Learning from the Behavior of Others - Conformity, Fads, and Informational Cascades

Sushil Bikhchandani, David Hirshleifer and Ivo Welch

INTRODUCTION
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Reports of actions or endorsements often influence the reactions and purchases of others
o Bestseller lists, claques, professional mourners, restaurant seating
Main argument:
o Learning by observing the past decisions of others can help explain some otherwise
puzzling phenomena about human behavior () and the theory of observational
learning has much to offer economics and business strategy.
Questions:
o Why do people tend to converge on similar behavior, i.e. herding?
o Why is mass behavior prone to errors and fads?
The human predisposition to imitate
o Given freedom, people usually imitate each other
o Evolutionary adaptation that has promoted survival use accumulated information
of generations before
People make similar choices because:
o They face similar decision problems, i.e.
They have similar information,
They face similar action alternatives,
They face similar payoffs
Exceptions:
o Opposing tastes can lead to opposing actions even if information is similar, i.e.
vegetarians and meat eaters
How do individuals determine which alternative is better?
o Direct analysis of the alternatives costly and time-consuming
o Rely on the information of others less initial cost observational/social learning
Other possible causes of conformity may exist which do not require great similarity in
individuals decision problems but offer positive payoff externalities:
o driving on the right side, wear fashionable clothing, sanctions upon deviants

A MODEL FOR OBSERVATIONAL LEARNING

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Observable Actions versus Observable Signals

o Observable signals
Individuals can observe both the actions and signals of predecessors
Information signals enter the pool of public information one at a time as
individuals arrive
all past signals are publicly observed
information keeps accumulating
individuals with same payoffs eventually settle on the correct
choice
o Observable actions
Individuals can observe (only) the actions but not the signals of their
predecessors
Individuals often converge on the same wrong action, i.e. lower payoff
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Learning from the Behavior of Others - Conformity, Fads, and Informational Cascades
Sushil Bikhchandani, David Hirshleifer and Ivo Welch

Idiosyncratic behavior error-prone choices of a few early individuals

determine the choices of all successors
Order of Information, Noise, and Information Externalities
o Why is the outcome from observable-actions so different from the observablesignals benchmark?
Because once a cascade starts, public information stops accumulating
private signals of subsequent individuals are being ignored
o Cascades start when information in the history of predecessors actions outweighs an
individuals private signal
o The order in which signals arrive matters greatly in observable-actions scenario
results are path-dependent
HHLL all individuals adopt
LLHH all individuals reject
HLLH probability of that Clarence begins a Up cascade
o Cascades are very likely after just 2 individuals! (observable-actions) approx. 75%
HH
0.2601
= 0.51 x 0.51
HL, coin toss 0.12495
= 0.51 x 0.49 x 0.5
LL
0.2401
= 0.49 x 0.49
LH, coin toss 0.12495
= 0.49 x 0.51 x 0.5
o In contrast, the probability of offsetting occurring is very small 0.004 after 8
players
o What is the probability of a cascade being correct?
Assuming V=1 0.513
= 0.38505/(0.38505 + 0.36505)
Up cascade
0.38505
= 0.2601 + 0.12495
Down cascade 0.36505
= 0.2401 + 0.12495
o In contrast, the probability of making the correct decision without observation at all
is 51 %, just 0.3% less than with action-observation!
Fragility
o Cascades are fragile and shatter easily when exposed to shocks such as
The arrival of better informed individuals
The release of new public information
Shifts in the underlying value of adoption versus rejection
o Spock example 2 signals
Informativeness of Past Actions
o Summary statistics may be misleading!
Sales statistics may leave out the order in which individual purchased goods
o The number of predecessors one can observe is relevant!
In agriculture one often just looks at the immediate neighbors for reference
o Cascades are less likely the more action alternatives there are!
As the set of alternatives becomes larger and richer, cascades tend to take
longer to form and aggregate more information
Differing Information Precision: Fashion Leaders
o Example of Aaron and Barbara:
Several neighbors decide between a Ford and a Toyota
Aaron, a car mechanic, buys first
His choice will be imitated because other people consider his expertise
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Learning from the Behavior of Others - Conformity, Fads, and Informational Cascades
Sushil Bikhchandani, David Hirshleifer and Ivo Welch

