Informational Cascade
A phenomenon where rational agents ignore their own private information or judgment to follow the actions of others, leading to imitation chains that can cause stock market bubbles and cultural fads.
THE IDEA
Imitation chains and pathologies: An informational cascade is a process where a purely rational agent follows others’ choices while ignoring his own private information (or judgment). You run, I follow you, because you may be aware of a danger I may be missing. It is efficient to do what others do instead of having to reinvent the wheel every time. But copying others can lead to imitation chains. Soon everyone is running in the same direction, and it can be for spurious reasons. This behavior causes stock market bubbles and the formation of massive cultural fads. (Bikhchandani et al., 1992; in psychology, see Hansen and Donoghue, 1977; in biology/selection, Dugatkin, 2001; Kirpatrick and Dugatkin, 1994).
When to use it
Identifying the dynamics behind asset bubbles and crashes
Understanding rapid adoption of new technologies or social norms
Analyzing political bandwagon effects during elections
Designing marketing campaigns to leverage social proof
FROM THEORY TO EVERYDAY LIFE
In practice
Stock market bubble
During the dot-com bubble, many investors bought technology stocks not based on their own research but because they saw others buying, leading to a cascade of buying that inflated prices beyond fundamental values.
Fashion fad
A new clothing style becomes popular because early adopters are seen wearing it, and others follow without independent evaluation, creating a rapid spread of the trend.
A MOMENT TO REFLECT
Put it to work.
Can you recall a situation where you followed others despite having contrary information? What was the outcome?
How might informational cascades contribute to inefficiencies in financial markets?
What mechanisms could break an informational cascade?
References
- A Theory of Fads, Fashion, Custom, and Cultural Change as Informational Cascades — Bikhchandani, S., Hirshleifer, D., and Welch, I. (1992)
- On the psychology of group decision-making — Hansen and Donoghue (1977)
CONTINUE THE CONVERSATION
Source texts
- The Black Swan The Impact of the Highly Improbable With a new section On Robustness and Fragility (Nassim Nicholas Taleb)