Market Bubbles as a Result of Information Cascades
We all know the phenomenon of market bubbles. The price of a good (or stock) rises and continues to rise to an unreasonable, unsustainable price until the bubble bursts and the price falls back down to a much lower level. There have been housing bubbles, stock bubbles (including the dot-com bubble of the 1990s), and others. Yet how do these speculative bubbles form?
One explanation is that they form based on error in the collective public’s judgment and the herd mentality of people. That is, they begin when an information cascade forms where the price of a good becomes greatly overvalued. For example, in the dot-com bubble, investors experienced overconfidence in the tech market, leading to overvaluations in tech stocks. Like all bubbles, the overvaluations began modestly, but as people observed others investing in these stocks, they chose to trust the decisions of others instead of their own valuations. Hence they too purchased the stock at the inflated price, and an information cascade was produced that raised the prices of these stocks higher and higher.
Herein lies the main difference between a market bubble and an information cascade in other areas. In a bubble, the price of a good experiences positive feedback: when the price of a good or stock rises, this leads to greater overvaluations of the good or stock by the public, more people buy or invest in the good, and the price rises even more. This continues until the price of the good or stock becomes so high as to be unsustainable, that is, the public’s grossly inflated valuations of the good or stock are no longer even as high as the actual price of the good itself. At this point the bubble “bursts” and the price quickly falls way back down to a much lower level, and the information cascade is broken.
Sources:
http://online.wsj.com/article/SB121089412378097011.html
http://www.economist.com/node/4079027?story_id=4079027