The concept of informational cascades seems to have a large following in academic circles. It is such an attractive idea because it offers a rational explanation for what appears to be irrational “herd-like” behavior. Information cascade theory is used to describe a situation in which an individual makes a decisions based on the actions of other people rather than on personal but incomplete information. While gaining popularity in political science, economics, sociology, and other scholarly fields there is some criticism of cascade theory and its implications. One such critic, a private equity professional and blogger who goes by the name Private Equity, argues in a post called “Cascades are a Poor Excuse for Stupidity” that scholars are taking cascade theory too far and rationalizing human stupidity. Private Equity writes:

It strikes me as quite tortured to label a market actor who possesses so little actual information about the contemplated transaction that he or she might be caught up in a cascade as “rational.” Particularly where, as here, the costs of an erroneous decision are extremely high and the decision is not forced.

When conducting research in the field of informational cascades one has to be careful about how one defines rationality. More importantly, one cannot discount the agency of the individual in making his or her choice.

There are political implications in informational cascade theory that have not been explored in class yet and I hope they will. If we assume that individuals caught up in the cascade were rational then they are not to blame for their loss in the event of a negative outcome. Private Equity argues that people will thus argue for bailouts and forms o government intervention to cover their mistakes. We see this logic in the wake of the housing market bubble. Investors and homeowners are asking politicians, banks, and presidential hopefuls to be bailed out from their poor investment. Informational cascades theory seems to provide us with a useful analytical tool but according to classical economic theory there is nothing strange about agents in a market trying to exploit a new opportunity. Whether it be a short line at the grocery store’s check-out counter, a profitable business endeavor, or investment in a specific stock people will continue to rush in until all an equilibrium is reached.

http://equityprivate.typepad.com/ep/2008/03/cascades-are-a.html