo Welch’s paper A Theory of Fads, Fashion, Custom, and Cultural Change as Informational Cascades (1992), and Learning from the Behavior of Others: Conformity, Fads, and Informational Cascades (1998), informational cascade is explained as a model with systemic fragility which to certain extent accounts for both social conformities and changes. For explication purposes, they discussed some applications of the cascade model in behavioral economics (consumer marketing specifically) and finance. First, by cascade theory, the common marketing strategy of starting sales at a low price and then raising it gradually afterwards would not be hard to understand: firms can use the low initial price to build up a positive cascade (by offering satisfactory quality with low price), and then later, with a higher price, convince the consumers that their product’s popularity is established by its quality instead of its low price. Same thing was observed by Welch (1992) in averagely severe underpricing of the public equity by the issuing firms.
Another potential application of informational cascade is in the market for corporate control. The so-called “conglomerate merger wave of the 1960” and its reverse movement can hardly be explained by only traditional factors, which could suggest the involvement of information cascade in such a process: the positive signals sent by the first few bidders can often attract more bids, even though the price is drawn higher.
Looking at the consumers’ side, we should see the rational assumption in economics is satisfied, since every agent is essentially performing Bayes’ rule in their mind when making such decisions, while they are not approaching optimal social utility with their supposedly rational decisions. Consumers can be easily mismatched to the winner of the positive-cascade-competition instead of the products of their true demand. This level of convergence is not a ramification of herd instinct/mentality, but abundant local and rational profit maximizing strategies, which in a sense conflict with the basic conception of a utilitarian society where optimal social utility is achieved by individuals pursuing their own interest rationally.
A reasonable suggestion to improve the situation can be the intervention of a third party (government, media, etc.), which introduces new information to and exchanges information in the current system so that ideally everyone shares symmetric information, lessening the cascade effect. As a result, one might attribute the aforementioned social inefficiency to asymmetric information, and propose that as we make progress in information exchanging, such a problem would solve itself. But what’s worth noting is that at the root of asymmetric information is the strong and weak power relation, is the dominance from one to the other, the removal of which would be fiercely defended by interest groups (in certain cases could be the ruling class). Obviously, I’m not suggesting that we should stop pursuing rationality thereafter, but that the rationality shaped under a specific local discourse system can have many tangled power and interest relations behind (some of them might not even have a clear subjectivity). The faith in this level of rationality might guide you to appreciate your locally smart decision, while deviating you away from seeing the deeper inequality at root, which necessitates using such level of rationality.
Following them might not lead you anywhere closer to what you want.
Source: https://www.ivo-welch.info/research/journalcopy/1998-jep.pdf
https://www.ivo-welch.info/research/journalcopy/1992-jpe.pdf