New Stocks and Market Crashes: The Pros and Cons of Information Cascades
Information cascades can both jump-start a public stock or product and cause a stock’s value to plummet or even crash a market. The former is relatively easy to control and take advantage of – firms manipulate this phenomenon all the time (1). The latter, however, can have runaway destructive abilities, and most certainly played a role in the market crash of 2008. Information cascades, therefore, can be both helpful or harmful. And even when they are supposedly helpful, there may be some ethical issues with utilizing them.
How do companies use information cascade phenomena to their advantage? When a company goes public, (begins selling shares to the general public and investors), an issuing firm must sell shares of the company at a certain price. The method that these firms use to eventually bring in the most money involves announcing an initial price that is lower than the true value of a share. Alternatively, they may secretly offer slashed prices for early buyers (1). That way, more shares will be bought initially, and the public will see this. Here is where the information cascade comes into play. The public then assumes that this stock must be of high quality, because they assume that someone has done his/her research and decided to buy shares. Consequently, many more people buy shares, and the value of the stock rises quickly.
A more concrete example of this occurs with book sales. In 1995, two co-authors secretly bought 50,000 copies of their own book (naturally, a business strategy book), which had received decent reviews at best. Nonetheless, their actions placed their book on the New York Times bestseller list, and sales skyrocketed. After that, they no longer needed to intervene to stay on that list (1).
There are interesting ethical questions to be asked here. In both cases, is it right to take advantage of information cascades to manipulate people into thinking that they are buying something for its quality? The ideological basis of capitalism involves the best product succeeding in the market, guided by the invisible hand. Is utilizing information cascades a fair bypass of this notion? The counterargument here, of course, is that a company (or pair of authors) that does so is working the system more intelligently and therefore inherently better – the hand of the market has not made a mistake. These questions, however, are abstract and philosophical, and there are more tangible inarguably negative effects caused by information cascades.
A possible example of this is a market crash. When stocks begin to fall, people assume that something has gone wrong with those stocks, and they sell their shares. This is the inverse of the effect seen when issuing companies set low initial prices to boost sales. There is another effect at play here, though, and that is the direct benefit effect. When the value of shares go down, they are no longer worth as much to you, and the value of shares go down as more people sell. Therefore, if it appears as though many people are selling and the stock is going to plummet, selling would be a smart move without taking into account information cascades. However, there were undoubtedly people in the crash of 2008 who sold stocks not because they knew what was wrong with them, but instead because they trusted that everyone else knew what was wrong with them.
Informational cascades can be a useful tool or uncontrollable self-perpetuating phenomenon; either way, they must be understood in order to comprehend decision-making in a group.
1. http://sites.uci.edu/dhirshle/files/2011/02/information-cascades-and-observational-learning.pdf