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Aggregate Uncertainty Can Lead to Herds

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  • Ignacio Monzón

Abstract

This paper presents a model in which homogeneous rational agents choose between two competing technologies. Agents observe a private signal and a sample of other agents’ previous choices. The signal has both an idiosyncratic and an aggregate component of uncertainty. I derive the optimal decision rule when each agent observes the decision of exactly two agents. Due to aggregate uncertainty, aggregate behavior does not necessarily reflect the true state of nature. Nonetheless, agents still find others’ choices a good source of information, and they base their decisions partly on the behavior of others. Consequently, bad choices can be perpetuated in this environment: I show that aggregate uncertainty can lead to agents herding on the inferior technology with positive probability. I also present examples in which herding occurs for arbitrarily large sample sizes.

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Bibliographic Info

Paper provided by Collegio Carlo Alberto in its series Carlo Alberto Notebooks with number 245.

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Length: 29 pages
Date of creation: 2012
Date of revision:
Handle: RePEc:cca:wpaper:245

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Keywords: observational learning; social learning; word-of-mouth; herding;

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  1. Karl H. Schlag, . "Why Imitate, and if so, How? A Bounded Rational Approach to Multi- Armed Bandits," ELSE working papers 028, ESRC Centre on Economics Learning and Social Evolution.
  2. Ellison, Glenn & Fudenberg, Drew, 1993. "Rules of Thumb for Social Learning," Scholarly Articles 3196332, Harvard University Department of Economics.
  3. Banerjee, Abhijit V, 1992. "A Simple Model of Herd Behavior," The Quarterly Journal of Economics, MIT Press, vol. 107(3), pages 797-817, August.
  4. Bikhchandani, Sushil & Hirshleifer, David & Welch, Ivo, 1992. "A Theory of Fads, Fashion, Custom, and Cultural Change in Informational Cascades," Journal of Political Economy, University of Chicago Press, vol. 100(5), pages 992-1026, October.
  5. K. Schlag, 2010. "Why Imitate, and if so, How? Exploring a Model of Social Evolution," Levine's Working Paper Archive 454, David K. Levine.
  6. Fudenberg, Drew & Ellison, Glenn, 1995. "Word-of-Mouth Communication and Social Learning," Scholarly Articles 3196300, Harvard University Department of Economics.
  7. Patrick Bolton & Christopher Harris, 1999. "Strategic Experimentation," Econometrica, Econometric Society, vol. 67(2), pages 349-374, March.
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