This is an excellent primer of the sub-prime crisis using champagne flutes to explain how it all went wrong. He also mentions the role of ratings agencies which should be considered in terms of herding and independence (or lack thereof) as discussed in chapter three of The Wisdom of Crowds.
To learn how the pension fund manager from a Norwegian village got caught up in this mess watch the slide show on the subprime crisis (some of the language may not be to everyone's tastes):
In class we looked briefly at some models of demand which are discussed in part III of chapter 3 of The Wisdom of Crowds. These would not come under the traditional textbook view of demand from the model of supply of demand. We looked at three
The readings are available in Section 3D. Elements of all three can be seen in this clip from 1994 film, The Hudsucker Proxy.
Quoting from The Wisdom of Crowds (part III of chapter 3):
"...the fundamental problem with an information cascade is that after a certain point it becomes rational for people to stop paying attention to their own knowledge - their private information - and to start looking instead at the actions of others and imitate them. (If everyone has the same likelihood of making the right choice, and everyone before you has made the same choice, then you should do what everyone else has doneBut once everyone stops relying on his own knowledge the cascade stops becoming informative. Everyone thinks that people are making decisions based on what they think the people who came before them knew. Instead of aggregating all the information individuals have, the way a market or voting system does, the cascade becomes a sequence of uninformed choices, so that collectively the group ends up making a bad decision - spending all that money on plank roads. That original model is far from the only theory of how cascades work, of course. In The Tipping Point, for instance, Malcolm Gladwell offered a very different account, which emphasized the importance of individuals - what he called mavens, connectors and salespeople - in spreading new ideas. In Bikhchandandani, Hirshleifer, and Welch's model of cascades, everyone has as much private information as everyone else. The only thing that made the early adopters of a product more influential was the fact that they were early, and so their actions were the ones that everyone who came after them observed. In Gladwell's world, some people are far more influential than others, and cascades (he writes of them as epidemics) move via social ties, rather than being a simply matter of anonymous strangers observing each other's behaviour. People are still looking for information, but they believe that the ones who have it are the mavens, connectors and salesmen (each of whom has a different kind of information). Do cascades exist? Without a doubt. They are less ubiquitous than the restaurant-going model suggests, since as Yale economist Robert Shiller has suggested, people don't usually make decisions in sequence. "In most cases," Shiller writes, "many people independently choose their action based on their own signals, without observing the actions of others." but there are plenty of occasions when people do closely observe the actions of others before making their own decisions. In those cases, cascades are possible, even likely. That is not always a bad thing. For instance, one of the most important and valuable innovations in American technological history was made possible by the orchestrating of a successful information cascade.
You can refer to the book to continue the story of this development. How does the cascade in The Hudsucker Proxy develop? Clearly the traditional model of supply and demand is of little use as cutting the price to almost zero does nothing to stimulate demand (Law of demand: when price falls quantity demanded rises). Is the little boy in the clip a maven?
Only watch this if you have eight minutes to waste! Otherwise read below.
To understand the experiment it's probably just enough to read this from The Wisdom of Crowds:
In 1968, the social psycologists Stanley Milgram, Leonard Bickman, and Lawrence Berkowitz decided to cause a little trouble. First they put a single person on a street corner and had him look up at an empty sky for sixty seconds. A tiny fraction of the passing pedrestrians stopped to see what the guy was looking at, but most just walked past. Next time around, the psychologists put five skyward-looking men on the corner. This time, four times as many people stopped to gaze at the empty sky. When the psychologists put fifteen men on the corner, 45 percent of all passers by stopped, and inceasing the cohort of obervers yet again made more than 80 per cent of pedestrians tilt their heads and look up. This study appears at first glance, to be another demonstration of people's willingness to conform. But in fact it illustrated something different, namely the idea of "social proof", which is the tendency to assume that if lots of people are doing something or believe something, there must be a good reason why. This is different from conformity: people are not looking up at the sky because of peer pressure or a fear of being reprimanded. They're looking up at the sky because they assume - quite reasonably - that lots of people wouldn't be gazing upward if there weren't something to see. That's why the crowd becomes more influential as it becomes bigger: every additional person is proof that something important is happening. And the governing assumption seems to be that when things are uncertain, the best thing to do is just to follow along. This is actually not an unreasonable assumption. After all, if the group usually knows best (as I've argued it often does), the following the group is a sensible strategy. The catch is that if too many people adopt that strategy, it stops being sensible and the group stops being smart.
