In class we talked about how informational cascades and the herding effect can either go well or completely disastrous just by the simple observation of another person’s decision. In this article, Robert Schiller explains how real estate housing bubbles are largely affected by the IC theory.
People are influenced by the decisions and outcomes of other people. An example given in the article talks about investing in the housing market. If houses are of low value and a person decides to invest in an expensive house, this influences others to invest in houses too since then they will believe houses are a good investment. The next person is ignorant of the housing market and prices, but because of the first person’s decision, he makes a rational decision to buy a house as well. Now that two people have bought houses, other friends, family, acquaintances will begin purchasing houses at low prices and even very high prices. Their information about the housing market is restricted to the opinions of the housing investors. Thus, a housing bubble is created. People buy houses because they “think” it’s a good time to invest according other people, realtors end up selling many houses, and then a decline takes place when people begin to think the time frame for investing is “bad.” Following the cascade in investing in houses, a downfall cascade occurs when people stop investing in houses.
Furthermore, studies from Mr. Bikhchandani and his co-authors showed “that the probability of the cascade leading to an incorrect assumption is 37 percent. … Thus, we should expect to see cascades driving our thinking from time to time, even when everyone is absolutely rational and calculating.”