Information Cascade Experiments

The theoretical literature on "herding" pertains to situations where people with private, incomplete information make public decisions in sequence. Hence, the first few decision makers reveal their information, and subsequent decision makers may follow an established pattern even when their private information suggests that they should deviate. This type of "information cascade" can occur with perfectly rational individuals, when the information implied by early decisions outweighs any one person's private information. These theories have been used to explain fads, investment line for a movie or restaurant may be enough to lure additional customers, even if they have heard mixed reviews from other sources. Economists are particularly interested in market implications of herding behavior, e.g., the possibility that investment booms and busts are analogous to information cascades. This paper surveys the results of experiments designed to evaluate cascade behavior with human subjects, both in simple "ball-and-urn" settings and in more complex, asset-market environments. The concept of an information cascade can be explained in the context of a specific numerical example that was used in initial laboratory experiments (Anderson and Holt, 1997). In this example, there are two states of nature, A and B, which are equally likely, ex ante. Each decision maker obtains an independent, private signal, "a" or "b," which has a two-thirds chance of indicating the correct state, i.e. Pr(a|A) = Pr(b|B) = 2/3. The decision makers are selected in sequence and asked to predict the state, with a monetary reward paid for a correct prediction. The predictions are publicly announced as they are made, but individuals are not able to observe others' private signals. The first person in the sequence must predict only on the basis of private information. This person should predict the state indicated by the signal because, with a prior probability of 1/2 for each state, the posterior probability is 2/3 for the state that is signaled: