We are in the midst of the subprime mortgage crisis, and the housing bubble has burst. People are placing blame on many variables - from the predatory practices of mortgage lenders, unscrupulous analysts, to lack of regulation in the markets - but could the housing bubble have come from the idea of information cascades?

The idea is very simple, and very similar to the examples used in class. Individuals in a group are looking to spend their money and are deciding whether or not they should buy some property/real estate. Let’s say that each individual’s information is useful, but not definitive, and not clear enough to make concrete decisions as to whether or not there is a housing bubble. Now each individual makes decisions sequentially (i.e. no one enters Town Hall Meetings to buy property) and reveals their decisions by actions - in this case, bidding on a house and rising the price.

Now suppose houses are low in value. Person 1 makes a wrong decision and bids on the house and raises the price. Person 2 faces no problem if his own information validates Person 1’s decision to pay a high price. He faces a problem if his beliefs contradict with Person 1’s, in which case he would conclude that he has no worthwhile information and must make an arbitrary decision - by flipping a coin per se.

The result is that now 2 people could be making a bad decision by raising the price. As others make purchases at rising prices, more and more people will conclude that these buyers’ information about the market outweighs their own. This is akin to the housing bubble.

Information cascades gives us insight into how rational people can make irrational decisions. Were all these people stupid? It can’t be. They were just caught up in the bubble and the information cascade.

Link: http://www.ohio.com/editorial/commentary/16246947.html?page=1&c=y