DP5219 Signal Accuracy and Informational Cascades

Author(s): Tuvana Pastine, Ivan Pastine
Publication Date: September 2005
Keyword(s): herding, social learning
JEL(s): D80, D82
Programme Areas: Industrial Organization
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=5219

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.