An information cascade is a situation where each person makes a decision/choice based on the observations or choices of others while ignoring his own personal information. Information cascade is a theory used in the field of behavioral economics as well as other social sciences. Informational cascades can be observed in various scenarios including financial markets, politics, and business strategies.

How an Information Cascade Works

Information cascades generally develop when there is no direct verbal communication between individuals.

A basic information cascade can be formulated as follows:

  • Let's assume for example that there are four individuals, M, N O, P. They are faced with two choices — either accepting (value = 1) or rejecting (value = 0). Each individual sequentially makes his or her choice.
  • M is the first decision maker, and as such, has no public information. He will make the decision based on his personal information. Let’s suppose he accepts (value = 1).
  • Now, N will have his own personal information, as well as the public observation that M accepted. Hence, he may choose to either accept or reject based on his conviction on both personal and public knowledge. For simplicity’s sake, let’s assume he accepts (value = 1).
  • Now let’s assume that O would ignore his personal information signal and simply accept (value = 1), since both of the previous actors did the same. This will result in formation of an informational cascade. O would add no additional information to the cascade as he is just imitating previous actors.
  • P will observe the choices of the previous actors and imitate them by choosing the same (value =1).
  • When an informational cascade leads to a correct outcome, it is generally referred to as an up cascade. Similarly, a path leading to wrong outcomes or rejection are called down cascades. 
  • The Bayesian probability formula can be used to calculate the probability of N making a choice after M has already made his decision.

Key Characteristics of an Information Cascade

Herd Behavior

After a point, very little new information is added to the cascade, and individuals just imitate others based on the premise that such a large number of people cannot be wrong. This is referred to as herd behavior. However, this imitation can lead to erroneous behavior on a massive scale.

Fragility

Information cascades are generally very brittle by nature, as individuals may be reacting only to hearsay and public observation. Any new public information or a more precise information source can change the actions, as well as directions of the cascade.

Disappearance of Information Externality

When an individual makes a public decision based on his own private information and commits an error, this is known as “information externality” and can be added to the public's knowledge.  But when decisions are taken based on past actions and by ignoring personal choices, there is no information to add to the public’s knowledge base.

Information Cascades in the Real World

Infants

Babies often try to imitate the adults around them. They mimic the actions and the facial expressions of adults. This is how they learn about what certain actions signify. Similar patterns can be observed in the mating habits of various animals. Human beings have survived, evolved, and thrived mainly on the powers of observation and information cascades.

Marketing

The daily consumption of products today, be it cereals, smartphones, or the restaurant that you pick for dinner, is generally based on a cascade of information from the surrounding environment. Digital marketing of products is a great example of a clever use of the cascade. Online reviews are another way for informational cascades to develop. With the increasing penetration of review aggregators, people often use what is recommended by others, rather than trying something out.

This is based on the premise that the general public, on the whole, will make the correct decision even though individual preferences vary.

Business Strategy

A lot of times it is observed that competitors within an industry also play the imitation game, even though this contradicts the general economic principle of “entering markets with less competition.” For example, look at the pattern of discounting in the retail industry. Everybody follows the first discounter, as nobody wants to trail the competition. Implicitly, every competitor thinks that the other might have better information about people’s choices, demographics, and recent fads.

How Cascades Affect Financial Markets

There are various stock market gurus that recommend various stocks. People religiously follow the regulatory fillings of marquee investors and imitate them. The average guy thinks that the financial pundit has more knowledge and information than he does and imitates the pundit’s stock picks.

Maybe that guy’s neighbor observes him boasting about his stock picks and so the neighbor also takes the plunge. This starts an information cascade where every participant has very little information about his decision-making. Hence, it is very important that the initial source in an information cascade is a very reliable and knowledgeable person. Otherwise, it may cause great financial harm in the long run.

The Bottom Line

Having knowledge about information cascades may not lead to direct monetary benefits to any individual. But knowing about this behavior and avoiding it, can save the individual from various bad decisions.

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