Hi There,
Welcome to the 2nd issue of “Tap to Unlock”, where I write about economics, finance, & strategy. And help you build a better perspective. Today I want to talk about information cascading. An interesting but often overlooked concept. It’s interesting to see how often we ignore our own opinion in making a decision. Without wasting much time let’s dive deep and enjoy.
An informal definition of Information Cascade
An information cascade is a situation in which an individual makes a decision based on observation of others without regard to his private information.
In marketing, cascades arise from the information surrounding a product or service. If a product has great reviews by thousands of reviewers, then people are most likely going to buy the product since so many other people have bought the product and left great reviews.
In finance, if a lot of people are buying a particular stock, they will think that those people know something they don’t. People investing in the same stocks as top investors lead to a cascade of people all buying the same stock. Robinhood traders buying airline stocks and cashing in. Or rise in share price in Hertz stock.
A more technical example
For example, Most of us have been in a situation where we have to choose between two restaurants that are both more or less unknown to us. Consider a situation where 100 people are all facing such a choice. There are two restaurants A and B that are next to each other, and it is known that the prior probabilities are 51 percent for restaurant A being the better and 49 percent for restaurant B is better. People arrive at the restaurants in sequence, observe the choices made by the people before them, and decide on one or the other of the restaurants. It is assumed that each person's signal is of the same quality.
Suppose that of the 100 people, 99 have received signals that B is better but the one person whose signal favors A gets to choose first. The first person will go to A. The second person will now know that the first person had a signal that favored A, while her signal favors B. Since the signals are of equal quality, they effectively cancel out, and the rational choice is to go by the prior probabilities and go to A. The second person thus chooses A regardless of her signal. Her choice, therefore, provides no new information to the next person in line: the third person's situation is thus the same as that of the second person, and she should make the same choice and so on. Everyone ends up at restaurant A even if, given the aggregate information, it is practically certain that B is better. To see what went wrong, notice that if instead, the second person had been someone who always followed her signal, the third person would have known that the second person's signal had favored B. The third person would then have chosen B, and so would have everybody else.
The above example is taken from Abhijit Banerjee’s paper “A simple model of Herd Behavior“, He is an American economist who is currently the Ford Foundation International Professor of Economics at MIT.
Though people are imitating the actions of others, it isn’t mindless imitation. Rather it is phenomena of drawing rational inferences with limited information. But imitation can also occur due to social pressure and it is difficult to distinguish the two of them.
For example, an experiment performed by Milgram, Bickman, and Berkowitz in the 1960s where one person on a street corner and stare up into the sky they observed that with only one person looking up, very few passersby stopped. When 5 people were staring up into the sky, then more passersby stopped, but most still ignored them. And finally, when 15 people were looking up, they found that 45% of passersby stopped and also stared up into the sky.
They interpreted these results as demonstrating a social force that grows stronger as the group conform to the activity (looking up) become larger or it could be that initially, the passersby saw no reason to look up as they had no information that suggested it was necessary, but with more looking up, future passersby may have rationally decided that there was good reason to also lookup since perhaps those looking up knew something that the passersby didn’t know.
Key Features
Cascades can be Fragile: A key characteristic of information cascades is that they are fragile. Many small changes can end a cascade. Too many memes of Robinhood traders beating Warren Buffet led to a massive selloff and a fall in the stock market.
Cascades can be wrong: Cascades can be wrong becuase they are based on decisions of earlier consumers and not how satisfied they actually were with their choice
Cascades can be based on very little information: Since people ignore their private information once a cascade starts, only the pre-cascade information influences the behavior of the population. This means that if a cascade starts relatively quickly in a large population, most of the private information that is collectively available to the population in the form of private signals isn’t being used.
Cascades v/s Wisdom of the Crowd
The 2nd feature of cascades, that they can be wrong, makes an interesting argument against the concept of the wisdom of the crowd which says that the aggregate behavior of many people with limited information can produce accurate results. So, how can cascades be wrong?
Well, the wisdom of the crowd assumes people make decisions independently meaning they don’t know what others have guessed whereas in cascades people see the earlier guesses of others and then make their decision.
Cascades and Herd Behavior
Smith and Sørensen in their research paper emphasize that there is a significant difference between them. An informational cascade is said to occur when individuals ignore their private information when making a decision, whereas herd behavior occurs when individuals make an identical decision, not necessarily ignoring their private information. Thus, an informational cascade implies a herd but a herd is not necessarily the result of an informational cascade.
Tweetable Remarks
Information Cascade is a situation in which an individual makes a decision based on the observation of others without regard to his private information.
Information Cascades v/s the wisdom of the crowd. The wisdom of the crowd assumes people make decisions independently. In cascades, people see the earlier guesses of others and then make their decision.
In marketing, cascades arise if a product has great reviews by thousands of reviewers, then people are most likely going to buy the product since so many other people have bought the product and left great reviews.