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Signal Accuracy and Informational Cascades

  • Pastine, Ivan
  • Pastine, Tuvana

In an observational learning environment, rational agents with incomplete information may mimic the actions of their predecessors even when their own signal suggests the opposite. This herding behaviour may lead the society to an inefficient outcome if the signals of the early movers happen to be incorrect. This paper analyses the effect of signal accuracy on the probability of an inefficient informational cascade. The literature so far has suggested that an increase in signal accuracy leads to a decline in the probability of inefficient herding, because the first movers are more likely to make the correct choice. Indeed, the simulation results in Bikhchandani, Hirshleifer and Welch (1992) support this proposition. This paper however shows this not to be the case in general. We present simulations that demonstrate that even a small departure from symmetry in signal accuracy may lead to non-monotonic results. An increase in signal accuracy may result in a higher likelihood of an inefficient cascade.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5219.

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Date of creation: Sep 2005
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Handle: RePEc:cpr:ceprdp:5219
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  1. Choi, Chong Ju & Dassiou, Xeni & Gettings, Stephen, 2000. "Herding Behaviour and the Size of Customer Base as a Commitment to Quality," Economica, London School of Economics and Political Science, vol. 67(267), pages 375-98, August.
  2. Lee Nelson, 2002. "Persistence and Reversal in Herd Behavior: Theory and Application to the Decision to Go Public," Review of Financial Studies, Society for Financial Studies, vol. 15(1), pages 65-95, March.
  3. Pastine, Tuvana, 2005. "Social Learning in Continuous Time: When are Informational Cascades More Likely to be Inefficient?," CEPR Discussion Papers 5120, C.E.P.R. Discussion Papers.
  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. Scharfstein, David S & Stein, Jeremy C, 1990. "Herd Behavior and Investment," American Economic Review, American Economic Association, vol. 80(3), pages 465-79, June.
  6. Gale, D. & Chamley, C., 1992. "Information Revelation and Strategic Delay in a Model of Investment," Papers 10, Boston University - Department of Economics.
  7. Zvika NEEMAN & Gerhard O. OROSEL, 1997. "Herding and the Winner's Curse in Markets with Sequential Bids," Vienna Economics Papers vie9711, University of Vienna, Department of Economics.
  8. Welch, Ivo, 1992. " Sequential Sales, Learning, and Cascades," Journal of Finance, American Finance Association, vol. 47(2), pages 695-732, June.
  9. Kennedy, Robert E, 2002. "Strategy Fads and Competitive Convergence: An Empirical Test for Herd Behavior in Prime-Time Television Programming," Journal of Industrial Economics, Wiley Blackwell, vol. 50(1), pages 57-84, March.
  10. Devenow, Andrea & Welch, Ivo, 1996. "Rational herding in financial economics," European Economic Review, Elsevier, vol. 40(3-5), pages 603-615, April.
  11. Avery, Christopher & Zemsky, Peter, 1998. "Multidimensional Uncertainty and Herd Behavior in Financial Markets," American Economic Review, American Economic Association, vol. 88(4), pages 724-48, September.
  12. De Vany, Arthur & Lee, Cassey, 2001. "Quality signals in information cascades and the dynamics of the distribution of motion picture box office revenues," Journal of Economic Dynamics and Control, Elsevier, vol. 25(3-4), pages 593-614, March.
  13. Anderson, Lisa R & Holt, Charles A, 1997. "Information Cascades in the Laboratory," American Economic Review, American Economic Association, vol. 87(5), pages 847-62, December.
  14. Angela A. Hung & Charles R. Plott, 2001. "Information Cascades: Replication and an Extension to Majority Rule and Conformity-Rewarding Institutions," American Economic Review, American Economic Association, vol. 91(5), pages 1508-1520, December.
  15. Banerjee, Abhijit V, 1992. "A Simple Model of Herd Behavior," The Quarterly Journal of Economics, MIT Press, vol. 107(3), pages 797-817, August.
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