Aaron becomes a fashion leader

o This I probably part of what underlies the success of product endorsements by
athletes about sports products / apparel / shoes / etc.
o To counteract this phenomenon judges might have to speak in inverse order of
seniority or rank (in military)
Differing Preferences and Payoffs: To Each His Own
o Differing preferences, payoffs and types may cause learning to be confounded
because individuals do not know what to infer from the mix of preceding actions
o Example: software writer and Java platform
Signal realization
Heterogeneous preferences
Heterogeneous payoffs
Imperfect rationality
o A later individual cant be sure why she has adopted early actions of early decision
makers are more noisy as indicators of their signals
Changing Tastes or Payoffs
o Payoff changes may lead to behavior changes without an apparent reason
o Faddish nature
Timing Choice and the Explosive Onset of Cascades
o The timing of sudden changes is usually unpredictable
o Higher precision individuals may trigger them as they have less to gain from waiting
to see the actions of informational inferiors
o Actions of other may be deferred until they see a trend
Costly Information, Alternative Information Sources, and Network Externalities
o Cascades may form instantly if information acquisition has a cost
Barbara may not want to pay the cost of investigation to acquire knowledge
but would rather just follow Aarons lead
o Cascades may even form if additional sources of information are available
The payoff of alternative A is visible to all but alternative Bs payoff is
invisible but in the end it turns out superior cascading on A more likely
o Cascades provide informational externalities (about the value of adoption) but also
network externalities
Joining a network may benefit both the joiner and others who have already
joined
Efficiency
o Discreet nature of decision causes inefficiencies
solution: trade in information
but: transaction costs
o third party (such as government) as a mitigation of cost
o other less centralized solution: communities and networks, internet
o Opposing effect: improved communication helps individuals learn about the actions
of others which might lead to a reduced incentive to gather information cascades
start sooner

Learning from the Behavior of Others - Conformity, Fads, and Informational Cascades
Sushil Bikhchandani, David Hirshleifer and Ivo Welch

APPLICATIONS
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Laboratory Experiments
o Provide cleanest tests of social learning theories
Controls minimize potentially confounding affects
Business Strategy
o Imitation vs. differentiation hypothesis
Cascades theory suggests imitation
Differentiation suggests less competition and more profit
o Example: TV shows
ABC, NBC, and CBS imitate each other successfully
o Example: large firms as fashion leaders, small ones as followers
o Example: Opening of a new branch by a bank information based imitation (banks
observe each other and where rivals already have branches)
Consumer Marketing
o Bestseller example
o Early adoption induced by low price may help start a positive cascade
o Underprices IPOs may lead to a positive cascade
Crime and Enforcement
o The decision to commit a crime is influenced by the environment
News of kidnappings, assassinations, hijackings, and serial murders may lead
to a cascade
Neighborhood
o Broken windows theory (or other social disorder sign, graffiti etc.)
People observe signs of criminality cascade of rule breaking
Politics
o Informational cascades in politics may be triggered by observing:
Public protests, demonstrations, riots, polls, voting results
o Historical example of East Germany
Medical (Mal)practice
o Medical treatments are (historically) prone to informational cascades
Doctors cannot stay fully informed about relevant medical research advances
in all areas
Bleeding, hysterectomy, tonsillectomy

CONCLUDING REMARKS
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Herd behavior is fragile

o Cascades are triggered by a small amount of information
o These include mixtures of:
informational effects, sanctions against defectors, network externalities,
preference effects
o discreteness or boundedness of possible action choices are realistic assumptions
Convergence arises locally or temporally upon a behavior, and can suddenly shift into
convergence on the opposite behavior
Examples include: fixation on wrong technologies, stock market crashes, sharp shifts in
investment and unemployment, bank runs, election outcomes
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